Dan Dobry

Private equity 2023 – what should we expect?

While limited partners grapple with the exact percentages of their target private equity allocations in the next year, one thing is certain: PE will remain a core asset class in institutional portfolios.

Institutional investors, including many public pension plans, are wrestling with how to structure their target allocations for 2023. For some, increased allocations to the asset class mark the path forward, driven by a bullish outlook on the long-term value of PE and declining asset values in other portfolio segments. For others, the denominator effect, inflation and other macroeconomic concerns, and inflated multiples raise concerns about high target allocations to the often high-risk, high-reward asset class.

As a result, institutions have taken different approaches, with some slowing down their PE allocations and others increasing allocations to stay in-policy.

For example, last month Calpers appointed a new leader of its restructured private market investment program. Under Anton Orlich, the team is responsible for growing the pension fund’s private equity assets from 8% to 13% of its portfolio. And in September, the investment board of the Iowa Public Employees’ Retirement System increased the pension’s PE allocation from 13% to 17%.

“My expectation is that PE allocations will continue to grow in 2023,” said Manoj Mahenthiran, private equity lead at PwC.

Higher inflation and rising interest rates will test PE’s resilience in 2023, and rising allocations next year will be largely a response to the denominator effect as public pension plans aim to stay within pre-established allocation boundaries. But, in the long term, Mahenthiran said, public pension plans will continue to increase their commitments to the asset class because they believe in the value of private equity.

“If the PE funds can demonstrate that they can get through this very difficult environment, and still generate those types of returns they’ve generated in the past, that will be the proof people need,” he added.

With public market return assumptions dropping steadily since the 2008 global financial crisis, public pension plans with fixed return mandates diversified their portfolios into alternative assets, such as private equity. This strategy led to tremendous growth in public pension plans’ foothold in private equity and rapid growth in AUM at private equity firms. From June 2020 to June 2021, total AUM across private markets reached an all-time high of $9.8 trillion, a $2.4 trillion year-over-year jump, according to a McKinsey & Company report.

“A lot of that has been driven by public pensions and their need to generate returns for their beneficiaries,” said Keith Cahill, head of North America institutional at JP Morgan.

Some institutional investors are less optimistic. In Coller Capital’s biannual survey of private equity investors, 93% of respondents said they view the macroeconomic environment as a significant risk to private equity returns in the next two to three years; 85% said the same about inflation.

Respondents’ target private equity allocations reflected these concerns. Six months ago, 42% of respondents said they planned to increase their target PE allocations over the next year compared to 27% in the latest survey, a 15 percentage point decrease.

Case-in-point: In a Dec. 7 board of trustees meeting at the Alaska Permanent Fund Corporation, which oversees over $70 billion in AUM, chief investment officer Marcus Frampton suggested the fund decrease its PE allocation target by 4% over the course of the next three fiscal years. In what he called a “strawman” investment policy proposal, Frampton suggested that APFC decrease its fiscal year 2024 target from 18% to 16% and its fiscal year 2025 target from 19% to 15%.

“I am as bearish on private equity as I’ve been in my career,” Frampton said in the meeting.

As of  Nov. 9, the APFC’s portfolio was 3.5% overweight in private equity. The fund will not decide on its target portfolio allocations until midway through 2023.

The good news for investors is that valuations of PE are coming down. In its 2023 private markets outlook, BlackRock noted that it has seen lower valuations and increased buyout, carveout and M&A activity in private equity.

But while some investors are concerned about private equity’s response to a possible recession, the best vintages tend to follow recessionary periods. During the dot-com bubble, the global financial crisis, the 2011 US downgrade and the outset of the COVID-19 pandemic, private equity returns consistently outperformed public index returns, according to the BlackRock outlook.

In the APFC meeting, investment advisory board member Ken Frier noted this trend and raised concerns about pulling back on PE during a market dip. In response, Frampton acknowledged that the previous recessions marked opportune entry points for private equity, largely because valuations came down. The difference this time around is the sheer amount of institutional capital in the asset class.

Private equity allocations will slim down in 2023, according to Martin Sanders, head of pensions investments at AXA Investment Managers. And, he said, the full impact on allocations won’t be apparent until about two years from now, depending on whether or not there is a recession and the depth of that recession. If a recession is shallow and public equities rebound, institutional portfolios will rebalance with traditional asset class returns coming back in line with those of alternative assets.

In his own pensions investment outlook for 2023, Sanders wrote that liquid assets—mainly public equities—need to see a rebound to rebalance portfolios and make room for new allocations. In 2023, Sanders anticipates private equity valuations to be revised downwards, which should also help to rebalance institutional portfolios skewed by the denominator effect.

“These revaluations often go slowly because there are stakeholders that have an interest in doing it slowly,” Sanders said.

Steffen Pauls, founder and CEO of Moonfare, a digital PE investing platform, echoed this view, stating that a severe recession in 2023 would lead to private equity write-downs, but a shallow one would have little effect.

While institutional allocations to private equity may be a mixed bag in 2023, Pauls said the overarching trend is a long-term shift into the asset class, driven by the effects of inflation and declining asset prices on institutional portfolios. Amid a nearly-frozen IPO market, Pauls also noted that the bulk of exits are dependent on the private markets, which will drive business to PE over a longer time horizon.

“The normal exit route is in the private markets,” he said.

Source of Information: From an article published by Jessica Hamlin

About the Author
Dan Dobry was the founder and a director of the GlobalNET Investment House, he was one of the founders of the Union of Financial Planners in Israel (UFPI) and served as the first Chairman and President of UFPI. Dan was the Global Council Representative for Israel for the Global Community (FPSB) from 2012 - 2018 and was a member of the Committee for Standards and Qualifications for the European Union (SQC) until December 2021.
Related Topics
Related Posts