Wellcome Trust warns of private equity ‘shakeout’

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The private equity industry is facing a “shakeout” that could result in painful losses for investors who piled into the sector without properly understanding the risks of holding illiquid assets, according to the chief investment officer of one of the world’s largest charitable foundations. 

Years of low interest rates have attracted a wave of “tourist capital” into private equity, Nick Moakes, chief investment officer of the £38bn Wellcome Trust, told the Financial Times Future of Asset Management Europe conference in London on Wednesday. 

“It’s people who are investing in assets that have inappropriate risk profiles for them, which is many types of money, but it’s all been prompted by the fact that capital was free, and it will wash out.”

Private equity groups used the post-financial crisis era of cheap money to expand dramatically, as investors poured funds into the sector in search of higher returns in exchange for forgoing easy access to their money — the so-called illiquidity premium.

Now both sides are adjusting to higher borrowing costs and some investors are finding that they have too much money tied up in private equity, according to Moakes, whose foundation is a big investor in the sector. “If you can’t cope with that illiquidity, you frankly shouldn’t be there,” he said. 

A “shakeout process” is already under way as investors try to unlock capital invested in private assets, sometimes by offloading stakes in private funds at a knock-down price, he added. “Secondary sales of really quite high-quality private equity funds are starting to appear, which you wouldn’t normally expect, except from people who’ve realised they’ve got too much of the stuff.” 

With a difficult market for exiting investments, Moakes expects to see a pick-up in distressed sales “because people who got overcommitted to private equity and other illiquids will be forced to raise that liquidity wherever they can, even if it means a deeply discounted sale”. 

Moakes also criticised the financial engineering that some private equity groups are resorting to in the tougher environment. For example, they have begun borrowing heavily against the combined assets of their funds to unlock the cash needed to pay dividends to investors. 

“I don’t like it at all,” he said of the practice. “The reason these facilities are used is to boost internal rates of return,” one measure of assessing an investment’s profitability. “Cynically, the reason why people want IRRs boosted on the asset owner side of the fence, is that many people in the investor world [have their pay linked to] IRRs.”

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Meanwhile, private equity managers are struggling to raise money, which is giving large, well-funded investors such as Wellcome the chance to demand better terms including more co-investment. Private equity firms typically don’t charge management fees on co-investment, making it cheaper to access private markets.

“We’ve made it absolutely clear that we’re open for business on co-investments and the pace of co-investments has accelerated quite sharply for us,” said Moakes.

The Wellcome Trust was founded in 1936 after the death of pharmaceutical entrepreneur Sir Henry Wellcome, founder of one of the predecessors to drugmaker GlaxoSmithKline. In 1995, the trust divested itself of any interest in pharmaceuticals by selling all remaining stock to Glaxo plc. It now exists with the sole mission of funding scientific research in climate change and health, infectious diseases and mental health.

The trust has delivered annualised returns of 14.1 per cent over the past decade. It is an investor across the private equity spectrum, from venture capital to large buyout groups. Moakes warned: “You need to be with the absolutely top-tier partners because the broad venture capital industry has done generally speaking a pretty poor job of delivering any illiquidity premium. If you invest in the median venture capital manager, you’re probably better off investing in an index fund.”

Additional reporting by Will Louch in London