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
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.
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.
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.
“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.
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.
“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
Kirk Dizon, Hall Capital Partners, San Francisco
STUPID TO HAVE A FIRE SALE
Official of major UK pension trust
GOOD PRACTICES ARE RESURFACING
Andrew Lebus, Pantheon Ventures, London
DISTRESS IS BEST
Investment officer at California family office
WE LIKE SMALLER BUYOUT FIRMS
Carroll South, director, Montana State Board of Investment
DISCOUNTS HAVE WIDENED
Fund of funds manager in Europe
DECENT CLOSINGS AT RISK
David Wilton, Private Equity and Investment Funds, IFC, Washington DC
RE-UPS HAVE PRIORITY
Jay Fewel, Oregon Public Employees Retirement Fund