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Private Equity 2020: Allocators Show Mixed Outlook

Over the course of the post-Great Recession economic expansion, private equity has enjoyed an explosion in both popularity and importance as an asset class. However, as the expansion has slowed and even become shaky at times, limited partners have shown increasing levels of concerns over their private equity investments and the ability of their general partners to deliver their promised returns.

On Dec. 6, Private Equity International (Preqin), a leading industry group and publisher, published a list of the key takeaways from its latest survey of LP sentiment. According to Preqin, while the private equity industry looks strong on the surface, tensions have been boiling up with increasing intensity in 2019 and promise to spillover into 2020.

Still fighting over fees

In recent years, allocators have become increasingly vocal on the subject of fees. According to Preqin, limited partners' struggles against high fees raged on during 2019, and will continue to define the private equity market in 2020:

"With LPs clamouring to put more money into private equity as it becomes harder for them to meet their actuarial returns through more traditional investments, it's easy to think investors must have made their peace with the asset class's relatively high fee burden. Not so: in perhaps a sign of increased scrutiny on the industry in the last year, 73 percent of investors agree that fees charged by private equity funds are difficult to justify internally - up 10 percentage points from last year."

Some of the biggest players in private equity include major pension funds and sovereign wealth funds. These deep wells of capital wield considerable power. Some of these fund allocators have managed to win concessions from the general partners of their favored private equity funds. Such concessions can take many forms, but most often they consist of reductions in management fees and access to co-investment.

In 2020, general partners will likely face even more pressure to reduce fees, as allocators continue to compare private equity against a strong stock market and other benchmarks that have performed well in 2019.

Beware of late-cycle style drift

As market cycles mature, asset managers often find themselves seeking opportunities outside of their original areas of focus (and sometimes beyond their areas of meaningful expertise), either by expanding the asset types they are willing to buy, or expanding into new and unfamiliar geographies. This so-called "style drift" has been increasingly evident among PE firms, with 2019 seeing a further intensification of the trend. Even blue-chip giants like KKR & Co. Inc. (NYSE:KKR) and Blackstone Group Inc. (NYSE:BX) are not immune to this tendency. Consequently, Preqin highlighted intensifying style drift as a potential problem for the private equity industry heading into 2020:

"2019's robust fundraising environment has again seen managers strike out into adjacencies, either within the confines of their flagship fund or through new vehicles. That alarm bell has grown louder this year, with 68 percent of respondents indicating they're seeing occasional examples of this among their GPs, up from 55 percent last year."

According to Preqin, style drift represents "a tell-tale sign that we're late in the cycle." This has certainly been the case for private equity funds during previous cycles, though many other asset managers have proven to be prone to similar behavior. That represents a somewhat ominous sign for private equity heading into 2020.

The specter of recession looms

While many economies, including that of the U.S., appeared to be teetering toward recession earlier this year, broad market confidence has returned in force. That confidence is not reflected quite so strongly among the LPs surveyed by Preqin. Indeed, they show strong signs of increased anxiety and caution:

"In mid-August, the yield curve inverted - long considered a harbinger of a recession - but then in autumn it righted itself. Could 2020 be the year the market finally turns? LPs are certainly concerned about it - almost three-quarters of respondents list a possible recession in core markets as the factor likely to have the greatest impact on performance over the next 12 months."

Private equity is an illiquid asset class by nature, so it can be challenging to exit at will. That can prove troublesome in times of economic downturn. The fact that LPs are showing such high levels of anxiety should be a wake-up call for all investors. These are the allocators responsible for managing some of the largest pools of savings in the world, and their multigenerational responsibility tends to give them a longer-term view of things. When they get nervous, all investors should get nervous.

Looking beneath the surface

Overall, 2019 was a solid year for the private equity industry. Record levels of fundraising showed allocators' continued strong appetite for exposure to the asset class. Yet these strong topline figures fail to conceal many underlying issues tearing at the industry.

Disclosure: No positions.

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This article first appeared on GuruFocus.