The continuing flow of capital that is being attracted by even the larger private equity funds appears to have put paid to any notion that investors in the asset class would opt out at a time when market conditions have become more challenging. However, the jury is out on whether the fundraising momentum will be sustained once the effects of any downturn can be more clearly seen. Andy Thomson reports.

When it emerged towards the end of last year that European buyout group CVC Capital Partners had been sounding out investors regarding its prospects of raising a new €11 billion ($17 billion) fund, recipients of the news might have been forgiven for allowing their jaws to drop. Even for an LP favourite like CVC, this seemed an audacious target. After all, had the liquidity crisis afflicting the banks not just resulted in a fallow half-year for LBO deals – a drought, moreover, that was forecast to last a good while longer?

By early March this year, there was still scant evidence of a leveraged buyout recovery. To say that activity remained muted would be a generous description. There was, however, a newsworthy development on the fundraising trail: CVC, it transpired, had not managed to raise €11 billion. It had gone comfortably beyond that, capping its Fund V at €12.1 billion – in the process surpassing the previous European record of €11.1 billion set by rival Permira in July 2006.

In an interview with London's Financial Times at a point when early discussions about the fund were underway, CVC chairman Michael Smith appeared confident that investors were looking beyond the problems in the credit markets. He was quoted as saying: “While limited partners are cognisant of the market upheaval, what we have seen with a number of investors is that they are obviously in this for the long term and, when they are in this for seven to eight years, they are not driven by the short-term climate.”

Smith appears to have been right. Fundraisings like CVC's might come to be seen in retrospect as symbolising a new strength of conviction from the investor community regarding the asset class's prospects. Faced with a drying up of deal flow, an economic downturn, stock market volatility and other hints of doomsday, LPs have considered their options and decided to keep shovelling in fresh commitments.

Consider the actions of Washington State Investment Board, for example. Already among the most committed pensions to private equity (in terms of percentage of total assets under management), in November last year the organisation announced it would be raising its allocation from 17 percent to 25 percent. Explaining the move, a Washington statement said private equity had produced “higher and stronger investment returns than could be obtained through more traditional investments”. Specifically, its private equity portfolio returned annualised performance of 15.76 percent over ten years, versus 7.85 percent for US equities and 6.51 percent for fixed income.

The giant California Public Employees Retirement System is also clearly persuaded of private equity's merits. The giant pension scheme, with more than $250 billion under management, hiked its allocation from 6 percent to 10 percent in December. In February this year, CalPERS announced commitments to five private equity funds, including $300 million to Oak Hill Capital Partners III, which has a $4.5 billion target.

And it's not just pension funds (corporate as well as public) queuing up to get into the private equity party. Mounir Guen, chief executive of global placement agent MVision, says demand for private equity is “across the board”, taking in a wide range of investors, some with long exposure to the asset class, others relative newcomers. While acknowledging that some sovereign wealth funds have been around for 20 years or more, Guen points out that “what's a little different now is that some of the newer sovereign wealth entities are trying to emulate organisations like GIC, and they're putting aggressive business plans in place to try and do in five years what GIC have done in 20.” He adds that these sovereign wealth funds have been emboldened by the “recent substantial profits” generated in private equity investors' portfolios.

What's a little different now is that some of the newer sovereign wealth entities are trying to emulate organisations like GIC, and they're putting aggressive business plans in place to try and do in five years what GIC have done in 20

Mounir Guen

For all this, it should not be assumed that concerns are absent when limited partner groups are presented with the opportunity to invest in a mega-fund proposition. Anecdotal reports suggest there is unease about the prospect of capital sitting idle while fees continue to be pocketed. Migration to the mid-market in search of deal flow, meanwhile, is not entirely trusted. Not only does it risk being interpreted as strategic drift, but also raises a question as to whether LBO groups have sufficient resources to competently oversee a larger stable of smaller assets.

Torben Vangstrup, a partner at Copenhagen-based ATP Private Equity Partners, is far from alone in the LP community in expressing some reservations about larger funds. In an interview for the March 2008 issue of PEI, he said: “You have to make sure you don't have all your eggs in one basket. The LBO segment looks a bit tricky and we're not very keen to build new relationships in that space.” He did add, however: “We have a couple of LBO funds in the portfolio that are sector focussed and we think they'll do very well.”

Guen believes there has been a “tilt” to the mid-market. He says: “The mid-market is more popular globally and investors are a little more hesitant about large global funds.” MVision has advised on a series of mid-market closings recently, including Italy's Invest industrial, Norway's HitecVision and Switzerland's Capvis Equity Partners – all of them comfortably beating their targets. Pan-European investor Bridgepoint, meanwhile, was reported at the time of going to press to be nearing €4 billion for its latest fund (with a source suggesting that a €5 billion cap might be reached by May, when a final close is anticipated).

In the US, too, there have been some striking mid-market fundraisings recently. For example, New Mountain Capital closed its third fund on $5.1 billion, having advanced well beyond its $3 billion target. The firm's previous fund closed in 2004 on $1.55 billion. New Mountain co-founder Steven Klinsky cited ability to cope with economic downturn thanks to its pursuit of “defensive” sectors such as education and healthcare. The firm also employs an extremely cautious attitude to debt. Founded in 1999, its first nine deals were equity-only and the next four had debt multiples no greater than 4x EBITDA.

Another notable recent success was The Jordan Company's $3.6 billion closing of Resolute Fund II in February, which surpassed a $2.5 billion target. Jordan's only previous limited partnership, Resolute I, had closed on $1.5 billion in 2002. Founded back in 1982, Jordan had, prior to this, raised capital only from its partners and an entity listed on the London Stock Exchange.

Not that the mid-market per se is attractive. An opinion often voiced by limited partners – all the more so now that economic data makes increasingly gloomy reading – is that the ability to differentiate your firm from the mid-market crowd is essential. But what does this mean in practical terms? In the case of operational strength – arguably today's most prized quality in a GP – perhaps it's the difference between having a couple of operational guys or, as is the case at Jordan, an Operations Management Group that has around a dozen professionals and dates back to 1988. Says Kristin Custar, chief administrative and investor relations officer at Jordan: “Other private equity firms may sit on boards and offer strategic advice. However, our operations team work in the trenches. They sit with the accounting departments, they sit with the IT departments and they help integrate companies.”

What's more, a lot of the firm's operational grafting is done in China. While Shanghai and Beijing are home to two of Jordan's four offices (complementing domestic offices in New York and Chicago), much of the work is done at portfolio companies in some of China's more remote regions. Custar says the core of the firm's China team has been together since 1994. In addition to advising US investee companies on their China strategies, she says the firm has made a total of 16 new and add-on acquisitions in the country including the June 2006 buyout of International Mining and Machinery – the first 100 percent acquisition of a Chinese state-owned enterprise by an American company.

While buyout deals such as these remain rare in Asia, investors have become increasingly alive to the opportunities presented by growth capital investments in the region. At a time when lack of leverage is an issue for some Western buyout funds, it would be no surprise to find Asia viewed as comparatively more attractive. Andrew Ostrognai, Hong Kong-based chair of the Asian private equity practice at law firm Debevoise & Plimpton, agrees with that supposition. He says: “There's a sense that investors in the West are still figuring out how credit issues will affect private equity and what it means for the future. Because Asian strategies tend to be less reliant on leverage, the region is seen as a relative bright spot.”

Ostrognai adds that last year was a “tremendous year” for Asian private equity fundraising that “set the bar very high”. But asked whether 2008 may see a new record total achieved in the region, he says that “all the signs are positive”. Ostrognai's team is doing its best to assist that prediction, having advised on a number of the more successful recent capital raisings in

the region. Among these was Orchid Asia, the Chinese GP which closed its latest fund on its $420 million hard cap. By contrast, the firm's prior fund had closed $20 million below target at $180 million.

Richard Laing, chief executive of CDC, the UK Government-owned fund of funds, agrees that fundraising in Asia is “very buoyant”. But he sees in this a potential cause for concern. Namely, in addition to experienced investors increasing their allocations to the region, he says there is also a swathe of new investors wading into Asia's emerging markets for the first time. Because of this, he says GPs in India in particular are finding “they can raise capital easily, and this is having an impact on deal pricing. Some fairly eye-watering multiples are being paid for businesses there”.

Laing is also worried that an economic downturn would result in much of the ‘new money’ fleeing. He says: “Would a US recession affect Asia? Yes. The question is not whether it would, but the extent. If there is a downturn at some point, will investors keep their nerve? Many didn't the last time there was a downturn.”

In the US and Europe, meanwhile, there are also some doubts expressed as to whether the fundraising train will speed along unhindered. After all, at the larger end, the lack of deals will have an impact on the rate of distributions. And, as funds that have been reliant on leverage are forced to compensate with a little more use of that good old-fashioned thing called equity, returns are not necessarily headed the way investors would like. Perhaps 2008 is not really the true test of private equity's relationship with its investor base. 2009 could be an interesting year, though.