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Recent PE market strength could mean disappointing returns

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With substantial new inflows of institutional money chasing the limited capacity of top-tier managers, many investors may be disappointe

With substantial new inflows of institutional money chasing the limited capacity of top-tier managers, many investors may be disappointed by future returns.

That’s the view of Mercer Investment Consulting, Inc (Mercer IC), which conducts research on investment managers across various traditional investment strategies and on alternative investment strategies, including private equity funds.

Tempted by private equity’s strong recent performance, many institutional investors are enthusiastically committing new money to alternative investments in 2006, but Mercer believes, investment slots with top-tier private equity managers are increasingly hard to obtain. In this environment, investors in private equity must evaluate the talent and track record of private equity managers and take extra care to ensure that due diligence standards are met.

Despite challenging conditions in recent years, investing in high-quality, top-tier private equity managers with significant experience and investment discipline should provide investors with a high probability of generating strong returns, suggests Mercer IC in its first-quarter Private Equity newsletter. Private equity markets generated strong returns in 2005, dominated by the small-to-medium buyout market sector, while stronger IPO and M&A markets buoyed Venture capital returns, but continue to be plagued by the technology bust of 2000, which remains a drag on performance.

Encouraged by robust investment activity and the realisation of profits from investment ventures, the first three quarters of 2005 saw an upsurge in private equity fundraising compared to the same period in 2004. This wave of new capital arises as limited partners boost alternatives targets or institute new allocations to private equity, a trend of the last few years that accelerated in 2005 and appears to be continuing in 2006.

"As a result of increased demand for private equity and a lack of quality investment managers in the market, slots in top funds were hard to come by," says Caroline Aboutar, a Chicago-based senior consultant with Mercer IC who specialises in private equity. "There has been a power shift. We’re seeing fewer examples of limited partners achieving investor-friendly terms. By contrast, there are more examples of general partners compressing fundraising schedules and insisting on solid commitments before limited partners complete formal due diligence.

"It’s unclear how such investment behaviour, with less time spent on thorough due diligence, will play out in the private equity market,’ adds Aboutar. ‘However, there is the potential for some limited partners to regret not being more disciplined. We foresee another private equity bubble, albeit not as significant as that of the late 1990s. Consequently, the effort to rapidly deploy as much capital as possible, coupled with pressure on deal valuations, may decrease return prospects.

"Institutional investors should take care to make rational investment decisions, taking the time to conduct formal due diligence," she concludes.

Mercer also believes that the private equity market in Europe is similarly robust.

"Within non-US markets, European private equity managers in the buyout sector have raised large sums of assets and face similar issues to those in the US," says Sanjay Mistry, one of the firm’s London-based senior consultants specialising in private equity. "With many changes taking place in the European private equity market, managers have lately attracted significant capital as many limited partner allocations are now equally split between the US and European buyout markets.

"Although the UK and Scandinavia markets are relatively familiar with private equity, other European markets are opening slowly to private equity investors, especially when one considers that European businesses operate at lower enterprise values," he adds.

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