LPs aim to dodge IRR compression

Limited partners think they can sidestep sagging private equity returns by constructing more concentrated portfolios. A survey suggests LPs will narrow GP relationships in 2011.

Eager for stronger absolute returns in difficult markets, limited partners are concentrating more cash in fewer portfolio positions to offset concerns that returns will compress across the global private equity industry, according to a recent study by the London-based financial services consulting group bfinance.

A migration to concentrated portfolios comes as investors anticipate a substantial drop in returns across the industry. Of 49 limited partners polled by bfinance, which included fund of funds, some 66 percent expected IRR terms to compress between 5 percent and 10 percent. 

Investors’ negative outlook on returns seems justified given the even gloomier sentiment emanating from fund managers. Of the 31general partners polled, some 73 percent predicted that IRR terms would broadly drop by 5 percent to 10 percent. Some 12 percent of general partners predicted a decline in excess of 10 percent.

The study found that 71 percent of investors plan to avoid the effects of this return compression by narrowing their allocations to fewer general partners as well as individual funds. 

While investors are looking for leaner and meaner portfolios in the face of industry-wide return compression, most general partners don’t imagine it will affect their assets under management. Some 97 percent of general partners say they expect their assets under management to remain stable or grow through 2015. And 60 percent of GPs say they remain optimistic they will not be impacted by the effects of compression.

Interestingly, concerns about falling returns for the broader sector have not weakened appetite for private equity investment nor has it diminished return targets set by limited partners. The study found that 71 percent of limited partners will continue to allocate to private equity, aiming for IRR of 15 percent or greater. About one-third of investors expect returns of 20 percent or better.

Limited partners polled by bfinance included institutional investors and fund of funds, most topping $2 billion in assets under management. About one-fifth had assets greater than $10 billion.