April 29, 2016
By Frank Fumai, Deloitte & Touche LLP
Private equity has grown dramatically over the past decade. Investor allocations, the outperformance of private equity versus public companies, and market appreciation have grown global assets to a new high of $3.6 trillion (excluding venture capital), as revealed in Deloitte’s upcoming report, “Private equity growth in transition: Evolve to meet tomorrow’s challenges.” This asset level puts private equity well above the $2.8 trillion held by its alternative investment peer, hedge funds, according to BarclayHedge, Ltd.
While the private equity industry is strong and healthy at present, most industry observers anticipate that the recent pace of growth will wane, at least in the near term. This viewpoint is supported by the maturity of the private equity industry itself and the current economic outlook.
There are other challenges facing the industry as well. Heightened levels of competition, escalating regulatory oversight, and emerging operational and enterprise risk requirements are squeezing profitability—even before the expected market slowdown.
Based on these factors, we believe the private equity industry may be entering a new phase of growth. The question is, what will this growth look like? We expect it may be more moderate than over the past decade, where the increase in assets under management over some multi-year periods reached double digit compound annual growth rates.
To shed more light on how this shifting environment may affect the industry, we have created a tri-scenario asset-based growth model that spans the next five years. Our estimates for industry growth, which include our perspective on both valuation levels and how we see dry powder increasing, will be detailed in our upcoming report.
Rising asset levels are only one part of private equity growth, however. In a slower market environment, firms will want to focus on growing profitability through restructuring and operational efficiencies as opposed to front office deal-making. To support this transition, we recommend in our report that managers consider the rising importance of three broad areas that relate to the growth and profitability of the private equity firm and its portfolio: the need to create robust internal controls and processes; a growing focus on value creation and operational excellence of portfolio companies; and the use of technology to enable tax transformation.
Of these three areas, which our report covers in greater depth, the processes around internal controls are receiving the most external attention. Transparency requirements by regulators and investors alike are creating the need for firms to take a closer look at how internal controls are set up, documented, and communicated to members of the firm and its portfolio companies. Well-documented controls, coupled with a strong training program, are key to having operational issues appropriately handled, while preventing deal-makers from being distracted by them.
The heightened focus on transparency also extends to fund marketing and valuation. In recent years the Securities and Exchange Commission has shown more interest in the marketing of private equity funds and the valuations used in the performance calculations, and advises that marketing will continue to be a risk area. To help manage this potential conflict of interest—and pass regulatory reviews—private equity firms need to establish clear controls, and ensure separation from any potential valuation conflict related to marketing or performance reporting.
These types of challenges illustrate the growing complexity of the private equity marketplace, a trend we see escalating over the next few years. While we anticipate private equity to remain attractive to investors, based on its outperformance versus standard benchmarks as calculated by Preqin, Ltd., balancing a firm’s objectives of funding growth and lowering costs may become a focal point of the new normal. In this light, initial outlays may be required to support technology, infrastructure, and operational improvements, even amid rising cost pressures. Yet, private equity firms that actively embrace this opportunity may be more effectively positioned for the future.
To receive a copy of the upcoming report, “Private equity growth in transition: Evolve to meet tomorrow’s challenges,” to be published in May 2016, click here, where you will also find Deloitte’s investment management updates. Click here to register for our May 31st Deloitte Debrief on private equity growth.
Frank Fumai is a partner with Deloitte & Touche LLP, where he leads the national private equity audit practice. For more information about Deloitte’s private equity practice, you can e-mail Frank at email@example.com. Deloitte is a Tier 1 Associate Member of the PEGCC