Ten Predictions for Private Equity in 2016 From Palico CEO, Antoine Drean

Considering the record $523 billion distributed by fund managers to investors over the past calendar year – nearly 10 percent above the previous high of $477 billion set in 2014 – private equity has never been healthier. These ten predictions for 2016 forecast sustained appeal and continued growth for private equity, but they also enumerate challenges for investors and managers.

Global Private Equity Assets Under Management

Global AUM by year
Private Equity Assets Increase by a Double-Digit Percentage

Private equity’s assets under management have grown to $4 trillion from just $30 billion since 1992. Structural catalysts behind long-term growth – notably private equity’s micro focus and its lack of correlation with public markets – aided by today’s low interest rates, have set the stage for PE assets to rise by as much as 20 percent this year. Rising sums committed to the asset class by traditional investors like pension funds, as well as rapidly increasingly allocations from newer investors such as sovereign wealth funds and family offices will drive much of that growth. With an activist approach to value creation, private equity offers the promise of 10 percent-plus returns even in years when public equity markets put in a poor performance. Our base case scenario is that private equity assets under management will double over the next five years, accounting for a significantly larger share of the globe’s professionally managed investment assets than today’s 5.4 percent.

Investors and Managers Fundamentally Reconsider How They Operate

In 2015 shadow capital, or investments outside of traditional fund structures, namely co-investment, direct investment and separate accounts, amounted to a record $161 billion out of a total of $629 billion raised, breaking above a quarter of all monies earmarked for private equity for the first time ever. With shadow capital likely to account for more than a third of all PE fundraising in 2016 – record distributions can’t be absorbed by reinvestment in traditional PE funds alone – investors and managers will be challenged as never before. In 2016, investors will increasingly seek to beef up teams with professionals experienced in making direct investments while managers rejigger cost structures and adjust their offerings to account for the importance of private equity outside of classic fund structures.

Secondary Investment Hits a New Record

Despite no need to unload funds to generate cash in today’s environment – remember those distributions – investors remain receptive to selling stakes on the secondary market. Supported by the emergence of mega funds as buyers, secondary prices have proved exceptionally stable and attractive, with growing numbers of investors using the market to calibrate exposure to managers, strategies and regions, making a supposedly illiquid asset class considerably more liquid. The current average discount for secondaries is 6 percent below fund net asset value in a market that could easily see $45 billion in volume this year, bettering 2015’s $40 billion record. With annual turnover accounting for roughly 1 percent of the global value of private equity funds, secondaries are on a long-term growth curve – like all of private equity.

Growing Numbers of Investors Launch Emerging Manager Programs

In 2016 as investors increasingly seek long-term solutions to investing high levels of distributions without lowering overall returns, they will follow leading lights like the California Public Employees’ Retirement System and the Canadian Public Pension Investment Board by launching emerging manager programs. The programs help promising, but generally small first and second-time managers scale up over time. In an industry likely to be characterized by relatively high prices for years to come – even if set to fall a bit in 2016 – investors are turning to less crowded niche investment spaces where pricing is better and teams are frequently just emerging.

Continuing Emerging Market Turmoil Offers Exceptional Investments

In a recent survey of 92 investors and 159 managers from Palico, a majority of managers note that high purchase prices are slowing their investment pace. The only exception in terms of regions is emerging markets, which have been roiled by economic slowdown, deep recession and sharp currency losses, particularly in anchor economies like Brazil and China. While emerging markets represent a highly diverse range of countries in various stages of development, they tend to share high long-term growth rates, rapidly developing middle classes and relatively low rates of private equity investment. As stock market investors continue to abandon emerging markets and local credit evaporates, private equity investors – given the asset class’s long-term horizon and ability to bridge the ups and downs of economic cycles – will find exceptional value, as some of the best companies in these economies look for new funding sources.

Investment in European Venture Capital Soars

The emergence of a vibrant ecosystem of serial entrepreneurs and venture capitalists in European capitals from London to Berlin, the arrival of ravenous corporate acquirers like Google and Facebook and the rise of competing local buyers, all within the past four years, means European VC investing will come into its own in 2016. Significantly cheaper valuations for startups than in Silicon Valley will be a major catalyst for European deal flow.

Venture Capitalists Further Concentrate Investments

Top venture capitalists will continue paying up for investments, despite current concerns about startup price inflation. But they will further reduce the number of companies they invest with – a practice that really started in earnest in 2015. As well-regarded venture capitalist Josh Kopelman of First Round Capital says, “we understand that our conviction in our decisions needs to be meaningfully higher in order to invest at meaningfully higher valuations.” By extension this means that startups will also continue to stay private for longer, with the best using their increased funding to eliminate competition and dominate their sector long before an initial public offering.

Pricing for PE-Backed Purchases Falls from Today’s Historic Highs, but Not by Much

The average purchase price multiple for private equity-backed acquisitions is hovering near 11 times corporate cash flow on a global basis, but that average masks much greater diversity than has been seen in years, particularly with reeling energy and commodity prices, a depressed euro, volatile stock markets and investor expectations of higher U.S. interest rates. But while prices for PE targets will fall in an expanding range of sectors and geographies in 2016, those drops will be limited, even with significant stock market declines. There has been an unprecedented accumulation of committed, uninvested private equity capital in the past three years, driven, again, by the effort to reinvest record distributions. Today’s mass of dry powder – some $1.3 trillion in classic fund structures – will keep competition for assets relatively intense, especially in developed markets.

PE Direct Loan Funds Fill the Banking Void

Regulatory pressure in the U.S., the slow pruning of balance sheets in Europe and credit retrenchment in emerging markets is rapidly changing the complexion of leveraged finance. An increasing share of leveraged loans is being supplied by private equity direct lending funds. Seen as low-risk investment vehicles, generating returns in the low double-digits and returning investor capital quicker than leveraged buyout vehicles, they accounted for some 18 percent of leveraged lending in Europe and the U.S. in 2015, up from only about 10 percent in 2012. Given what many predict will be a further seizing up of bank lending in 2016, PE direct loan funds could see their market share rise to 25 percent by the end of the year. More deals like the one recently struck between Barclays bank and PE credit specialist Ares, allowing banks to indirectly profit from leveraged finance as originators – but not as lenders – will add to the momentum.

The Creation of PE Vehicles for Individuals Accelerates

While 77 percent of private equity managers say they have solicited capital from high net worth individuals, an even higher 9 out of 10 say they plan to raise capital from HNWIs for their next investment vehicle, according to Palico’s survey. The trouble has been how to effectively access these investors. Pantheon and Partners Group, two giants of the funds-of-funds world with plenty of distribution muscle, recently launched vehicles aimed at tapping this market. Their blueprints, which involve partnering with registered investment advisers and defined contribution retirement plans, will be followed by other funds-of-funds groups in 2016. These new vehicles – combined with online marketplaces like Palico – will provide effective beachheads for accumulating substantial assets from HNWIs and, eventually, from non-accredited retail investors. Despite major challenges for managers when it comes to marketing, individuals – attracted by the same dynamics as institutional investors – increased their exposure to private equity 30 percent between 2013 and 2014, according to the U.S. Securities and Exchange Commission.