Private equity’s growth has given rise to creative investment structures as asset allocators of all sizes seek exposure to the industry, according to McKinsey & Co.
The consulting firm said in a research report Wednesday that private equity’s net asset value has increased more than sevenfold since 2002. That's twice as fast as public equities over the same period.
“Private equity is no longer alternative, rather, it’s becoming entirely mainstream,” said Bryce Klempner, a partner at McKinsey and a co-author of the report, by phone. “Even institutions that thought they were either too big or too small to participate in the private markets now believe that they should or must.”
Private equity isn’t one-size-fits-all. Accommodating investment structures have proliferated in the industry as investors seek flexibility from secondaries and long-duration funds, according to the report.
“The rise in secondaries is not just about returns,” McKinsey said in the report. “These funds are injecting liquidity and creativity into the marketplace.”
Secondaries funds buy stakes in private equity pools from limited partners, or LPs. Asset allocators may find “differentiated returns” from these funds as they are further along the so-called J-curve, according to the report. The curve, shaped like a J, shows how private equity performance tends to dip before increasing over time.
It’s clear that firms are interested: secondary transaction volumes were projected by Coller Capital to reach an all-time high of $55 billion to $60 billion in 2018, according to the report. Also, nine secondaries firms have raised more than $9 billion each since 2008, McKinsey said.
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Long-duration funds are also on the rise among institutional investors, as it can pay off to hold some private equity assets beyond the traditional holding period of eight to 10 years, according to the report.
“It has become a common refrain among LPs that they would rather see longer hold times than pay the incremental transaction fees that result when one of their external managers sells a portfolio asset to another,” McKinsey said.
Long-duration funds may be palatable for skittish investors because of increased trading in the secondaries market. Locking up investments is less of concern when there's more opportunity to potentially sell their stakes to other investors.
“A deeper secondaries market also makes it easier for LPs to make such a long commitment, by offering the potential of an exit ramp,” McKinsey said.
Meanwhile, the growth in capital call lines of credit, or fund leverage, has helped compress the J-curve, the consulting firm's research found. General partners, or GPs, obtain these credit lines by using capital commitments from their LPs as collateral.
“Over time, smaller J-curves will generate bigger pay-outs for GPs and higher net IRRs for LPs, albeit slightly lower multiples given the cost of the credit line,” McKinsey said, while noting that scrutiny of such fund leverage has grown.