Recent years have witnessed the emergence of private equity investing in full spotlight. Venture capital and buyout funds were frantically raised, injecting billions of dollars in innovating and restructuring the world economies. Since the early 1990s, private equity investing has steadily grown from a new and independent asset class. The industry has grown from $70bn in the 1980s to over $550bn in the 1990s1, mainly driven by the entrance and inflows of pension funds. Private equity is now seen by most investors as a tool to improve the risk/return profile of their traditional portfolios over the long-term. As market corrections developed over the last 18 months, and because of the disappointing results of many private equity partnerships, many investors are pondering whether this asset class will still deliver its promise of higher returns, or if the marvellous rise we experienced was just an anomaly.

The truth about the asset class
Is it really true that private equity investing delivers on its promises of return enhancement, moderate correlation and risk diversification? The bottom line is yes, but private equity is an inefficient industry. Historically, average private equity returns have been at or below public equity returns with a spread between top and low quartile funds of approximately 200 bps and widening. Private equity investing has other drawbacks: no liquidity, no daily price, lack of transparency, no regulatory oversight, high minimums, restricted access, etc. Most
fundamentally, it is complex, time consuming and long-term.
The legendary inefficiency of the industry, while making it difficult for newcomers, is at the same a great opportunity for experienced investors. Developing an information advantage allows an investor to have a privileged view on the whole market and ultimately, to benefit from over-performance by selecting top teams worldwide. Unfortunately, all funds are not created equal. The critical point in order to generate superior risk-adjusted returns, over the long-term and throughout cycles, is to be able to correctly identify these top-quartile teams early and to build long-term relationships. The second important point is to be able to construct solid portfolios with manageable cash flow structures.
Investors can use a variety of tools to successfully benefit from investing in the asset class: primary, secondary, co-investments, and first-time versus established funds. Among these, secondary investing is now bright in the spotlight. Private or institutional investors willing to re-balance their private equity portfolios have led to an increase in the secondary market activity. While being a potential diversifier to an existing portfolio (vintage years, sectors, geographies, earlier cash flows and returns, etc), secondary investing can be double-edged: the pricing of secondary opportunities can be very difficult to evaluate, particularly in the current environment, but is paramount for the success of the investment. The last 18 months have probably been the most risky period for secondary investing as private equity asset values have continuously declined every quarter, creating new challenges in the appropriate and prudent pricing of these transactions.

Demand continues to increase
Typical early private equity investors have been universities, endowments and certain high net worth individuals. Institutional investors, such as pension funds, have discovered and entered the asset class in the 1990s. Recent studies show that US pension funds and foundations/endowments have been among the most active investors in private equity. These investors have driven the most important influx in the asset class in the 1990s, growing from 23% of all private equity commitments in 1992, to 60% in 2001. European institutional investors’ commitments to the asset class are still lagging behind, but are expected to grow rapidly over the next few years. Even in these difficult markets, private equity continues to be seen as a return enhancer and risk diversifier over the long term.

Perceptions back to reality
Private equity investing is both risky and long-term. The good returns of the early 1990s, and the frenzy of the late 1990s made it too simple to become a private equity investor. Too much capital was committed to private equity funds at the same time as public markets started to act as venture capitalists. With the surrounding enthusiasm, too many investments were made in companies which should not have been funded and prices paid were abnormally high. There was an overall lack of discipline in the industry, while, on the other hand, a number of experienced and disciplined investors stayed true to their core competencies and did not fall to the temptation. Since mid-2000, the landscape is made of drying exit paths, liquidity squeeze in financing and declining valuations. As a consequence, overall returns have declined and the spread between top- and low-quartile general partners has been increasing further
dramatically. Consolidation is likely to occur, and many secondary portfolio opportunities are likely to come to market.

Is now the right time to invest in private equity?
The whole industry went from euphoria to negativity, and is now heading back to normality. Today, many investors are concerned that the recent corrections would mean the end of the golden days of superior private equity returns. On the contrary, the history of this asset class over a long period of time shows that the industry is cyclical. In fact, private equity investing does fulfill its promises of superior returns best at times of hesitancy and dislocation of public capital markets. In particular, funds raised in the early 1990s, during difficult economic times, did outperform public markets by about 620 basis points to date. It is at times of uncertainty that private equity produces the best absolute and relative returns. Today, the industry is back to reality and many profitable investments will be done in this part of the cycle, but, in order to generate superior returns, the investors’ challenge remains to pick the best general partners consistently, and not just to buy the asset class blindly.
Additionally, investors in private equity should be mindfull that professionalism, talent and experience are prerequisites, while alignment of interest among all parties remains one of the most important considerations to take into account. The private equity industry attracts the best talent in the financial industry, it gives its participants a nice option on profitability. Every investor has to make sure that this option is not free and that there is a full alignment of interests of all the parties involved.
Ivan Vercoutère is a partner and Giacomo Biondi Morra is vice president at LGT
Capital Partners
1 Source: Venture Economics
2 ‘Alternative Investing by tax-exempt organizations 2001’, Goldman, Sachs & Co and Frank Russell Company study on alternative investments

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