September 28, 2011 12:52 am

Survival of the fittest

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In the glory days of private equity, investors were scrambling to pour as much money into leveraged buy-out groups as they could afford.

In 2007, one UK mid-market buy-out house completed its fundraising within 28 days, as investors did not waste any time with in-depth examinations of the funds to which they were committing their money.

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A few years and a series of global financial shocks later, and investors’ enthusiasm has given way to disenchantment with an asset class that was once highly coveted.

In the fundraising wave that is expected this year and next, buy-out groups will face a much tougher environment. Investors are more selective and less willing to write big cheques. They take more time to decide and grill private equity managers about their past performance and future investment strategy.

“Before the credit bubble burst, I felt like a bouncer at a nightclub,” says the manager of one of the largest private equity funds in Europe of the shifting relationship with investors. “Now it feels more like being a Greek restaurant owner.”

Peter McKellar, chief investment officer at SL Capital Partners, one of the UK’s largest investors into private equity funds, says: “Investors, particularly the larger institutional ones, are re-examining their portfolios – in many cases they are still overcommitted to private equity, an asset class that in some instances did not give them the returns and cash-flow profile that they had expected.”

“Many managers will be raising smaller funds – if they even raise a fund at all,” he adds.

The volume of completed fundraisings worldwide has been on the rise recently, with 120 private equity groups – including venture capital, property, debt and infrastructure funds – raising an aggregate $66bn in the second quarter, according to Preqin, the private equity research company.

But those numbers are still a far cry from the record $214bn that was raised four years earlier, in the second quarter of 2007. With 1,676 funds currently on the road vying for a total of $680bn, the signs are that too many buy-out bosses are chasing too few investors.

“The pie has shrunk – period. And the guys all know that, so they are fighting hard for the pie that remains,” says one large institutional investor.

Almost nine in 10 investors expect to turn down some requests by private equity groups to reinvest into their next fund generation, according to a recent survey of 110 investors from Coller Capital, the world’s biggest investor in second-hand private equity interests.

Fund managers say that US pension funds and endowments, which in the past wrote some of the largest cheques to buy-out funds, will sharply reduce the number of private equity groups in which they want to invest. Banks are also set to invest much less, as they are hamstrung by regulatory constraints that, in effect, bar them from investing in risky assets such as private equity and hedge funds.

Insurance companies and smaller pension funds in Europe are expected to increase their exposure to private equity, but their cheques are likely going to be too small to compensate fully for the drop in demand elsewhere.

With the traditional investor base shrinking, buy-out bosses such as David Rubenstein, co-founder of Carlyle, one of the largest private equity groups in the world, are jetting further afield to court investors. Investors in Asia, the Middle East and Latin America are increasingly looking to put money into private equity.

But in places such as China and South Korea, the money is in the hands of a handful of sovereign wealth or pension funds that usually concentrate on investing in the industry’s brand names, such as Carlyle, Blackstone or KKR.

For the mass of medium-sized private equity groups, these pools of cash are hard to tap.

Investors are forecasting a Darwinian time for private equity in the next few years, comparable to the drastic shake-out in the venture capital market in the decade after the dotcom bubble burst. Institutional investors polled by Coller Capital recently predicted that one in five private equity groups would disappear during this decade.

Steffen Meister, chief executive of Partners Group, one of the largest European-listed private equity investors, says: “The bifurcation of fundraising successes will continue. The niche players with a great track record and the global asset managers will continue to be successful in their fundraising, regardless of the environment. But groups that are sitting between those chairs will find it more difficult.”

The recent turmoil in financial markets is set to exacerbate this trend, as some investors are coming close to their target allocations to private equity after falling values in publicly traded assets have spurred a denominator effect.

But even for those buy-out groups that already have raised fresh capital, the balance of power has dramatically shifted from the buy-out bosses towards their investor base.

Philip Masterson, investment manager at SEI, a services provider to the asset management sector, says this decade will be “the era of the investor”.

One indicator of closer investor scrutiny is that private equity groups have taken 15 months on average to close a fund in the second quarter of this year, compared with the 11 months that were common in the boom years of 2005-07.

Investors say even many of the funds that successfully closed this year, such as Montagu, the UK buy-out firm that collected a €2.5bn ($3.4bn) fund, had a long “pre-marketing” period that preceded the official fundraising.

A number of groups also had to compromise on fees to lure investors into their funds. Sweden’s EQT Partners and the UK’s BC Partners, which are in the process of raising €4.25bn and €6.5bn, respectively, both offered “early bird” discounts on their management fees to those investors who came in ahead of the first closing.

Management fees for existing buy-out funds with more than $1bn in capital have already dropped from close to 1.9 per cent in 2008 to just above 1.7 per cent in the past year, data from Preqin show. Industry insiders say this pressure on fees is set to continue, with some large investors even trying to push through separate accounts that invest alongside the funds and have no management fee at all.

Mark Calnan, global head of private equity at Towers Watson, says: “Across the board, there is a general feeling in the investor community that the industry needs to change to improve alignment of interests. Some larger investors want more control, and fees are very much on the agenda as well.”

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