After emerging from one of the most difficult economic environments in history, most private equity professionals had started to feel a little more confident by the middle of 2010 and were looking forward to 2011 – and rightfully so. Companies that had held out on selling started to creep back into the market in 2010, and by the end of last year, deal volume had picked up significantly. In 2010, private equity deal volume reached $195.7 billion globally, up 53 per cent over 2009’s total of $105 billion. The fourth quarter alone saw $57.8 billion worth of private equity deals get completed, according to Dealogic.
What’s more, investment banks saw $9.9 billion worth of revenues come from advisory work on behalf of financial sponsors, according to Dealogic. That was more than twice the $4.4 billion generated in 2009. The data leave no question that private equity activity began rebounding in 2010. That’s the good news. However, regulatory changes and difficulty in raising new funds are two obstacles facing the deal-makers today.
After aggressively putting the money to work during 2004-2007, private equity firms that raised capital during that period now need to raise new funds. According to PitchBook, private equity funds globally raised only $148 billion in 2009, 54 per cent less than they did in 2008. 2010 wasn’t great either; only $90 billion of capital was raised during the year (see Figure 1). Funds that would normally have raised capital in 2009 and 2010, postponed fund-raising in hopes of launching new funds in more favourable market conditions. Now that deal-makers are seeing a marked improvement, 2011 is expected to be a crowded fund-raising market. In fact, globally there are about 700 private equity and venture capital funds, either already in the market or expected to be in the market to raise funds during 2011. They are all competing for the same dollars to be doled out by LPs.
With all the pent-up demand for new capital, private equity firms are finding that LPs are firmly in control these days. LPs aren’t quickly forgetting the challenges that arose during the 2005-2007 time period that left them less than enthusiastic about private equity firms for most of 2009 and 2010. As a result of private equity firms being able to raise a record amount of capital and the wide-open leverage markets, many firms paid aggressively for the companies they purchased. As expected (with the benefit of hindsight), this is already negatively affecting returns. Private equity vintage funds from 2007, for example, are showing an average internal rate of return (IRR) of negative 14 per cent. Mezzanine funds from the same year are showing an average IRR of negative 32 per cent.
It’s not surprising that LPs have pulled back on their allocations, as evidenced by the already changed fund-raising environment. For example, in 2007, the Blackstone Group raised a $21.7 billion fund, the largest private equity fund ever raised. But its latest fund, Blackstone Capital Partners VI, held a final close of just $13.5 billion in July, 2010. Madison Dearborn Partners set out to raise a $10 billion fund in 2008. After 28 months, the firm closed on roughly $4.1 billion, far below its revised target of $7.5 billion set in the summer of 2008.
It’s not all bad news, though. In fact, LPs’ sentiments toward private equity are actually becoming more positive than they have been in recent years, especially toward middle-market funds. According to a survey conducted by Probitas Partners at the end of 2010, Private Equity Market Review and Institutional Investor Trends Survey for 2011 project that 46 per cent of respondents plan to focus their attention in 2011 on investing in middle-market ($500 million to $2.5 billion) buyout funds.
However, the number of private equity firms, able to raise capital, are likely to diminish overall, and there will be a divide between firms that can raise new funds and those that can’t. “Fund-raising will be subjective, based on the GP. There will be a growing divide between the haves and the have-nots. Fund-raising will be very easy for some because they have had spectacular track records and a loyal LP base. These firms won’t have to make huge concessions either,” says Erik Hirsch, chief investment officer for investment advisor and funds-of-funds manager Hamilton Lane, whose clients include MassPRIM, the state of Washington and the United Brotherhood of Carpenters. “Then, there’s another group for which none of this is true. These firms are having serious problems, which will eventually lead to a weeding out in the market.”
It’s important to note that even the firms that can’t raise new funds will not go away immediately – we won’t see the wind-down of those funds for another five years. “It’s a slow death,” warns Kelly DePonte, a senior professional with placement agent Probitas Partners. “In the venture capital industry, you saw a tonne of funds raised in 1999 and 2000 that didn’t finally decide to wind down until 2007 or later. I think about 10 per cent to 15 per cent of private equity firms may disappear, but it will happen slowly.”
If a private equity firm raised its most recent fund in 2006, it should be raising its next fund in 2011. Even if a firm can’t raise a new fund for three years and isn’t making new investments, it will still be managing some portfolio companies bought with its previous fund. It won’t be until 2014 or 2015 that these private equity firms will finally cease operations.
As an aside, with fewer firms in business and the size of some firms potentially smaller, it only stands to reason that there will be a decrease in investment professionals’ headcount over time as well. “We are expecting fewer professionals to staff the firms, but this isn’t necessarily a bad thing. It will help bring down administrative costs associated with being a larger fund which the LPs ultimately pay for,” says one LP, referring to the fees they pay private equity firms to manage their assets.
So what will it take to attract new investment and keep LPs happy? Well, not all LPs’ needs and expectations are alike. Certainly, investors will have their own specific combination of concerns and expectations. That said, some common themes and approaches will resonate with most LPs. As previously discussed, better alignment of interest (including addressing concerns about management fees) will be important. In addition, improving infrastructure and operations to reduce costs and heighten transparency will become an area of focus. Differentiation through industry specialisation and alternative investment strategies is gaining momentum. And finally, enhancing performance through a more proactive approach to value creation will be required to produce attractive returns in a very competitive market place.
LPs are making a greater push for operational enhancements. Because, LPs are under pressure from their pensioners to know more about how their money is being invested, especially if there’s any type of irregularity in the market. Illiquid assets like private equity assets add extra concern. From there, the pressure trickles down. LPs then turn to fund management, demanding accurate information in a timely manner. “LPs are under pressure to let their investors know where their assets are and what their exposure is. Right now, there is a gap between private equity firms that get this done in an acceptable time frame and those that lag four weeks with the excuse that they don’t have a CFO or a back office. LPs are absolutely going to make a distinction and will penalise firms that can’t produce this information when it is requested,” says Hirsch.
For example, before Monument Group allows any of its private equity clients to present funds to LPs, it insists that GPs be prepared to demonstrate their firms’ infrastructure strength. “LPs notice it, comment on it and are more and more interested in hearing about it,” says Campana. “We have our GPs talk very specifically about their back-office initiatives and how they help the firm better manage its portfolio companies. The next thing LPs want to know is how that translates into returns. Sometimes that’s hard to answer. Some value additions can actually cost money, but GPs should then be able to demonstrate how having better reporting technology or providing more purchasing power to the portfolio companies has turned into more sales leads or greater demand.”
The bottom line is that a private equity firm’s job is twofold – to be a good investor and a good fund manager. Being a good fund manager is something most LPs feel GPs have lacked in the past. Being a good fund manager requires private equity firms to have best practices in place concerning infrastructure, reporting and cost. “The big guys are good at this because they have been under pressure to disclose more. More firms need to hire CFOs, invest more in their firms and give LPs timely information that’s usable,” says Hirsch. “Going forward, having infrastructure in place will be a requirement to play the game. An LP won’t even look at you if you don’t have it in place.”
(Jack DiFranco is the National Managing Principal, Private Equity, Grant Thornton LLP, an independently owned and managed accounting and consulting firm).