The implications of the liquidity crisis remain unclear, but confidence is high that investors will not lose their appetite for private equity – and even the larger funds finding it difficult to finance new deals don't seem to be losing support. Andy Thomson reports.

Today, when LBO professionals ponder whether it will take as little as a few months or as much as a year, it transpires they're no longer referring to the length of time likely to elapse before a new deal can be lucratively refinanced. They are, instead, considering how long it might be before the near-moribund larger deal market shows signs of sparking back to life.

Still shrouded in the fog that has settled over it since the sub-prime meltdown in the US triggered a broader liquidity crisis, the LBO market has slammed on the brakes. Figures from data provider Dealogic for the third quarter of 2007 show global M&A value falling 42 percent to $1,000 billion from $1,740 billion in the previous quarter. The private equity sector, meanwhile, registered an even more dramatic tumble, down 68 percent to $130.3 billion.

Given the extent of the slump, one might conjure a mental picture of the largest investors in private equity mopping sweat from their furrowed brows as they fret over the mountains of cash they have committed to buyout funds that is now sitting idle. Instead, the temperature of the LP community seems far from feverish. A sense of calm prevails.

As a consequence, there is no sign of a fundraising meltdown. Anecdotally, sources say they are not aware of any lowering of targets taking place among funds currently in the market. And that includes some fairly hefty vehicles either in the market now, such as KKR's $17 billion 2006 fund, or coming to market soon, for instance CVC's €10 billion European Equity Partners V. Figures from data provider Prequin in September showed private equity funds in the process of raising around $540 billion of new capital in total. The firm said its findings “suggest the industry is ignoring fears about the credit crisis”.


Current Last Website Founded Offices
Large Buyout Funds (>$3 billion)
Apollo Investment Fund VII 15,000 10,100 N/A 1990 New York, London, Los Angeles
Avista Capital Partners II 3,500 2,000 2005 New York, Houston
Bain Capital X 16,000 8,000 1984 Boston, New York, London, Munich, Hong Kong, Shanghai, Tokyo
Blackstone Capital Partners VI 25,000 21,700 1985 New York, Los Angeles, London, Paris, Mumbai, Hong Kong
Bridgepoint Euro Private Equity IV €4,000 €2,500 1980 London, Frankfurt, Madrid, Milan, Paris, Stockholm, Warsaw
Carlyle Partners IV 17,000 3,900 1987 Washington, New York, San Francisco, Denver
Carlyle Europe Partners III €5,000 €1,800 1987 Washington, London, Paris, Frankfurt, Munich, Milan
CCMP Asia Opportunity Fund III 3,000 1,575 1999 Hong Kong, Melbourne, Seoul, Shanghai, Tokyo
Clayton, Dubilier & Rice Fund VIII 5,000 4,000 1978 New York, London
CVC Capital Partners Asia III 4,000 1,975 1981 Hong Kong, Seoul, Singapore, Sydney, Tokyo
CVC European Equity Partners V €10,000 €6,000 1981 London, Paris, Frankfurt, Stockholm, Amsterdam, Milan, Madrid
Diamond Castle V 3,500 1,875 2004 New York
GI Partners III 3,000 1,437 2001 Menlo Park, London
Golden Gate Evergreen 4,000 1,800 2000 San Francisco
Kelso Investment Associates VIII 5,000 2,100 1971 New York
KKR Asia I 4,000 N/A 1976 Hong Kong, Tokyo
KKR Europe III 7,700 4,500 1976 London, Paris
KKR 2006 16,625 6,000 1976 New York, Menlo Park, London, Paris, Hong Kong, Tokyo
Madison Dearborn Capital Partners VI 10,000 6,500 1992 Chicago
Morgan Stanley Capital Partners VI 6,000 N/A N/A 2007 New York
New Mountain Partners III 3,000 1,500 2000 New York
Oak Hill Capital Partners III 4,500 2,300 1984 Stamford, CT; Menlo Park, New York
Pacific Equity Partners IV AUD 4,000 AUD 1,200 1998 Sydney
PAI Europe V €10,000 €2,697 1998 Paris, Amsterdam, Brussels, London, Madrid, Milan
Resolute Fund II 3,500 1,500 1980 New York
Silver Lake Partners IV 10,000 3,600 1999 Menlo Park, New York, London
TA XI 4,500 3,500 1968 Boston, Menlo Park, London
Thomas H. Lee VI 8,000 6,400 N/A 1974 Boston
TPG Asia V 4,250 1,500 1992 Shanghai, Hong Kong, Melbourne, Mumbai, Tokyo, San Francisco
Warburg Pincus Private Equity X 12,000 8,000 1971 New York, Menlo Park, London, Hong Kong
Welsh Carson XI 4,000 3,272 1979 New York, San Francisco

Arguably of more substance is the observation that the appropriateness or otherwise of LBO fund sizes and structures are being very carefully scrutinised by limited partners. Because management fees are charged as a percentage, the quantum of capital raised is a sensitive issue even when there are no question marks over a GP's ability to deploy the capital. But when the new deal pipeline looks dry for the foreseeable future, the issue becomes more pertinent still. Aerni points out: “There are funds in the market at the moment with target sizes that have resulted from the level of investment activity of the last two years. Some might now view these funds as oversized.”

Steven Costabile, global head of the private equity funds group at AIG Investments in New York, says that now is a time for GPs to explain

to LPs exactly why their planned fund size is appropriate. “LBO funds can no longer take it for granted that they will step up two or three times on the amount they raised last time. They have to understand that the strategy must work in the context of the present opportunity and the fund must be set up to address that opportunity.”

However, action to modify fund size targets may be limited as well. There are no suggestions at this point of any hasty revisions taking place on the part of GPs, nor is there any indication of declining demand to access funds from the LP side of the fence. But there's little doubt that an increasingly vital point of negotiation between GP and LP is ensuring that the correct fund structure is implemented to take account of the changing dynamics of the market.

In practical terms, this is likely to mean the greater use of top-up funds, whereby a main fund raised for deals up to a certain size is supplemented by an additional pool of money to be tapped for larger deals only. Crucially, management fees are typically charged on top-up funds only once the capital is invested, thus helping to ease investors' concerns about LBO funds' fee bonanza continuing unabated in the face of a larger deal drought.

But while concerns do exist, there is little evidence that limited partner attitudes towards larger funds have fundamentally changed. Several say they have received calls from LBO fund managers informing them that their powder is likely to be kept dry for the time being. Given the out-performance that has been delivered by such funds over the last few years, investors say they are generally content to take a pragmatic view of any proposal to slow down the pace of capital deployment.

Moreover, investors are putting a positive spin on developments. If a longer investment period means an end to GPs returning to market for fresh capital every couple of years, this, they say, can only be a good thing. After all, internal resources at LP groups have in some cases been stretched to breaking point by the logistical demands of the fundraising boom. The shortening – or even elimination – of due diligence has been an unhealthy symptom of this.

General partners, too, may welcome a “pause for breath”. “From now on,” says Bisgaard-Frantzen, “GPs will have more time to do the deals they do rather than being forced to get deals done within a matter of weeks.”

Many say that, once the LBO debt overhang has been slowly absorbed, the market will take on a more ‘normal’ appearance. In other words: more equity in deals, less and more expensive debt and tighter banking covenants. After the froth of recent times, one senses that this prospect too is greeted favourably.

Nonetheless, along with the predicted return to pre-boom conditions comes an acceptance that performance expectations in relation to large buyout funds should be adjusted down. For mid-market buyout funds, this represents an opportunity to turn investor heads away from their larger brethren – not least by hanging a sign in their windows marked “business as usual”.

Says Kelly DePonte, a partner at San Francisco-based placement agent Probitas Partners: “Mid-market deals generally haven't used as much leverage and have not incorporated some of the riskier terms and conditions such as covenant-lite. As a result, mid-market volume is only down a little and there's a feeling that mid-market strategies will hold up over the long run.”

There are a couple of caveats to the notion that recent developments have left the mid-market unscathed, though. For one thing, the distinction between the upper mid-market and the LBO space is a fine one and some of the riskier deal structuring features seen in the latter space undoubtedly permeated the former to a degree. In addition, it seems natural to assume that at least some LBO funds will entertain the notion of keeping their large deal teams busy by dipping down into the mid-market and, as a consequence, driving up competition for deals.

“LBO funds can no longer take it for granted that they will step up two or three times on the amount they raised last time.”

Despite this, mid-market funds will likely assume that getting a foot in investors' doors will be easier than it has been for some time. Other types of fund, too, will take the view that current market conditions are likely to mitigate in their favour when it comes to raising new pools of capital. Mezzanine funds are frequently cited as an example. Often forced to take subordinate positions by the second lien boom and accept a declining rate of return, mezzanine investors have as much reason as anyone to celebrate a return to market normality.

As might be expected, investors in distressed situations are the subject of renewed interest now that conditions have become more challenging. Living up to the maxim that they are nothing if not opportunistic, some private equity firms are currently raising socalled “hung bridge” funds to invest in the overhang of debt stuck on banks' balance sheets (see feature page 64).

Secondaries funds might also be recipients of renewed interest as opportunities to buy assets and fund positions at a discount start to become apparent (see boxed item page 58). Antoine Drean, founder and managing partner of Paris-based placement agent Triago, says that he has seen plenty of evidence of LPs selling buyout positions through his firm's secondary transactions business, Triago-X.

Says Drean: “Many LPs with large buyout positions are trying to establish which funds are genuinely creating value through buying well and reorganising businesses effectively and which have produced good returns only through the use of leverage. They are looking to keep the former in their portfolios and remove the latter.”

And then there's emerging markets. Don't expect a seismic reallocation of capital from West to East, say market sources. Equally, don't assume that diversification by geography has not edged its way up the priority lists of at least some investors. After all, given that GP strategies in developing economies tend to be based on growth rather than financial engineering, they have a lot to recommend them when the banks pull in their horns.

Seeing through the fog is no easy task, but the murk surrounding the liquidity crisis is dispersing sufficiently for new investment opportunities to become detectable. At the same time, LPs will think hard before abandoning the larger funds that arguably now face more testing times. After all, access is hard won and easily lost – decline an opportunity to invest and there will be no lack of replacements eager to take your place. While a slower pace is predicted by many, no-one is expecting the private equity fundraising bandwagon to grind to a halt anytime soon.