Asset Allocations to Private Equity

The fundamental trends driving the private equity markets are favourable to the growth of private capital. Many years ago, private equity investing began as a “friends and family” market, where individuals would finance new deals within their direct business networks. Over time, institutional investors began to enter the asset class, frequently placing private equity in a basket with other “alternative investments” such as real estate.

As the financial returns to investors from the asset class have become more apparent, private equity markets have grown more mainstream, and today nearly all institutional investment portfolios in the U.S. include a private equity allocation. Allocations among different types of institutional investors have varied over time, depending on their relative appetites for new investment products and their perceived needs for liquidity. Those institutions with higher allocations have tended toward higher performance, leading to growing allocations among all institutions over time and driving the overall growth of the private markets.

As private markets have grown and more and more companies have moved away from the public markets, a natural response from investors has been to increase their allocation to the private equity asset class. However, in spite of all of the natural advantages of private equity, certain investors have chosen not to enter the private equity markets because of the lack of liquidity. Private equity funds have traditionally required investors to “lock in” their capital for periods of eight to 12 years at a time, with minimal opportunities for liquidity during this period. In recent years, the majority of mid-size to large institutional investors, as well as many high net worth individuals, have become more comfortable with this requirement, recognizing that they do not require short or medium term liquidity across their entire investment portfolios. In considering the appropriate allocation to an asset class such as private equity, investors can review the record of large institutions with many years of experience in the sector. In the U.S. market, approximately 4% of total investment assets (amounting to US$900 billion) was held in private equity at the end of 2004. Among large U.S. institutional investors, the ratio is higher. In 2005, a survey of 176 leading U.S. and Canadian institutional investors by Russell Investment Group found that on average, private equity accounted for 7% of their asset allocation.

Currently, most institutional investors consider an appropriate allocation to private equity in the range of 5% to 10% of total portfolio assets. Within Canada, the very largest institutional investors have been active participants in the private equity markets at levels comparable to their U.S. peer group for many years, with increasing allocations to the sector driven by continuing strong returns:

Canada Pension Plan Investment Board, with total assets of $103.3 billion, reports that it has committed approximately $16.5 billion to private equity investments, of which approximately $7.5 billion has been invested, as of November 2006.
Ontario Teachers Pension Plan, with total assets of $95 billion, maintains a global private capital portfolio of approximately $6.0 billion in private equity investments, as of June 2006, and reports “a successful track record in private equity with returns in the range of 25% per annum over the last 15 years.”
The Caisse de depot et placement du Quebec reports that its current investments in private equity represent 5.1% of its overall portfolio of $122.2 billion, and generated returns of 22.3% in 2005.
OMERS (Ontario Municipal Employees Retirement System), with assets of $41.1 billion, holds approximately 5.8% of its portfolio in $2.4 billion worth of private equity investments which generated returns of 23.2% in 2005.

These very large institutions have developed highly specialized investment teams with the internal resources to work effectively as active investors in this sector. Their smaller colleagues, however, have largely missed out on the growing private equity markets, with minimal participation in the sector.

The relative lack of private equity investment allocations among Canadian institutional investors can be explained, in part, by the relatively less accessible Canadian market to date. Although the number of independent private equity managers in Canada has steadily grown over the last 10 years with many delivering superior returns and attracting significant institutional capital, there are still few well-established fund managers in Canada with sufficient track records to demonstrate international top-quartile performance based solely on quantitative assessment. Until recently, the Canadian market has suffered from a shortage of funds of funds, advisors and other efficient mechanisms to permit smaller institutions to access the private capital markets efficiently. The growth in the overall Canadian private equity market is also a more recent phenomenon, and so a large number of Canadian institutions have been less exposed to the overall market opportunity.

The Canadian private equity market is maturing. It occupies core allocations of the largest Canadian pension funds and is no longer considered “alternative” by many portfolio managers. Today, smaller institutions are actively exploring the market, and seeking efficient ways to enter the asset class. At the same time, seasoned ex investment bankers and business operators have identified the opportunity and are entering the market to start new private equity funds. As a result, the number of new private equity funds has grown significantly. In 2005, Kensington reviewed proposals from more than 90 active and prospective funds looking for capital.

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