Where should you invest in private equity today?
Fund raising for private equity deals soared by more than 40% to a new record in 2017, as investors sought out lower volatility, higher returns and diversification away from traditional asset classes. But such popularity can pose its own challenges, if too much money chases too few deals.
Intuitively, it is easy to see that fund raising volumes and future performance may be related. Increased fund raising leads to increased “dry powder” – money raised but not yet deployed – tougher competition for deals, higher prices and lower subsequent returns. The reverse is also true, with slack periods for fund raising often foreshadowing better performance. Clearly, other factors matter too, not least the broader economic and financial market environment but, as Figure 1 shows, the relationship has been reasonably consistent over time.
Figure 1: Increased fund raising has led to lower returns
Source: Preqin, Schroder Adveq, 2018. Fund raising amount has been de-trended and inflation adjusted.
Past performance is not a guide to future performance and may not be repeated
Where are the opportunities?
Our proprietary Schroder Adveq Fund Raising Indicator (Schroder Adveq FRI) was developed to help tie down the fund raising/returns relationship. It has had a negative correlation with vintage year performance (correlation coefficient of -0.4) and has been a leading indicator for long-term (5-10 years) performance. A high figure has been associated with poor future returns and a low figure with stronger returns. Used in this way, it can identify areas of the market that are better placed to deliver returns and those where caution is required.
Right now, it is flagging a divided market. In terms of realisations, it is suggesting that investors should accelerate exits in the large buyout, late-stage venture/growth and Chinese renminbi-denominated strategies. For new investments, however, it points to more favourable conditions in small and mid-sized buyouts, early-stage venture and in certain emerging markets (Figure 2).
It should not, however, be relied on in isolation. Although robust regression techniques are used to estimate the long-term trend, data limitations mean that relatively few data points underpin the analysis and the parameters of the regression analysis may change as new data are received. Furthermore, some of the assumptions may prove unrealistic and the return data can be incomplete and subject to biases. Notwithstanding these reservations, the intuitive underlying rationale for the relationship between fund raising and future returns provides a degree of confidence about the predictive power of the Schroder Adveq FRI.
Within the buyout market, the indicator confirms that fears of overheating in the large buyout market appear justified, although things are not as stretched as they were before the financial crisis. In contrast, fund raising in the small/mid market has been relatively stable over time. This stability is underpinned by the fact that more established small/mid buyout managers tend to migrate towards larger funds and larger buyouts. Their replacement by newer managers, who tend to run smaller funds, acts as a natural stabiliser of fund raising volumes in the small/mid sector.
Figure 2: Some areas of the global private equity market are much more popular…
Source: Schroder Adveq, 2018
Similarly, fund raising for late stage venture/growth capital is at an extreme, but earlier stage investments are more favourably positioned. Fund raising volumes here have been well contained and healthy new company creation rates are driving a steady increase in deal prospects.
There is a different sort of bifurcation in Asia, particularly China (Figure 3). The Chinese US dollar market looks in good shape, as do India and the rest of Asia ex-China, but the Chinese renminbi market has experienced rapid expansion. Recent fund raising volumes here have been large. Chinese RMB investors need to be especially discriminating when making new investments. Helpfully for overseas investors, who can access the US dollar but generally not the renminbi market, there is little overlap. They may therefore be better served by focusing on those parts of the market where there is low or no competition with the RMB universe.
Figure 3: …as are some emerging private equity markets
Source: Schroder Adveq, 2018
For the brave, Brazil could present an intriguing contrarian opportunity. Fund raising has collapsed, but any investment is high risk given the economic backdrop, so especially careful due diligence and fund selection are imperative.
We plan to update the Schroder Adveq FRI on an annual basis and publish it to help investors’ decision-making. While helpful in terms of top-down signals, investors should always remember that major performance differences will always exist across private equity funds, so bottom-up considerations are paramount.
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