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There is an estimated $1.7trn of unallocated capital commitments as the hunt for yield continues. We look at how competition for deals, increasing transparency and a post-pandemic search for value look set to dominate thinking in alternative assets.
- The average pension fund value plummeted by 15.2% in Q1 2020, but the recovery of public markets over the past nine months has helped large-scale investors steer away from crisis
- PE funds have an estimated $1.7trn of dry powder – unallocated capital commitments – ready to be invested
- Pension fund asset allocation to real estate, PE and infrastructure has moved from about 7% in 2000 to more than 26% in 2020
- In the first six weeks of 2021, buyout firms had announced $29bn of takeovers featuring European companies, up 60% on the same period in 2020
The low-interest-rate environment has skewed all sorts of metrics for investors. The pandemic has thrown volatility into the mix: the average pension fund value plummeted by 15.2% in Q1 2020, according to the Moneyfacts UK Personal Pension Trends Treasury Report, but the recovery of public markets over the past nine months has helped large-scale investors steer away from crisis.
According to the British Private Equity & Venture Capital Association (BVCA) and PwC’s most recent research, the long-run annual return for UK private equity (PE) funds is something north of 14%. No wonder investors are still chasing the promise of higher yields in PE, hedge funds and a range of other assets outside the traditional equity/bonds split.
So what are the key trends in the field right now?
1. The wave of money must go somewhere
There is an estimated $1.7trn of dry powder – unallocated capital commitments – ready to be invested. Data specialist PitchBook predicts US private equity alone will top a record $330bn of fundraising in 2021. Pension fund growth during 2020 has added to the pressure. In the world’s 22 largest pensions markets, assets rose 11% to $52.5trn (£38trn) during 2020 as savings ratios climbed.
So it’s no surprise that 88% of PE investors in a recent survey by Lincoln International said their most important objective this year was deploying capital. The slowdown in deal-making in the first half of 2020 ratcheted up the need to invest, resulting in a faster pace for deals in the second half. Unquote estimated that, in 2020, the UK would have seen a reduction in deal values year on year of just 13%, despite the global lockdown.
2. The surge to alternatives is set to continue
According to the Thinking Ahead Institute, pension fund asset allocation to real estate, PE and infrastructure has moved from about 7% in 2000 to more than 26% in 2020. “We’ve also seen a decade of professionalisation in the world of pension fund trustees that’s created a much wider use of more sophisticated investment tools,” says Richard Butcher, chair of the Pensions and Lifetime Savings Association (PLSA). “We see much more use of complex instruments to damp down risk. But we also need growth.”
Although Butcher is clear PE and still tends to be a minor allocation for most UK pension funds (especially mature defined benefit schemes; alternative allocations tend to be higher in the US), that hunt for growth is going to further plump investor war chests.
“Hopefully as we move into a more certain environment, and as vaccine rollouts really take hold, confidence in deals will build,” says Paul Tandy, senior director of institutional banking at RBS International. And the evidence of deals building up in European private equity is already here. In the first six weeks of 2021, buyout firms had announced $29bn of takeovers featuring European companies, up 60% on 2020, according to Bloomberg.
3. Competition for assets
PE general partners (GPs) are only interested in assets with a compelling story. Competition for deals at the right price, with clear strategic value or high growth potential will get even more fierce given the stark contrast between winners and losers within and between sectors during Covid-19. Hospitality, retail and travel, for example, have become defined by distressed assets – which can create opportunities for high-risk investment.
But in healthcare, e-commerce and tech, buoyant valuations are making value plays harder to execute. “Yield and the protection of capital value will remain key priorities,” says Tandy. “Being able to achieve that in new and smarter ways is going to be key.”
A recent PwC analysis cites four areas for investability: adaptability to fast-changing consumer habits; picking winners as industries evolve; innovation, especially in transformative tech; and new approaches to accessing capital markets. That’s going to make due diligence and more proactive portfolio management even more important.
“Fund managers are responding to investor pressure for transparency. We’ve certainly seen a maturing of governance standards in Jersey”
Elliot Refson, head of funds, Jersey Finance
4. Time to take ESG seriously
“Environmental, social and governance (ESG) and climate change are genuinely important factors now,” says Butcher. “That’s partly driven by legislation, especially with the government’s commitment to the COP26 agenda. But it does mean reducing investment in certain areas. And if, as an investor, you don’t feel you can influence the stewardship of a business, these days you have to make a decision.”
Jersey Finance’s Elliot Refson adds that Covid-19 has intensified the ESG focus. “Fund managers are responding to investor pressure for transparency,” he says. “There is also clearly interest from regulators and standards setters to develop an appropriate regulatory framework. We’ve certainly seen a maturing of governance standards in Jersey.”
One more ESG factor to consider: the green revolution. “Covid-19 has put a huge strain on the public purse, and we’re likely to see a lot more pressure and incentives to invest in the ‘long economy’,” says Butcher. That means long-term R&D for transformative tech, large-scale infrastructure and green projects. Governments all over the world would love to replace taxpayer-funded projects with private money – and with the right incentives and return profiles, that could start to happen.
5. The ways funds are managed is changing
Lockdown has engendered creativity in alternative investment – using remote due diligence, for example, to keep deals on track. It’s accelerated a wave of digitisation within firms that’s changing the way fund managers operate, evaluate portfolios and communicate. “There’s definitely a drive to automate and make more efficient use of data,” says Tandy. According to recent Deloitte research, “2021 has the potential to be the year that laggards face strategic risk, not from what they offer investors but from how the offerings are supplemented by digital capabilities”.
Proactive portfolio management is also critical. Private equity managers have always had a reputation for being activist shareholders. But in a more unstable world, finding portfolio synergies and transformation opportunities is more important than ever. In Deloitte’s survey, 44% of portfolio companies had improved operating margins through ownership synergies alone. That’s pretty compelling at a time when cost control is paramount.
6. Rates matter
Cheap money isn’t going away… probably. “It’s hard to see much changing in the low-interest-rate environment,” says Tandy. “There’s more talk about inflation risk thanks to stimulus and the increased savings ratio, but central banks don’t seem to be too worried about that at the moment.”
Meanwhile, the other rates to watch might be currencies. Increasingly international funds – globalisation of investment had been a theme well before 2020 – will be conscious of forex risk as well as arbitrage opportunities. That’s particularly true in emerging markets, where clear pathways out of the pandemic could trigger renewed investment interest in pursuit of growth that’s less achievable in mature and ageing markets such as Europe and the US.
For deal-doers and their investors, the ground rules will be the same as always: look for quality assets with growth potential to match the risk profile. The challenge in 2021 and beyond – which underpins all these trends – is how Covid, the economic recovery and the ‘new normal’ affect deal rationale. Timing, transparency and tactics are more important than ever.