Quant modelling in private equity a sign of maturity

Managing director of Adveq, Peter Laib, believes private equity fund-of-fund portfolios need more analytical oversight and that diversification should be driven by the timing of capital in the market, not the number of funds. He spoke with Amanda White about the next phase of private equity as an asset class.

Managing director of Adveq, Peter Laib, believes private equity is entering its third phase, centring around portfolio construction and developing a better understanding of risk and return.

“There is some over diversification of fund-of-funds in private equity,” he says. “We have to develop an analytical basis for proper portfolio construction. Some analysis says 12 to 13 funds in a portfolio, I don’t necessarily support that.”

In fact Laib, who heads up the $4 billion private equity fund-of-funds provider, believes a more fundamental understanding of diversification is necessary if the asset class is going to progress.

“I believe diversification is not the number of managers, but time – diversification of capital put in to the market,” he says.

According to Laib’s view of the world, private equity has had three distinct phases in its relatively short life as an attractive investment target for institutional investors.

Up until the year 2000 private equity was not included in asset/liability studies and managers were rarely asked the same questions as in other asset classes.

From 2001 risk elements were introduced, and providers such as Adveq started considering quantitative risk measures that were standard in other asset classes.

Now Laib believes the asset class is entering its third phase.

“In 10 years we will have to be able to describe portfolios in a way that is very quant; how portfolios will react when exposed to interest rate and exchange rate fluctuations and various economic conditions. This has to happen if the industry wants to get out of the alternatives pocket. It shouldn’t be in the alternatives pocket,” he says.

“One CIO I spoke with recently said he doesn’t look at investments in asset classes anymore, rather he looks at four options according to economic conditions – cash, government bonds, assets, and companies. He asks, do I believe in companies, then if so I can invest in them through debt or equity in the private or listed markets. This way of looking at the world we will see in the future.”

According to Laib investors need to look at the fundamental assumptions for their view of the world, such as inflation versus deflation, before they can think of asset classes.

Another philosophical discussion he has been having, mostly in the German speaking world, is whether the private equity model is broken.

This has been prompted by the non availability of debt, and alternatively could be asked as: did private equity only work because there was cheap debt?

“The large buyout market, which is three quarters debt and one quarter equity, is dead for now,” he says. “It will return when we see earnings yield in the industry higher and cost of debt lower, but that won’t happen in the near future.”

The venture model is not broken since it has nothing to do with debt, he says. However it faces a different set of challenges.

It is estimated that about $10 billion of capital put into US venture in recent years has been provided by the endowments.

“Of the top 25 names, about 75 per cent of capital has been provided by US endowments,” he says. “Many of the funds haven’t got any capital raising experience, they haven’t needed to. Now they can’t get the first close because they can’t raise the money and no one is replacing the endowments.”

The implication here is that only the very best funds can raise money, and selectivity regarding deals has increased.

“As investors it’s great: we can now get into funds that were closed before.”

According to Laib, venture is not driven by technology or innovation but by investors wanting to buy a company that grows, so capital inflow is a driver. He says overall capital influence in the industry is a key ingredient to choosing an investment.

“Even if you are with a good manager, capital inflows will dominate. Investors should pay more attention to that.”

Based on a global benchmark, Adveq favours China and the US, but not Europe. And in the US, it has its eye on the turnaround equity segment.