When Anglo-French buyout house Duke Street went public in February with an admission that it had been forced to mothball its fundraising efforts, there was a sharp collective intake of breath across the European buyout industry. Focused on the mid-market in Britain and France, Duke Street has a decent brand – and, while it may have had a few less than successful investments in recent years, it is hardly alone in that regard.
The firm’s decision to give up trying to raise a traditional ‘blind pool’ fund and instead raise capital on deal by deal basis is emblematic of the problems facing GPs globally – but particularly in Europe, where record numbers of private equity firms are chasing a diminished pool of cash.
According to Private Equity Connect, PEI’s data service, there are 1,249 GPs on the road this year seeking a total of $685.4 billion. That’s going to be a big ask. Fundraising in the final quarter of 2011 was weaker than at any time since the credit crisis, which meant the total capital raised for the year was just $205.8 billion. Only 347 GPs managed to close their funds.
The figures appear to support apocalyptic predictions that up to 50 percent of private equity firms could close their doors in the next few years. “We are seeing the beginning of a huge shake-out in the industry,” says Francesco di Valmarana, a London-based partner at global private equity investor Pantheon. “We are observing a flight to quality. There’s a whole tail of funds who got by on money that couldn’t get into the best [funds] – it’s much harder for them now.”
Of course, the magnitude of the problem depends whereabouts on the planet you sit, since there’s a definite Old World/ New World split developing.
In the eurozone – which remains stuck in a macro-economic quagmire and susceptible to further sovereign debt trouble – GPs are facing a real challenge, as investors shift their allocations to booming emerging markets.
Mounir Guen, founder and chief executive of London-based placement agent MVision Private Equity Advisers, says: “Investors are taking their allocations for the rest of the world [i.e. outside Europe and North America] from 0–5 percent towards 20–25 percent. The amount of capital that is being displaced to allow that to take place is huge – and it is mainly coming out of Europe’s pocket.”
“Anecdotally, LPs are very wary of Europe,” adds Jeffrey Eaton, a partner at US-based placement agent Eaton Partners. “It is similar to attitudes at the beginning of the tech meltdown: people didn’t know exactly what was going wrong, but they knew it was not good.”
It is similar to attitudes at the beginning of the tech meltdown: people didn’t know exactly what was going wrong, but they knew it was not good
Tom Keck, a San Francisco-based partner at global private equity investor StepStone Group, believes that with European GPs currently trying to raise much more money than there is capital available in the market, only half will meet their targets.
That said, even within Europe, the investment climate – like the macro-economic picture – is a mixed bag. Scandinavian private equity firm EQT, for instance, raised the biggest fund in the last quarter of 2011, collecting €4.75 billion from investors who were happy to back one of Europe’s biggest success stories.
“There are markets within markets, with Scandinavia of most interest to investors,” says London-based Andrew Kellet of Axon Partners. “It is a resilient market and perhaps the best from a macro-economic perspective. The GPs as a whole also have good records. If you compare that with markets like Southern Europe, [where] there are well-documented macro and political issues … [although] a significant number of LPs also experienced performance issues with GPs in places like Italy and Spain before the recession.”
In emerging markets, there are signs that the “Made in China” brand is no longer enough to attract LPs to new funds, with investors becoming concerned about the amount of hot money entering East Asia.
“There’s lots of interest in emerging markets, although the bloom is starting to come off the rose [due to] the idea that GPs have raised too much capital too quickly and growth is slowing,” says Keck.
According to Guen, LPs can be a little too forgiving in these countries. “LPs are a bit more open-minded when it comes to selection in the rest of the world. But they need to be more careful. If you have a bar, you should apply it globally.”
Keck believes (perhaps counter-intuitively ) that American GPs are in a very strong position to attract funds because they offer the stability lacking in east Asia – along with moderate economic growth and the benefits of investing in the dollar (which will remain the world’s reserve currency for some time to come). “The US is in pretty good shape. There’s a very strong home bias for US institutions, which helps,” he says.
Eaton agrees: “It’s been pretty brutal for the last couple of years. But we’re seeing some signs for optimism now.”
Wherever you are in the world, the most important thing for GPs is to be different.
“LPs are demanding differentiation in key business areas including [sourcing] – can the GP get the mythical proprietary deal?” says Kellet.
Strong corporate governance and the precepts of responsible investing are becoming increasingly important for LPs, as is managers’ ability to improve the operational performance of portfolio companies rather than relying on financial engineering for gains – essential in an environment where macroeconomic growth is more or less flat.
That said, the prevailing economic gloom is proving a boon for at least one strategy in cash-strapped Europe: appetite for distressed and turnaround funds has been growing.
“The good mid-market buyout funds remain what investors want – either the top domestic country- focused funds or pan-European or US funds,” says Patrick Petit, president and CEO of Paris-based Global Private Equity. “But there is also a significant demand for secondaries, distressed or turnaround funds in Europe and the US.”
“Distressed investing is always going to be a niche area, but the people who do that can point to some pretty good data on timing,” says Kellet. “Credit funds are also very popular, which takes us to the edge of what could be considered private equity. It looks like an historic opportunity to supplement bank lending.”
Whatever the strategy concerned, the role of placement agents continues to be valued (at least for those GPs not big enough to build up an internal fundraising machine). After all, in these straitened times, an agent who has good access to LPs with money to spend is worth their weight in gold.
“We had all thought that placement managers might disappear, but that is absolutely not what has happened,” says di Valmarana. “They are increasingly sought after by GPs in a highly competitive environment.” His own firm’s interaction with them tends to be “quite functional”, he suggests, since they’re generally pretty familiar with the funds in which they are likely to invest. But that won’t be true of all LPs.
“Even some of the big houses want to develop their relationships with a specific class of investors such as family offices and Middle Eastern investors, which often constitute a moving target [that’s] hard to access,” explains Petit.
That said, Global and its rivals do have to tread carefully in the current climate, he admits. “We see 200 firms a year; we take five. What is important as a placement agent is your reputation – and your reputation is not superior to the quality of the funds you represent.”
SWEETENING THE DEAL
For most GPs though, improving their marketing will only get them so far. If they’re going to avoid the fate that befell the 183 funds estimated to have closed their doors last year (and the figure is expected to be higher in 2012), many will also have to make concessions on terms.
That’s particularly true because many LPs are capital constrained – not only by the lack of decent distributions lately
We had all thought that placement managers might disappear, but that is absolutely not what has happened
Francesco di Valmarana
(after what has been a pretty quiet period for exits) but also because of the so-called ‘zombie funds’ now cluttering up their portfolio.
A study by secondaries specialist Coller Capital, released in February, highlighted the scale of the problem surrounding those unsuccessful GPs that are holding onto investments for as long as possible in order to keep collecting management fees (which typically equate to around 2 percent of the fund’s value).
The survey found that more than half of investors globally have had capital locked in a fund like this, with the phenomenon particularly prevalent in North America. “I would say there are thousands of funds out there [who are] just sitting idle on cash earning management fees,” says Guen.
That amounts to billions of tied-up dollars – and investors who have had their fingers burned in this way are, not surprisingly, being very careful to avoid making the same mistake again.
“While GPs were allowed at least one dud fund before the credit crisis, that is no longer the case.” says Guen. “The turning point for the industry is the work out of investments made in the 2006/07 period. We have to flush that out of the system.”
As a result, hard-pressed GPs have had to come up with various financial and logistical carrots to entice LPs back into the market. The best and simplest mechanism is to return cash to LPs so they can reinvest it, of course. But in the absence of that, there are other options.
“GPs are using a range of incentives to get investors in. They are offering preferential access to co-investment and to secondary deal flows. Volume discounts are [also] fairly common,” says di Valmarana.
“We’ve seen incentives like early fee breaks for first closers, discounts for investors who are writing bigger commitments, higher preferred returns, and some cases of LPs requesting that management fees only be charged on invested capital,” adds Eaton.
London-based BC Partners is a good example: it offered investors a 5 percent early bird discount when it started fundraising for its latest buyout vehicle in 2010. (It ultimately got to its €6.5 billion target early this year).
Fees are another big bone of contention, of course. “LPs want to know monitoring and transaction fees go to the fund, not the GP. Other areas where LPs are negotiating hard include key man provisions, no- fault divorce and clawbacks,” says Simon Wigg, a partner at placement agent Axon Partners.
Addressing liquidity concerns is another area for negotiation. “There will also be ‘stapled’ opportunities to buy in the secondaries market and put new money into the GP at the same time,” adds Kellet.
In March, it emerged that The Carlyle Group would offer investors in its sixth global buyout fund the opportunity to sell their stakes early, with five preferred secondary specialists already lined up as potential buyers.
And while LPs appear to have relatively little success in shifting the typical management fee and carried interest percentages downwards (2 and 20 still seem to be the respective norms, across the board), some firms are offering a different mix: “A less common example is that GPs who previously had premium terms are offering investors a choice between higher carry or a higher management fee,” says Keck.
For instance, while raising its latest fund, buyout giant Bain Capital has apparently been offering investors a choice between higher carry or higher management fee.
Keck also points out that the bigger GPs are also offering more bespoke solutions that allow big clients to shift their investments quickly across different asset classes. “This [move towards asset allocation] is probably a lesson from 2009 where credit markets became highly dislocated but recovered quickly and investors didn’t have enough time to take advantage,” he says.
So will all these incentives and discounts persuade investors to stick with private equity as an asset class?
Petit argues that it will not be enough to save all the managers currently in the market. “We will see teams disappearing because they are unable to raise successor funds. We also see some GPs raising capital on deal by deal basis.”
Others are less pessimistic. “We don’t think it’s going to get as bad as some people say,” says Kellet. “It’s early days; the congestion is still a long way up the python. But the next 12 months will be crucial.”
Most observers also point out that as with marketing, short-term financial incentives can only get you so far; ultimately, the strength of a fundraising proposition boils down to track record.
“Any GP who is coming to market and has demonstrated the ability to complete private equity investments with a competitive return should be able to raise money,” says Long.
Or as Guen puts it: “All these people talking about first close discounts and other incentives… Give me a break. It’s all about performance.”
Ultimately LPs are most interested in one thing: good returns. So unless managers can point to an unblemished track record, they’re going to have to come up with innovative ways to stand out from the crowd. Either way, fundraising this year is likely to be a long, hard slog.