A new study has found that the number of German institutional investors with an allocation to private equity has risen by 25% since 2003. In addition, target allocations to private equity have substantially increased to 3% of total assets from an average of 2.2%.

The study was carried out by Stefan Jugel of the Wiesbadener private equity institute on behalf of Greenpark Capital, a UK secondaries specialist, and Unigestion, a leading asset management firm and provider of private equity solutions. Its objective was to assess how appetite for private equity has evolved among German institutions over the past two years and how the secondary market in particular is perceived.

The responses of more than 80 leading German insurance companies, pension and support funds indicate that private equity is now a firmly established investment strategy for German institutional investors. The findings also demonstrate an increasingly sophisticated approach to the asset class, with the use of secondaries as an accepted strategy.

Since 2003 there has been an explosive growth in the industry. By mid-2005 private equity funds in Germany had invested €20.3bn in around 5,600 companies, with a combined turnover of €114bn. With portfolio companies employing a total of 638,000 people1, the private equity industry is now the second largest employer in Germany after the public sector.

To put this into context, European private equity funds raised $306.5bn (€242.5bn) between 1999 and 2005, representing 27% of global funds raised.

Secondary funds globally account for $37bn, or 3% of the total funds under management, with Europe accounting for $10bn. Returns, particularly in Europe, have been stellar, consistently outperforming the public markets over the past decade2.

There are a number of drivers behind the demand for private equity. Good performance has acted as a magnet, as has the ever increasing search for alpha.

On a more strategic level, the characteristics of private equity demonstrate decorrelation to other traditional asset classes such as equities and bonds. In addition, private equity can provide downside protection in an environment of high prices for stocks and bonds.

Private equity for German institutions is moving from a more politically motivated investment rationale associated with business and job creation, to a more long-term return oriented strategy as a means of meeting the liabilities and obligations of pension funds and insurance companies.

Professionally managed vehicles, both fund of funds and dedicated secondary funds, have been the main beneficiaries of the growth in German exposure to private equity.

It is often assumed that as investors become more sophisticated and increase their in-house experience, they take on the task of managing their private equity exposure themselves.

However, the study suggests instead that German institutions have come to recognise the difficulties of managing private equity in-house, and have identified the need to use specialist services to maximise the return from this asset class. In terms of regional preferences, the majority of institutions reported an elevated exposure to German private equity, with regional investment initiatives cited as an incentive.

On average German institutions have an allocation of just under 30% to their domestic market. Outside Germany, commitments were equally distributed between the rest of Europe and the US. Asia, which is seen as a very exciting market with huge potential for some investors, appears not to be on the radar screen of the majority of institutions surveyed, with an average allocation of 1% of total private equity commitments.

One of the most interesting findings is that German institutional investors are twice as likely as the global average (7% versus 3%) to have chosen to invest in private equity via a secondaries fund.

Secondaries transactions are defined as the purchase of interests in private equity funds and other assets from investors seeking an early exit.

Secondaries provide the opportunity for a risk-reduced investment in private equity and broad diversification by vintage, geography, industry and stage of investment. The earlier return of capital and reduction in the J-curve effect are complementary to primary fund investment draw down schedules. By purchasing interests in mature primary funds, secondaries funds enable investors to invest ‘back’ into earlier vintages.

While Germany is mirroring the investment pattern of incorporation of secondaries as a core component of private equity exposure previously observed in the US and UK, it is doing so at an accelerated pace.

Its higher-than-average commitment to secondaries funds sets this trend in sharp relief.

The report emphasises the high level of sophistication among German investors.

For a relatively young primary market one would not necessarily expect such a widespread acceptance of secondaries.

The fact that allocations are more than double the global average shows the attractions of secondaries obviously appeal to German investors.

For German investors using the secondary market to buy private equity exposure, the key argument is that it offers good returns with a relatively low risk profile. Nearly half the respondents (46%) mentioned yield and risk/return as their main reasons for investing in secondaries.

Perhaps surprisingly the key selling points usually quoted by UK secondaries managers did not appear, namely access to restricted funds, vintage diversification and J-curve reduction.

German institutions have recognised the benefits that private equity provides in meeting their long-term liabilities but are relatively behind the curve in terms of meeting their allocation targets.

An accelerated exposure to secondaries allows them to rapidly build exposure to a diversified private equity portfolio and put money to work quickly, therefore achieving their target allocation much sooner.

The research clearly shows that German institutions value exposure to the secondary market through the services of a professional secondary investor rather than through direct attempts, and that from a sellers perspective they see established secondary players as possessing more desirable attributes than other buyers.

According to the research, German investors mainly value the discretion offered by secondary funds, which is a major advantage for securing dealflow within the industry.

Other key characteristics offered by secondary players include fair pricing and the ability to structure complex transactions, including delayed payment and the division and break-up of portfolios.

German investors’ reasons for investing in secondaries show a high level of sophistication. Secondaries were once perceived as offering an exit from underperforming investments, but increasingly the motivations for selling are internally driven, such as portfolio balancing, internal restructuring or a change of investment strategy.

Nearly half of German investors (44%) gave those as their main reasons for selling to a secondaries manager, with just 11% citing dissatisfaction with an investment. For a relatively young private equity market that level of sophistication is surprising.

Germany has some long-term issues that it needs to face particularly in terms of pension levels and ageing population level and private equity is one of the only investment arenas in which they are going to achieve the returns that are required to plug the gap and meet requirements.

Therefore, we see an increasing number of German institutions turning to private equity to increase their overall returns and also generally an increase in exposure to PE as institutions become more comfortable with the long-term stability, positive returns and de-correlation of private equity in comparison to other asset classes.

Francesco di Valmarana is investment director head of secondaries at Unigestion and Joanna Jordan is co-founder of Greenpark Capital

(1) Ernst & Young: German Private Equity Activity 2005

(2) EVCA

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