July 16, 2014
Interviewed by: Tom Franco
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The Seven Biggest Challenges Facing PE

Altius Partners’ Eric Warner tells Privcap about the major issues facing the private equity sector, as identified by Altius’ Dr Richard Charlton, in a new research report. Co-investment and the outlook for growth markets, Europe, secondaries and infrastructure are areas of concern, says Warner.

Altius Partners’ Eric Warner tells Privcap about the major issues facing the private equity sector, as identified by Altius’ Dr Richard Charlton, in a new research report. Co-investment and the outlook for growth markets, Europe, secondaries and infrastructure are areas of concern, says Warner.

The Seven Biggest Challenges Facing PE

With Eric Warner of Altius

Tom Franco, CD&R:

We’re here with Eric Warner, co-CEO of Altius, to discuss a new report issued by the firm that discusses some of the challenges—seven challenges, to be precise—the private equity world will confront. At the top of the list is co-investment. Eric, what are your thoughts on co-investment and what LPs should be looking for?

Eric Warner, Altius:

Thanks, Tom. Thanks again. It’s great to be here.

You’re right. This report we issue annually. And there is a fair bit on co-investment as one of the challenges. This is the praci in this report for a much larger white paper the firm has also recently published, authored by Dr. William Charlton, who heads our U.S. investment business. Basically, this sought to take a sample of realized investments we had in our portfolio—just short of 900, ranging from 1979 to about 2010. It’s a wide range of economic cycles and situations.

Looking at potential co-investment portfolios from those realized deals in sizes of five, 10, and 20, looking at the average IRR those would’ve produced. Then, attaching a Monte Carlo simulation engine to it, running through 10,000 simulations, just to see what the likely return might’ve been over that range period.

Essentially, it concluded that this was both buyout and growth deals, about two to one—two-thirds buyout and one-third growth. Basically, there was no scenario where the average of the growth was a good investment. The average return was about -8%.

The buyout did a bit better. The average return over all that analysis was about 14%.

Franco: Do you have a sense that LPs are getting too comfortable with the idea of investing alongside their key GP relationships?

Warner: No, I don’t think we get that. This is a trend that’s been growing. A lot of the LPs who are doing it have been investing in funds over many cycles and now want to go to that next step. And, frankly, there are very good reasons to be doing it, as you know.

There are some interesting operational challenges, though, which the report also picks up. They are that, as you know, co-investments happen within a very short, concentrated timeframe. It’s more like a corporate-finance transaction. It’s not over a one- to two-year fundraising. Many institutional investors are not geared up to do things that rapidly. It doesn’t fit into nice quarterly board meetings and preparing the rec and going through the process. You really need to be prepared. You need to have skilled, trained people who can do it and who can respond quickly. We’re seeing this develop as a trend as well.

Franco: Switching gears, another trend the report identifies is emerging-market exposure. Clearly, LPs in a slow-growth world are seeking ways to enhance their exposure to growth markets, even frontier markets.

Warner: This is a mistake that’s been many times in the past. The equation of GDP growth does not equate to good private equity returns. Most of those emerging markets, for example, only offer growth capital, which is much slower to mature to develop to the point of exit. Frequently, the GP doesn’t have total control over the exit decision. We’ve seen a lot of LPs who are disappointed with their emerging market portfolios, particularly the pace of realizations.

Franco: There seems to be some concern about Asia, which comes in and out of favor. Can you apply any corrective context?

Warner: We’ve seen the steady emergence of a select number of managers, primarily in developed Asia—comprising Japan, Indonesia, and Australia—who are doing buyouts and are actually starting to distribute more capital. I think the Asian private equity review calculated that in 2013, there was an increase in the distribution. About $25 billion was returned to investors. And that was a year-on-year increase over 2012. We are expecting the same level of increase to happen in 2014.

In contrast to what I’ve just said about the emerging markets, there are pockets where you can expect reasonably good returns.

Franco: Let’s change gears and go to a part of the world where growth is not the issue. It’s non-growth. I’m referring to Europe specifically. What’s your take on the outlook for private equity in a low-growth economic environment? How does a manager in a one-to-two percent GDP sort of market survive?

Warner: It’s interesting. You could say Europe has been a low-growth environment for many years. It’s not far behind the U.S. You could say the U.S. has been a low-growth environment for a number of years as well, maybe slightly more percentage. There have been substantial and consistent private equity returns made there, as you know. In fact, for many years, the returns from Europe were marginally above those of the U.S., according to our data.

It’s really about people who have the ability to source, to analyze, to develop, and to close significant businesses where they can add value and grow the return over time.

Actually, I think the stats are that some 45 billion euros of fresh capital was raised last year in Europe. We’re seeing a very big pipeline for fundraisings coming down the pike this year.

If anything, one of our concerns is that there’s probably too much dry powder where it’s feeling a bit heavy. We’re worried about how the pricing discipline and the investment discipline will hold with that much money to put out.

Franco: Let’s switch to secondaries. This is another area identified in the report as being something to take stock of.

Warner: Yes. Curious that it was kind of a bifurcated market in 2013, wasn’t it? The first half was rather dry and seemed to indicate a lot of slowdown. The second half came on like an express train.

This is another sign of the maturity of the market, of the asset class coming of age. It’s now almost a routine portfolio-management tool amongst most of the LPs we talked to. They are looking for ways of enhancing or adding to their portfolios, and of mitigating the J-curve effect. A thriving established secondary market offers that possibility.

There’s likely to be an increasing deal flow into the market, regardless of the macroeconomic background, just from that regulatory pressure alone. I think the average is between 3% and 5% of the total and the volume of the market will be secondaries. We see that as likely to be sustained going forward.

Franco: Do you see a danger of the focus on secondaries injecting an element of short-termism into what was always considered a long-term asset class?

Warner: Potentially. It depends a bit on what the framework is for the approach. As I said before, if it is looking for in-fills to the portfolio or additional exposure in the portfolio you already have, then not. If it’s looking to move more quickly than the market is geared to do, then, yes, you’re right, it could be a danger.

Franco: LPs are also taking more of an interest in real assets and infrastructure.

Warner: Yes.

Franco: Talk about those areas.

Warner: Infrastructure is an area that the Altius team has been involved with for over two decades. Some of them, before they were at Altius, but our real assets team has invested over $2 billion into private real assets, which we define as the main, not including real estate for us, although that is a real asset.

The interesting thing is that the longest and deepest suit is in the private energy space, which in the U.S., of course, the energy spectrum has been privatized for a long time—over two decades. A whole variety of energy and energy infrastructure managers have grown up that have consistently done well over that period.

In Europe, it’s the reverse. Energy is very much in the hands of all the national governments, whereas infrastructure has been privatized, which is just the opposite in the U.S. The result of all that is that infrastructure, which you mentioned particularly—we see that as an emerging asset class.

We do think there’s a place for it. We think there are some benefits that come to any institutional investor from having private real assets. It’s not well correlated to the main asset classes of equity and bonds. It’s heavily correlated to inflation, most of the assets. There’s some inflation hedging or protection potential.

Those are all good reasons to have it in your portfolio. But again, like our comment about Asia, it’s very important to be selective, to have a close look at what you’re buying, what you’re investing in, how long the people have been together, what kind of incentives they have, and so forth.

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