Over the past few years, private equity has evolved from being a rather exotic, non-traditional alternative investment category to becoming a standard part of many institutional investors’ portfolios. Institutions in Europe are steadily increasing their allocations to private equity, motivated by the expectation of higher long-term returns relative to traditional public markets. With interest growing in this investment category, many investors are struggling with issues of how much of their portfolio to allocate to private equity, how much to commit in order to get their allocation actually invested, and how best to implement their investment strategy.
The recently published report on alternative investing by tax exempt organisations* shows how major institutional investors around the world have addressed these issues. The report draws on a survey of 526 large public and corporate pension funds and endowments and foundations in the US, Canada, Europe, Australia and Japan, and was carried out during the summer of 2001.

Increased strategic allocation to private equity
According to the report, institutional investors are continuing to increase their allocations to private equity investments (see chart). While in the US institutions still have the highest commitment to the asset class, with an average allocation of 7.5% of total assets, European investors are growing their strategic allocations very rapidly. In continental Europe, the average strategic allocation reported by respondents has increased markedly from 2.8% of fund assets in 1999 to 3.4 % in 2001. The increase in the UK has been even more pronounced, jumping from an allocation of 2.2% of fund assets in 1999 to 3.7% in 2001. Further growth is anticipated by survey respondents in all regions, with strategic allocations in 2003 expected to reach 4.2% in the UK and 4.5% in continental Europe.
We have seen a significant rise in interest in alternative investments by European institutions over the past year, backing up the results suggested by the report. In general, experts agree our view is that an allocation to private equity should be considered is appropriate for by investors with relatively long time horizons, whilst also bearing in mind and that the level of commitment should be determined with the investor’s liquidity considerations in mind. An investor’s strategic allocation to private equity should be viewed as a component of the overall equity allocation and should probably be set at no less than around 5%, if it is to have a meaningful effect on the overall portfolio. In our experience, it is almost impossible to use standard risk-return optimisation models to determine the ‘right’ allocation to private equity because of the difficulty in estimating the correct risk premium for private equity and the appropriate correlation with other asset classes.
Due to the nature of private equity, it can take several years for an institution to actually invest the money that has been allocated to the asset class. Private equity managers “call” capital from investors on a just-in-time basis over a period of years, seldom draw down the full amount of a fund and simultaneously make distributions and return capital to investors, as they sell holdings in the portfolio. Institutional investors have discovered that they need to commit as much as 30 to 40% more than their policy allocation to private equity in order to get the capital “in the ground”.
According to the report, continental European investors reported that only 52% of their policy allocation had been invested by 2001, and had over-committed to the tune of 40% of their strategic allocation in an attempt to get more capital actually invested. UK investors reported an investment level of 46% of allocated capital and an over-commitment level of 16%.

Huge variation in performance
The primary motivation behind investing in private equity is the expectation of higher returns. Over long time periods, private equity can outperform traditional public equity markets because of several key structural characteristics. Our view is that an appropriate expected return for private equity should be about 300 to 500 basis points above long-term public market returns.
According to the report, institutional investors have been satisfied with private equity performance; over 92% of US respondents and nearly 90% of European respondents said that private equity returns had either met or exceeded their expectations.
However, the report also found that private equity returns vary widely amongst investors, even within the same vintage year and investment strategy (ie, venture, LBO, mezzanine and expansion capital). This enormous variance in performance, unparalleled in other asset classes, highlights the necessity of diversification across different private equity managers, sectors, regions and strategies and also demonstrates the importance of expert manager selection. In our opinion, it is critical to identify and have access to both the current ‘top-tier’ private equity managers and the promising managers of the future, in order to build a successful long-term private equity investment programme.
Institutional investors often lack the expertise and resources to perform private equity manager selection successfully, and may not have access to these ‘top-tier’ managers. Small asset size, along with relatively high minimum investments into funds make it hard to construct a well-diversified portfolio. In addition, smaller investors find that the administrative operations for private equity investments (extensive legal due diligence, quarterly reports, accounting for unpredictable capital calls and distributions, etc) are more complex and onerous than for traditional investments.

Successful implementation for new private equity investors
Instead of building up in-house private equity expertise over time, many institutional investors in Europe have chosen to outsource their private equity investments by participating in the asset class through a funds of funds. A professionally managed multi-manager private equity fund of funds overcomes the obstacles relating to diversification, top manager identification and access and administration.
The report shows that these vehicles are becoming increasingly popular, particularly in Europe where survey respondents said that 19% of their commitments were made through funds of funds in 2001, up from 16% in 1999.
Investing in private equity is not appropriate for all investors, since it requires long time horizons and a higher tolerance for risk than more traditional investments. However, over long time periods, private equity investing has proved to be rewarding for institutional investors. Interest in private equity continues to rise, and investors are actively engaging in over-commitment strategies in order to get a larger portion of their commitments actually invested. Further, by pooling assets in a multi-manager fund of funds, investors can gain access to top-tier managers, expert due diligence and monitoring, portfolio diversification and back office support.
Helen Steers is managing director of European private equity at Frank Russell Company, based in Paris
* The 2001 edition of the Goldman, Sachs & Co and Frank Russell Company Report on Alternative Investing by Tax Exempt Organisations was published on 19 December. The full survey can be obtained from Frank Russell Company (dvichot@russell.com), and from Goldman, Sachs & Co (daniela.panczel@gs.com).

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