Riders on the storm

Jeremy Lytle is the envy of general partners with a fund in the market. As head of investor relations at mid-market investment specialist ECI Partners, one of the UK's oldest private equity firms, Lytle late last year helped corral £430 million (€455 million; $633 million) in capital for the firm's largest fund closing to date.

ECI surpassed its initial target of £400 million for the fund, which will invest in businesses with enterprise values between £10 million and £150 million.

Lytle was able to replenish the London-based firm's coffers in just three months – an eye-catching speed considering the fundraising took place in an environment of economic crisis and cash scarcity.

“Against the backdrop we encountered in October and November, there was always the possibility that we wouldn't be able to do the close as a first and final,” says Lytle, who notes that 90 percent of the fund's capital came from existing investors. “But the fact that it was a first and final, we're absolutely delighted with.”

Although ECI's successful fundraising was announced last year, it provides an illuminating glimpse of the paradox that will define private equity fundraising in 2009.

By almost all accounts, general partners are confronting the worst fundraising market in recent memory, with many industry veterans predicting a capital raising drought that will be more severe than the post-telecom downturn of the early 2000s.

The denominator effect, insiders say, has strangled limited partner liquidity. Pensions, endowments, family offices and foundations have all fallen victim to its repercussions.

Institutional investors are still for the most part optimistic about private equity as an asset class that can deliver outsized returns. But because of over-allocation issues, most simply don't have the cash in hand to commit.

“The fundraising market right now is very grim, extraordinarily grim,” says Bob Mast, managing director at Boston-based placement agent Monument Group. “We at Monument have been in the business since 1994. This is easily the worst market we've seen in our existence.”

Still, as Mast readily notes, some firms like ECI are able to close funds, and at near breakneck speed. So what is driving these seemingly divergent trends?

There is no doubt that the fundraising market in 2009 will be nowhere near as frothy as it was in 2007 or during the first six months of 2008. But the landscape is not completely barren – instead, like many other aspects of private equity, it is in the process of being redrawn.

VINTAGE YEAR AHEAD
Recent converts to the asset class, which only recently launched their allocations to private equity, are well aware that 2009 will likely be a fruitful vintage year for many funds. Those investors are eager to commit to opportunistic strategies, from distressed and turnaround funds to mid-market buyouts and secondaries.

Back in October last year, as reported in PEI, general partners and placement agents were beginning to complain about how the dual forces of declining public equity values and dwindling exit distributions were making limited partners extra cautious about over-weighted allocations to alternatives.

The investors who have been in the most trouble have been in the market a long time. It doesn't matter if they are an endowment, foundation, pension or family office – those are the people that are tending to be over-allocated Kelly Deponte

That was before the brunt of the financial crisis ripped into the public markets, sending the Dow Jones Industrial Average down more than 400 points and sinking the total assets under management of nearly every institutional investor.

Now several prominent limited partners with long-established private equity programmes are well above their target allocations, and in some instances have surpassed the upper limit of their target allocation range.

The $182 billion California Public Employees' Retirement System's actual allocation to alternatives stood at 13.8 percent as of 31 October 2008, according to the most recent data available.

That figure is well above the pension's target allocation of 9.5 percent and also above the upper limit of its allocation range at the time, which stood at 13 percent.

In response, CalPERS voted in December last year to temporarily raise the upper limit of its target allocation, from 13 percent to 18 percent.

Many other prominent US investors with large legacy portfolios, including the $97 billion Florida Retirement System and the $147 billion California State Teachers' Retirement System, have adopted similar emergency measures ahead of more comprehensive allocation reviews scheduled for early this year.

The expansion of allocation targets for private equity should be viewed as a positive sign for the asset class, as in many instances it reveals an appetite on the part of investors to continue making fresh commitments to attractive funds and to support capital calls.

By the same token, the new policy ranges should not be interpreted as a sign that institutional investors are anyless cash-constrained than in the second half of 2008.

A recent survey conducted by UK secondaries specialist Coller Capital found that, over the last year, 80 percent of US limited partners have refused to re-up with at least one of their existing managers, while 63 percent in Europe and 52 percent in Asia have taken similar measures.

Looking forward to the remainder of 2009, institutional investors expect cash constraints to persist. According to a study by San Francisco-based placement agent Probitas Partners, most limited partners expect global commitments to private equity in 2009 to total less than $200 billion.

By contrast, in 2007 private equity firms raised roughly $438 billion, and through the third quarter of 2008 had amassed $374 billion.

“The investors who have been in the most trouble have been in the market a long time,” says Kelly Deponte, a partner at Probitas. “It doesn't matter if they are an endowment, foundation, pension or family office – those are the people that are tending to be over-allocated.”

Deponte adds that private institutional investors like endowments and foundations are in many instances more cash-constrained because they are suffering from a steep drawback in income – namely, philanthropic donations. Pensions, on the other hand, can count on relatively stable contributions from current employees.

FINDING SOLACE
Despite the gloomy fundraising outlook from investors with sizable legacy portfolios, general partners may find solace in a regulation many have vocally loathed: mark-to-market accounting.

Many LPs awaiting year-end asset valuations for private equity funds are hoping that the upside of any significant write-downs in investors' private equity programmes will be more liquidity.

“Overall, the first quarter of 2009 will be very, very slow,” says Deponte. “After that, for those established investors that are up or near their target allocation, if they've got large exposure to mega-buyouts, write-downs may come into play.”

It remains to be seen how much mark-to-market may counteract the denominator effect. Certainly for those limited partners that invested major sums in mega-buyout funds over the last two years, write-downs may prove substantial.

In the meantime, general partners looking to raise fresh capital are turning to those institutional inves tor s most immune from denominator worries: i.e., those with young private equity programmes.

That new-found focus is part of the reason why Adam Tosh, chief investment officer at the $17 billion Kentucky Retirement Systems (KRS), has never been so popular.

KRS launched its private equity programme in 2003, and maintains a 7 percent target allocation to the asset class. After investing $610 million in private equity in 2007 and $455 million last year, its actual allocation is a relatively modest 3.9 percent.

EVERYONE CALLING
Tosh, who notes that after fourth-quarter returns are tallied KRS may decide to hike its alternatives allocation to allow for more investment, observes: “Placement agents have always been aggressive. What I think is more noticeable are the well established firms that maybe a year ago didn't necessarily come calling. Now everyone's our best friend.”

Tosh has been so impressed with the quality of managers that have come knocking at his door that he refuses to rule out any strategy. Like other investors, he is well aware that recession years tend to yield very satisfying returns, and says he would be more than willing to become over-weighted to the asset class if the opportunity warrants.

However, he also stresses that he will be more inclined to invest with managers that adhered to their core competencies during the buyout boom and did not indulge in style drift.

“Everyone is now talking about the organic growth of a company, and it's really funny to hear it come out of some of these organisations' mouths because a year ago it was all about financial engineering,” says Tosh.

European investors, arguably slow to embrace private equity, are now poised to wield more power than before as they have suffered less from the allocation woes that have plagued their North American counterparts.

LOUDER VOICE
“As US funds bring on more European limited partners, we will have a louder voice than we have had in the past, and collectively our interests are going to be a bit more solidified,” says Anna Dayn, a private equity adviser at UK and Dutch pension consultant Cardano. “LPs tend to pack together to get what they like, and having more European limited partners will give us a strong voice.”

European GPs may enjoy a slight advantage in fundraising in this regard, as they enjoy longer relationships with limited partners based in the region than US firms. Those with niche North American investment strategies may be at a disadvantage, as some European investors will be reluctant to commit capital to strategies which require a lot of education.

In any event, don't expect North American or European investors with young alternatives programmes to rush in early before a first close. Because most are well aware that the likes of CalPERS and CalSTRS have their hands tied, newer investors are planning to take their time with commitments, and will not be so pressured by the threat of not being able to access an attractive fund.

WHAT'S HOT
So which strategies will limited partners with available capital find most worthy of investment in 2009?

Distressed debt, turnaround and special situations funds will likely be very popular among investors, as they were in 2008.

Nearly 59 percent of limited partners in the Probitas Partners survey said they expect the best returns for 2009 vintage funds to come from distressed debt vehicles.

Funds targeting the small to mid-market, such as those managed by ECI Partners, will also find a receptive audience among limited partners as the execution of these strategies is deemed to be less reliant on the frozen credit markets. Mezzanine funds will also attract interest.

The appetite for distressed, mid-market and mezzanine funds all makes sense considering the relatively bleak macro-economic outlook, and have been popular during recessionary periods in the pas t. But another investment strategy with a less-established history is also attracting attention.

Secondaries funds look poised to have one of their best fundraising years on record in 2009. According to the Probitas survey, secondaries rank only behind distressed debt funds as the most attractive to investors in the coming year.

There's a growing militancy on the part of some of the limited partners. They're saying the general partners have been walking all over us for the last 20 years and now we can make some things happen Bob Mast

“We've always been active in secondaries but the risk/return profile and the pricing were not in a range to do much in the last of couple years,” says Cynthia Duda, a managing director in the investment management team of Capital Dynamics, the Swiss alternative asset adviser and manager. “But the quality and the volume are there this year.

General partners favoured with LP commitments should expect to give ground on negotiable aspects of fund structures – transaction fees, waterfall schemes, fund sizes and, in some instances, even management fees.

“We see a lot of people giving ground on fund size, accepting lower caps or decreasing the size of their fund,” says Mast of Monument Group. “There's a growing militancy on the part of some of the limited partners. They're saying the general partners have been walking all over us for the last 20 years and now we can make some things happen.”

DON'T PUSH TOO HARD
But limited partners should be cautious not to push general partners too far. Just as the power pendulum swings in one direction, it can just as easily spring back in the other.

“We don't believe that now's the time to pressure GPs with respect to fees just because the tide has turned,” says Katherina Lichtner, head of research for Capital Dynamics. “We have to make sure alignment of interests is correct but we also have to make sure our GPs are properly funded to attract the best talent – particularly now.”

Even in the toughest of times, limited partners may be cutting back – but they are not cutting GPs' funding lines completely. Look in the right places and the capital essential to the industry's continuing prosperity can still be found.

LIMITED PARTNERS IN THEIR OWN WORDS
PEI recently interviewed dozens of LPs around the world. Here are excerpts of what they said

HYBRID APPEAL
“Does the private equity opportunity look as good as the credit opportunity for people who buy debt at 50 cents on the dollar now? Firms that can combine the two strategies are very interesting to us right now.”

Kirk Dizon, Hall Capital Partners, San Francisco

STUPID TO HAVE A FIRE SALE
“We have no issues – our portfolio across the board is highly diversified both geographically as well as by style. We're signed up to various commitments and we'll meet them when they come due. It would be stupid to have a fire sale of assets. I wouldn't sell equities now. Now is the time to consider what other strategies are out there and where we're going in the market.”

Official of major UK pension trust

GOOD PRACTICES ARE RESURFACING
“Private equity is endlessly creative and will adapt to a new cycle, returning to its core business model – growth. Good practices, which might have been overshadowed by the effects on returns of leverage, are now resurfacing. What may occasion real change are significant increases in regulation on both sides of the Atlantic.”

Andrew Lebus, Pantheon Ventures, London

DISTRESS IS BEST
“We've started doing an overweight to distress. Some distressed funds might have been too early so we're taking the view that we need to keep allocating to this for the next few years. We'll never find the bottom, but in the next five to ten years we're going to look pretty good.”

Investment officer at California family office

WE LIKE SMALLER BUYOUT FIRMS
“We're not signing up with any of the mega-buyout firms. We do have small buyout firms in the mid-cap arena, and we like the smaller buyout firms because they focus more on improving the company and exiting out.”

Carroll South, director, Montana State Board of Investment

DISCOUNTS HAVE WIDENED
“We are thinking about the secondary market. We've only been active there on a one-off basis, looking on a single-LP basis but never on a more sophisticated basis. We will have to build another team to focus on that opportunity. Discounts are quite large and have widened a lot.”

Fund of funds manager in Europe

DECENT CLOSINGS AT RISK
“Normally when the IFC backs a fund we're sure it's going to have a decent closing. But in this market you have to ask if that's still going to happen so easily.”

David Wilton, Private Equity and Investment Funds, IFC, Washington DC

RE-UPS HAVE PRIORITY
“In 2009 it looks like it's going to be re-ups only. Re-ups have first priority here because we have an existing relationship with [managers]. So, in a time when you have limited money to commit, and with quite a few re-ups coming back, they'll have first call on the money. But that's always been the case.”

Jay Fewel, Oregon Public Employees Retirement Fund