Alt Investments

Private Capital Amasses Dry Powder; Not All Returns Will Fade - Preqin

Tom Burroughes Group Editor 8 August 2019

Private Capital Amasses Dry Powder; Not All Returns Will Fade - Preqin

This news service talked to the research firm about trends in sectors such as private equity and hedge funds, and about how certain parts of the market are becoming arguably overcrowded.

This publication is looking at the field of alternative investments. A prominent organisation that tracks developments in areas such as private equity, real estate and hedge funds is Preqin, a research firm. Its reports shed light on returns, fund-raising, investor’s requirements, and fees. (To see other recent articles in this series, see here and here.)

How useful do you consider it to think of “alternative assets” as being at the less liquid end of the spectrum (with venture capital and special situation hedge funds, private equity, etc, at one end, and listed equities at the other)?
There is no doubt that alternative assets are a less liquid investment than listed equities or bonds. However, it is no longer the case that an investor would necessarily have to wait for years for their investment to mature. The rise of “liquid alts” in the hedge fund space have seen more products with redemption frequencies measured in days rather than months enter the space. At the same time, on the private capital side the secondary market has increased the number and attractiveness of options allowing investors to redeem their stakes before the end of a fund’s intended lifespan.

In the alternative asset class space that you track, what are the main trends you see (in hedge funds, private equity, venture capital, real estate, infrastructure, commodities, others)? For example: increased/decreased wealth management interest in certain areas (please give examples); use of specific types of vehicles (listed alternatives, offshore structures), redemption/liquidity requirements, etc?
There are a lot of different trends going on in different parts of the market. To take a really top-level view, there are maybe two key trends that are influencing the alternatives space at a macro level.

The first is in private capital, where we are increasingly seeing the emergence of a two-stream industry, with the activities of the largest fund managers becoming further detached from the rest of the industry. The very largest firms are able to raise huge amounts of capital very quickly, with many of their vehicles routinely oversubscribed, and are raising further capital through co-investments and separate accounts. They are participating in multi-billion dollar deals, and have much more leverage when negotiating LPAs.

By contrast, smaller and emerging fund managers face an extremely challenging fundraising market, in which the number of funds seeking capital is twice as large as it was even five years ago. Once they do raise capital, the competition for mid-market deals is fiercer than in almost any other segment, and potential returns are being squeezed from all sides. As these conditions continue, the two sides of the industry seem to be operating increasingly independently of one another.

The second major trend is on the hedge fund side. Performance in the industry has been variable in recent years, with 2015 and 2018 marking low points, while 2017 saw double-digit returns. In recent years there have been a handful of high-profile redemptions from large investors, and the general sentiment towards hedge funds has been more negative than in any other asset class. This has particularly been thrown into focus when compared with the historic bull run that has taken place on public indices.

This has prompted a renewed focus on the value of hedge funds in a diversified portfolio. Investors have certainly not turned their back on the industry as a whole, but many now report that they are looking to consolidate their hedge fund holdings, and refocusing on positioning themselves defensively rather than seeking to make outsized gains. This means that fund managers are facing an intense level of scrutiny, and need to justify their value to investors in order to raise and retain capital. As this scrutiny has come to bear, we have seen the net growth in the number of active hedge funds taper off, and the industry has seen more consolidation around consistent strong performers.

A big challenge is for accurate reporting about the valuations and performance of alternatives (calculating net asset values, etc). How in your view is the wealth management industry served today in getting such data? There are a few firms out there developing technology, such as FundCount, Private Client Resources, etc. Is there still work to do? 
Preqin does offer performance and cashflow data to its clients, including wealth managers, so we are not a neutral party in this case. That said, we are very much focused on allowing investors to get really granular data on their portfolios, how they are performing, the NAV and cashflow data. It is equally important to allow investors to see the context: how does one fund in their portfolio compare with another on a like-for-like basis? How does their alternatives portfolio compare with public markets? These are not necessarily easy problems to solve, but there is marked improvement year-on-year.

Of course, there is a ceiling to these efforts, based on two key factors: most funds do not have particularly stringent reporting requirements, and when they do report, there is no widely adopted format or depth of reporting. On this second point especially, industry groups like ILPA are doing a lot of work to publish reporting guidelines and transparency charters, but the first point is more or less intrinsic to the industry.

There is a lot of money going into private capital (private equity, debt, property, infrastructure) and we read comments about the build-up of “dry powder” (uncommitted capital) that is accumulating. Is that a cause for concern? Could yields be squeezed? Has the chase after returns caused some excesses?
Total private capital dry powder has reached $2.46 trillion as of July 2019 – twice the level it was at as of the end of 2009. This wall of capital moving into the industry is certainly compressing yields in some sectors: many real estate fund managers have reduced the targetted returns of their funds in market, private debt fund managers are seeing their yields compress, and buyout funds are facing extremely high asset pricing and fierce competition for deals.

But it is not the case that high dry powder is universally stymying alternative asset managers. The ratio of dry powder to called capital for private equity has not risen across the board – that is, even though dry powder is building up, fund managers are calling up more capital each year. Further, fund managers following some strategies do not report significant rises in the difficulty of finding good deals or in asset pricing. In the longer run, it seems likely that certain parts of the market will absolutely feel the squeeze, but others will be relatively unaffected. The challenge for investors will be to differentiate which is which.

Hedge funds have had mixed results in recent years and their traditional 2 and 20 (annual management fee, performance fee) per cent fee models have been squeezed. Do you see further fee compression? 
We have long said at Preqin that the “2 & 20” model is no longer reflective of the industry. There are still a large number of funds that have retained that setup, we are increasingly seeing firms adopt not just lower fees, but different fee models. For instance, “0 & 30” or “1.5 & 15” models, where more or less emphasis is placed on meeting demanding returns objectives, are being brought to market.

It is not certain that we will see fees come down across the board, but investors are focusing much more on the link between fees and performance. It seems likely that we will see hurdle rates and high water marks become more important, and we might see performance objectives go up as much as we see fees go down.

How much has the squeeze on yields for listed equities and other conventional asset classes encouraged a shift to alternatives?
In general, we are seeing high appetite for alternatives from investors, and they do cite high risk-adjusted returns as a key advantage for some asset classes (but importantly, not for all). However, we could not definitively cite a link between lower returns in other asset classes and a capital shift to alternatives.

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