Fundraising Conundrum

I thought I would touch on the topic of fundraising this week. I read an article earlier in the week that mentioned there is a large overhang of dry powder (committed capital) that still has to be put to use by private equity funds to the tune of about $145B.

The article (link here), also mentions their guess is about 10% will go unused. Compound that with many funds out there on the fundraising trail at the moment and you have a perfect storm of limited commitment from LPs, and PE funds desperately trying to raise their next vehicle. What is a PE firm to do in such a case?

Note: this is mostly an anecdotal post from my own observations based on conversations I've had with PE contacts in the last few months.

Some background:
Typically, when a PE fund is out shaking the tin cup, they like to point to current usage of existing funds (look how many companies we bought in the last 18 months!), and any recent exits (look how much money we made!). In an otherwise slow M&A market, that’s not always easy to do for a number of reasons:

  • Multiples for attractive companies can quickly out-price appetite for smaller PE firms
  • Competition from strategics is still strong, particularly when they offer 100% cash
  • It’s not the best seller’s market if you’re still reeling from poor performance over the past few years
  • Financing is indeed available but interest rates are higher than many investors like

All of the above will impact potential returns on any completed deals, sometimes underwriting single-digit returns as a result. But why would a PE firm do this? Well, they obviously need to put the money to work. But how can you spin that to current and potential LPs? Well, keep in mind they need to put capital to work as well.

Limited Partner Challenges
LPs are typically in charge of multiple asset classes of investment, private equity being one in the alternatives group. Suppose, for instance, they have $1B to put to work in PE, allocating half to the middle market funds and the rest to the big guys. Of that $500MM allocated to the middle market, they might spread it around to 20 or so PE funds. Of course you want to choose those with highest returns and best general partner teams, but for numbers 18, 19 and 20 on your list, don’t you loosen the underwriting guidelines a bit?

Dodd-Frank Impact
Now factor in Dodd-Frank, which limits any PE fund from tapping the commercial banks that might have been lead or prominent investors in their last fund(s). If you had a commercial bank in for 50% of your fund, and you don’t adjust your next fundraising target, that can be a significant void to fill with new limited partner commitments. No easy task.

The main point here is that all of this is siding with the argument that there is going to be a shakeout in the industry. It might not be swift, but I’m sure you’ll see (and have already seen) some PE funds lower their fundraising goals for subsequent funds, or choose not to raise another fund at all. Yes, that sounds dramatic, but it’s real and it’s happening right now. And sure, there are exceptions as there are to every rule, but on the grand scale we are seeing the beginnings of these impacts in real time today.

What Does This Mean To You
So what does that mean for aspiring PE pros coming out of business school or the top tier of their IB analyst class? Well, fewer/smaller funds likely means less jobs available in the next few years. For some, it might be time to reconsider your career goals or to at least factor in some back-up plans in case the route to PE doesn’t work out in the short-term. For others it means to bust your ass at work and keep networking as best you can to make sure your résumé is on top of an increasing stack in hopes to catch the right eye for your next career move.

 
Best Response

Timely post. There has been an ongoing bifurcation in the PE space where the megafunds and a few MM firms with stellar track records are getting the vast majority of new institutional LP allocations while many MM firms are getting left out.

As result, the megafunds are flushed with a lot more capital than they can possibly deploy sensibly. A NYTimes article from last december stated that, if not soon invested, PE funds would soon have to return around $200b to their LPs. Some firms, notably Centerbridge, already decided to return hundreds of millions back to investors so that their strong returns would not be diluted.

http://dealbook.nytimes.com/2012/10/01/more-money-than-they-know-what-t…

The other side of this coin is that, there are plenty of MM firms that are having hellish time getting their next funds off the ground. This is affecting even once high flying firms like J C Flowers. The hard truth is that anyone with less than mediocre returns in their last fund probably won't get another shot at a new one. Bloomberg says that one in four of firms will probably not survive once their current funds are liquidated. Even being a partner at one of those firms does not save one from being out of a job there.

http://www.bloomberg.com/news/2013-02-12/buyout-boom-shakeout-seen-leav…

skylinegtr94:
LPs are typically in charge of multiple asset classes of investment, private equity being one in the alternatives group. Suppose, for instance, they have $1B to put to work in PE, allocating half to the middle market funds and the rest to the big guys. Of that $500MM allocated to the middle market, they might spread it around to 20 or so PE funds. Of course you want to choose those with highest returns and best general partner teams, but for numbers 18, 19 and 20 on your list, don’t you loosen the underwriting guidelines a bit?

In this fundraising environment the LPs are still holding all the cards as far as MM allocation is concerned. I doubt they feel the need to loosen their underwriting standards anytime soon. If anything, they can afford to be as stringent as they want as, again save a few superstar funds, there are more equally qualified (and all more or less generic) candidates than they want to give money to.

Save a few niche markets with high barriers of entry, returns for PE firms of all sizes are likely to be considerably more modest than before. In fact the hottest area in PE right now appears to be not so much raising new funds for more acquisitions as much as unwinding existing "zombie" funds in the secondary market. Those who buy secondary interests of distressed PE portfolios are having a field day.

Maybe more megafunds can think outside the box and spread some love with their poorer MM brethren. Better give some money to the MM guys to play with or co-invest in their portfolios than return them to the LPs and forfeit the management fees for free.

Too late for second-guessing Too late to go back to sleep.
 

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