If you want to know what LPs are thinking about private equity right now, I highly recommend this podcast by my colleagues Adam Le and Chris Witkowsky. It’s about 20 minutes long, so you can listen while you run or work out at the gym.
While the podcast doesn’t delve specifically into venture capital, it is worth listening to the overarching discussion about the impact of rising interest rates on private equity. That’s because VC funds compete with buyout and other private funds for capital in investors’ private equity allocations. As the podcast notes, private equity is losing some of its luster due to rising rates.
Jim Pittman, global head of private equity for British Columbia Investment Management Corp, said on the podcast that he expects to see alternatives exposure fall as more money moves into fixed income.
When we were in a near-zero interest rate environment, institutional investors tasked with meeting specific targets had no choice but to bulk up on PE and veer away from fixed income strategies like government and corporate bonds. Bonds are now a viable option since interest rates have risen. The Federal Reserve this week boosted the range of the federal funds rate to 4.25-4.5 percent, and it will probably raise it a least a few more times as it battles nagging inflation.
“When you’re trying to hit a 7 percent plus-or-minus return for the fund overall, what you’ve seen over the last 10 years is that most of that was driven by infrastructure/private equity,” Pittman said.
With interest rates on the rise, LPs can now get meaningful returns from bonds with far less risk than private equity. “Any time you can allocate more money toward investment-grade bonds/fixed income, it’s a critical part of hitting your 7 percent bogey,” Pittman said.
Now that government bonds are paying upwards of 5 percent, you can move more capital into fixed income and “actually dial down the risk of your portfolio,” he said. “And you will see that happen in many of the pension plans if the interest rates stay mildly high.”
Another issue VC fundraisers need to take into account is that they are now facing more competition from asset classes that benefit from higher interest rates, including infrastructure, real estate and private credit.
“We’re starting to see on the credit side and infrastructure side more and more attractive opportunities, and we do have capital to invest in growing programs in both of those verticals,” Craig Ferguson, managing director of private equity for Investment Management Corporation of Ontario, said on the podcast. “Opportunistic investing can be a little more pointed in both of those areas.”
No going back
No one is predicting that rising rates will cause institutions to move back to the traditional 60/40 split between equities and bonds. What is likely to happen in the near term is that LPs that grew their alternatives allocations to 50 percent will bring them down 5 percent if interest rates continue to make bonds attractive, Pittman said.
We are already starting to see early signs of a shift. The CIO of Alaska Permanent Fund last week said he had become “bearish” about private equity and suggested the possibility of reducing Alaska’s PE allocation from 17 percent today to 16 percent in the 2024 fiscal year and 15 percent in 2025. That would be a big change, since the sovereign wealth fund’s allocation is set to rise 1 percent in each of the next two years. Alaska’s board isn’t scheduled to consider changes to its allocation till next spring.
Cutting a PE allocation would be a dramatic move, so institutions would give any such determination considerable thought before they did it. A much easier decision is just slowing down your private equity investment pace. Three pensions have already said they plan to do just that in the coming year: Los Angeles City Employees’ Retirement System, Sacramento County Employees’ Retirement System and Teacher Retirement System of Texas, as we previously reported.
If more LPs slow their PE investment pace, the result will be a tougher fundraising environment, as VCs will have to compete with buyout and other PE funds for a smaller number and smaller amount of commitments. Managers with existing relationships will go to the front of the line, making it harder for new and emerging managers to get an LP’s attention.
In fact, LPs are already saying they are more reticent about investing in first-time funds. Affiliate title Private Equity International reported that its recent survey of LPs found that 26 percent of investors said they were less likely to invest in first-time managers in the next 12 months, up from 15 percent in last year’s survey.
The bottom line is that raising and closing a fund is going to take more work than it has for the past several years.
“I do think general partners are having a bit of a rude awakening,” Drew Schardt, head of global investment strategy at Hamilton Lane, said on the podcast. “It’s no longer good enough just to say, ‘My performance has been good and historically when that has happened you’ve given me double your last commitment.’”