Spinning round and round

The fundraising carousel remains in full swing, and limited partners are struggling to cope with the pace. With strong distributions driving new commitments, few practitioners are preparing for a slowdown. Philip Borel reports.

In March, the European Private Equity and Venture Capital Association (EVCA) published statistics showing that European private equity funds had raised an unprecedented €90 billion ($120 billion) of capital in 2006, 25 percent more than in 2005.

The news had a strange effect on industry observers: it barely seemed to register.

The reason is simple: private equity has become saturated with superlatives. After many months of extraordinary growth, industry professionals no longer blink at hearing numbers that only a year or two ago would have seemed outrageous. €90 billion of private equity capital raised for Europe in a single year? Why, of course: With the ten largest European funds having contributed more than €40 billion alone, EVCA's calculations for last year appear eminently plausible.

Whether the industry's lack of amazement reflects complacency is a moot point. It is certainly understandable. Globally, more than $400 billion was raised last year. And with a new “largest buyout of all time” being announced at least once a quarter, it is no surprise that private equity professionals have learned to take the big numbers in their stride.

What tends to exercise them more is the question of how long the fundraising boom will carry on. As activity levels are reaching ever more dwindling heights, so too is the noise being made by the industry's many critics growing louder by the day. To many, private equity is now an asset class under siege, and regulatory intervention is seen as a worry in many LBO hot spots around the world. At the same time, probing questions are being asked about the sustainability of the benign conditions in the credit markets that are driving deal flow.

No matter: few fundraising specialists are predicting that a slowdown in fundraising is imminent or at least close. To the contrary: institutions hunting for yield continue to look for it in alternatives, and private equity ranks high on their list of priorities. “If I were spending my time listening to institutions telling me they were pulling out of alternatives and going back into indexes, I'd be anticipating a correction. But that's just not what I'm hearing,” says Lyons Brewer, a partner at US-based placement agent C.P. Eaton.

What many institutions are talking about is their appetite for more. A recent limited partner survey conducted by Coller Capital, the secondary specialist, found that 49 per cent of existing investors in private equity were planning to increase their allocations to private equity this year.

In addition, say market sources, new investors with substantial funds to invest are expected to enter the class for the first time.

According to Preqin, a research house, 2007 could see global private equity break through the $500 billion fundraising barrier for the first time. A study published in January estimated that approximately 900 new funds were being marketed at the time, with another 500 being readied for launch. These funds will likely attract between $450 billion and $500 billion of commitments between them, Preqin said.

There are several reasons for the widespread optimism, most notably the fact that previously raised private equity funds have deployed their capital very quickly, and returned profits at an equally impressive rate. As a result of these two trends coinciding, general partners are returning to the market sooner than expected, often with much larger offerings than before, and limited partners are greeting them with open arms.

A recent example was the latest offering from media and communications specialist Providence Equity Partners. In late February, the Rhode Island-based firm closed its sixth fund on $12 billion after four months of active marketing. The fund was nearly three times the size of its predecessor, which closed on $4.3 billion in 2004.

There has been a seismic shift away from the public markets into private equity

Rainer Ender

Such is private equity's appeal to the buy side at this point that insiders speak of a fundamental change of attitude among institutional asset allocators. “There has been a seismic shift away from the public markets into private equity,” says Rainer Ender, a managing director and buyout specialist at fund of funds Adveq in Zurich.

Ender notes that public market indexes such as Britain's FTSE have risen in the past two years but overall public market capitisations have stayed flat regardless. This might be a result of investors having chosen to reinvest the proceeds from listed companies (such as paid out dividends, shore buybacks and going privates) into the private markets, with private equity groups and hedge funds the main beneficiaries.

At some point, this trend may reverse – but fundraising strategists are not expecting to pass the inflection point any time soon. (Asked whether Adveq is forecasting further growth of its assets under management in 2007, Ender responded: “Definitely.”)

The change of pace in the market place has brought challenges to GPs and LPs alike.

Says Philip Bassett, a partner and head of investor relations at Permira in London: “The quantum of capital has changed enormously, and the timetables have become much tighter. Today, completing a fundraising in just a few months is not unusual at all.” Bassett oversaw his firm's latest campaign in 2006, which culminated in the closing of Europe's largest LBO fund to date, at €11 billion.

The biggest funds, such as the recent offerings from the likes of Permira, Blackstone, Texas Pacific Group and Kohlberg Kravis Roberts have been the most visible beneficiaries of the trend towards more private equity. Partly because they can absorb very large contributions, they are popular with the largest institutions. As a result, individual commitments in excess of $500 million are no longer deemed exorbitant. (KKR, which is currently raising a $16 billion-plus global fund, saw it fit to mention in its marketing literature that anyone committing more than $975 million would be eligible for a fee discount.)

The fact that many investors are looking to reduce the number of individual GP relationships in their portfolios is also helping to fill the pockets of the largest groups. According to the Coller Capital survey, the proportion of LPs which have declined to reinvest with one or more of their GPs has increased steadily in recent years – from 45 percent of those polled in the summer of 2005 to 76 percent today.

There can be no doubt, in other words, that more money is flowing into fewer pockets. Is capital concentration reducing the amount of money available to smaller funds? To the contrary, argues Mounir Guen at MVision, a London-based placement agent: “If you make a $500 million commitment to a mega-fund, you will likely want to put another $1 billion into a variety of other strategies pursued by smaller funds – unless your strategy is to have overemphasis on large funds. We're seeing an unusual amount of capital trying to get into smaller funds. The mega-funds have been a real booster to the entire market.”

Another important advantage of the mega-funds is that they are differentiated by size. In the mid-market on the other hand, standing out from the crowd is more difficult – especially in Europe, where more GPs are still operating as generalists than in North America, where specialisation is more advanced.

Robert Thole, a partner at Beneluxfocused mid-market investor Gilde Buyout Partners in Amsterdam, observes: “I think fundraising is slightly different for mid-market funds. Everyone benefits from the increased appetite for private equity. But we do have a little bit more convincing to do than the larger firms.”

Buy side representative Ender at Adveq concurs: “There are few small funds that have easy fundraisings. But the best ones are still going to attract interest from large LPs who are using venture, small buyout and distressed funds to balance their exposure to the mega-funds.”

For the LPs, the breakneck pace in the market place is taxing primarily in terms of getting all the work done. Resources are limited, especially at public sector institutions, and general partner groups returning to the market earlier than expected are inadvertently exposing the capacity constraints of their clients.

If I were spending my time listening to institutions telling me they were pulling out of alternatives and going back into indices, I'd be anticipating a correction. But that's just not what I'm hearing

Lyons Brewer

This is why investors are reviewing the number of active relationships in their portfolios. It is also why, according to market professionals, some institutions that have already exhausted their allocations for 2007 are effectively borrowing from their allocations for 2008 to take advantage of current opportunities.

Yet another consequence of the fundraising boom is that limited partners are looking to streamline their fund selection processes to make them more time-efficient. ATP Private Equity in Copenhagen for instance, Denmark's largest private equity investor and renowned for its thoughtful, methodical approach to the asset class, recently cut the time allocated to doing due diligence on a new fund commitment from 400 to 250 hours.

It is fair to point out though that, according to ATP Private Equity managing partner Jens Bisgaard- Frantzen there are several reasons for this – not necessarily directly related to the current fundraising market. “We have improved the efficiency of our processes because we have learned to focus more on the relevant issues such as team dynamics and the investment DNA of the senior investment professionals and, lastly, we have got more experience over the past six years after more than 150 due diligence processes,” he says.

To be sure, the acceleration of the private equity fundraising cycle is more problematic to some LPs than it is to others. Investors that are relatively new to the asset class and keen to build up their portfolios quickly will generally be more accommodating to the current pace than proprietors of mature programmes whose commitment plans are more rigid.

Well equipped to cope with the current market dynamics are also many funds of funds. These aggregators of limited partner capital are experiencing strong demand from smaller investors whose budgetary limitations require them to outsource their private equity activities to professional asset managers, rather than attempting to cover the asset class in-house. “In terms of resources, small investors often have no choice but to outsource – which is why funds of funds are very busy garnering capital,” says Guen at MVision.

At what point fundraising will decelerate is difficult to predict. Everyone canvassed for this article expressed strong confidence that over the long term, private equity as a genuinely global asset class would continue to grow significantly. No one expected private equity's newly acquired political notoriety to have an impact on its ability to grow its assets under management.

In the short term, however, a slowdown is likely to set in as soon as distributions from earlier vintages start to dwindle, as this will reduce the need for rapid reinvestment. This means that the large funds, which have been pumping large sums of money back into institutional pockets, will continue to set the pace. “Let's be grateful for the big guys. As long as they continue to generate distributions, fundraising will remain busy for the whole of the industry,” says Brewer at C.P. Eaton.

When the downturn comes, the buy side's willingness to follow one of the fundamental axioms of private equity asset allocation theory will be put to the test: if you want to do well in private equity, it's best to invest right through the cycle. Timing the market rarely works, so the key to a well-constructed portfolio lies in meaningful participation vintage year in, vintage year out.

Accordingly, experienced fund investors are showing no inclination to jump off the carousel, even in the event that the pace might quicken further. Says George Anson, a London-based senior managing director at Harbour Vest Partners, one of the largest and most-longstanding funds of funds: “You're not going to stop investing in buyouts. But we don't want to get carried away. It's all about discipline and portfolio construction.”