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Private Equity: Venturing Forwards

 3 min read / 

As an industry, private equity (PE) is incredibly flexible; the ability to respond to rapidly changing market conditions is what has set it out in the past. However, in times of monumental shifts in practice, such flexibility may not be enough.

Inflexion 

 As Bain & Company highlights in its ‘Global Private Equity Report’ for 2014, the industry today is at an inflexion point. The diagnosis of “in the doldrums” follows from the fact that deal value, and count, has not deviated much from past years. The increasingly competitive environment, fuelled by an availability of debt (a result of low interest rates in developed nations), has compounded this, and made good deals hard to find at the right price.
Despite this, the past year has seen capital distribution flow towards Limited Partners, contributing to a consistent positive cash flow. The reasons for this fall largely on ubiquitous dividend recapitalisations, and an increasing number of exits; however, such moves have begun to limit portfolios, which could contribute to future risk if funds fail to re-diversify. The major upside to such capital distribution is that it not only puts the industry in the spotlight for future investors, but also gives it more freedom to formulate strategies (as it instils investor confidence).

 The Effects of Volcker 

 Investor confidence is an important facet to note, as the industry is rapidly changing following post-2008 regulations. The one to keep an eye on is the Volcker rule, which came into effect April 1st 2014 (with compliance expected by July 2015). With the aim of trying to constrain the exposure that contributed to the financial crash, the regulation limits investment in ‘covered funds’ (which include PE) to 3% of a banks Tier 1 regulatory capital.
The effects of the Volcker rule can already be seen, with firms like J. P. Morgan spinning off their PE arm. This trend is due to the fact that increasing pressure on banks limits their ability to operate effectively; in the PE industry, 3% of Tier 1 capital limits the size of acquisition that such an arm could make, and thus limits the potential for profits. Many banks see the stress of continuing to operate in the industry outweighing their presence.
However, this is not the case for all banks, as some see huge opportunity being created by the void. For example, Morgan Stanley recently raised $1.7bn for ‘Fund IV’, which will target China and South Korea. Such an opportunity has a lot of promise, as its previous three funds are thought to be returning a net internal rate of return of over 20% (in part why Fund IV was able to raise such capital).

 Everything To Lose

 With the Volcker rule settling into place, the PE industry is likely to become much more focused on independent funds. Whilst this could contribute to more of a niche-focus, this may not necessarily be a bad thing. Indeed, the Volcker rule is not the main issue for the industry; instead, the challenge for General Partners is formulating distinctive investment angles, following an oversupply of funds. With developed nations looking to raise interest rates in the next year, this oversupply will wither, but not before asset prices are pushed up – the industry has everything to lose in the meantime.

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