Key Risks in Private Equity – October 2018
A substantial amount of capital flowed into private equity since the aftermath of the crisis, as institutional investors (known as Limited Partners or LPs in private equity land) sought to protect their portfolios from short-term market volatility and in their search for higher investment returns. The amount of annual funds raised by private equity firms reached an all-time high in 2017 clearly showing the substantial growth of the industry. The industry now stands at over US$3 trillion in assets, more than twice the size it was a decade ago. Notwithstanding this, LPs in aggregate appear to still be increasing their allocation to private equity. Moreover, the level of dry powder as well as valuation entry multiples on recently completed deals across private equity funds are relatively high and it has very much become a seller’s market; this begs the question of whether the market could be witnessing a situation of “too much capital chasing too few deals”. Given their private nature, investors have always performed due diligence on managers (also known as General Partners or GPs) and their offerings. However, with the current market as the backdrop, LPs need to be even more disciplined in how they allocate capital assigned to private equity, in how they ascertain the level of risk present in those investments, and overall in their approach to manager/investment selection.
Additionally, recent well-publicised events around the liquidation proceedings of the Abraaj Group, a private equity fund which at its peak managed $14billion of AUM (in early 2018) and was the biggest private equity firm in the Middle East, have brought to the forefront operational risk concerns particularly around the adequacy of corporate governance standards and the robustness of the operational framework within some private equity funds. These events have once again emphasised that although most GPs may be well run, many well capitalised, some with blue chip investors, LPs simply must do their due diligence to be sure. Moreover, as the old adage goes “profits cover problems”, so as we head into more challenging times, high profits may be harder to achieve, and so more problems are likely to be “uncovered”.