‘Shadow capital’ rises behind ‘patient capital’

The $5.6bn leveraged-buyout fund raised by the founders of KKR in 1987 as they pursued the takeover of RJR Nabisco was seen as enormous at the time. But the size of the LBO fund — which was made famous in the book and later film of the same name, Barbarians at the Gate — would barely raise an eyebrow today.

According to US Securities and Exchange Commission statistics on SEC-registered private funds, at the end of 2014, private equity funds managing at least $2bn collectively had $1.2tn in net assets.

Even these funds are increasingly raising capital surrounded by an ocean of other long-term, private markets also vying for the cash of institutional investors. Private equity firms such as the modern KKR have long since become alternative asset managers for the purpose of serving institutional investors seeking higher returns than can be obtained from bonds and equities.

Globally, according to Preqin, a data provider for alternative assets, over 1,000 funds last year raised $550bn of private capital, broadly defined. That made 2015 the third year in a row in which funds tapping investor demand for assets in infrastructure, private debt, and real estate — not only buyouts and venture capital — have raised half a trillion dollars for investments.

Private equity’s $287bn share of this pie in 2015 is still a sizeable amount. But the weight of capital flowing into private markets — looking for higher yield, despite the lack of liquidity and high fees demanded by private equity investment — is making traditional private equity funds and their lifespans less relevant.

Classically, private equity funds lock up investors’ capital for about 10 years. After raising the capital, fund dealmakers spend time picking assets with the goal of returning the money in five to seven years’ (hopefully having doubled or tripled it) through a sale or stock market listing. Yet only a third of private equity backers now invest in the industry purely through classic 10-year funds, according to a survey late last year by Palico, an online private equity fund marketplace.

Just as many investors now invest at least a 10th of their assets in private equity either by taking stakes alongside managers in deals — so-called co-investments — or in direct deals they have sourced on their own, Palico found.

Only a handful of large pension and sovereign wealth funds around the world have the in-house investment teams with the expertise for such direct investment at scale.

The rise of such “shadow” capital over traditional fundraising may grow larger however as other investors look to bring the pace of deploying capital in private equity into their own hands. According to Palico’s survey, three-quarters of investors reported that it took managers three years or more to invest half of the capital they had committed to funds. Waiting a long time for buyout executives to find and make deals is part and parcel of private equity investing and the “patient capital” it is supposed to represent. Yet 43 per cent reported that the pace of deployment has slowed down, a sign of prices for buyouts being pushed up by the rush of capital into the industry.

The . . . capital flowing into private markets is making traditional private equity funds less relevant

This is problematic for many investors given the 1 to 2 per cent management fees they are paying on the capital they have committed, not to mention the opportunity costs of keeping cash on-hand in a low interest-rate world until it is drawn down for deals.

Hence the appeal of so-called shadow capital investments. “What is really important is what you do with the money between commitment and it being drawn down, and what you do with the money after it’s returned,” says Jonathan Bell, chief investment officer at Stanhope Capital, a London-based private wealth manager which launched a private equity platform for its clients last year.

Funds “need to have the cash to be able to make commitments,” Mr Bell adds. “It’s important to keep it at a level where you can keep the money working when it’s not being invested.”