Fundraising trends in private equity

October 2023  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

October 2023 Issue

As we entered 2023, limited partner (LP) sentiment toward private equity (PE) was weaker than in 2022, in a world still emerging from the after-effects of the global pandemic. According to our research analysing the current state of the PE landscape, portfolio valuations, the macroeconomic environment and a decrease in distributions were at the forefront of investor concerns.

Fast-forward two quarters and while LPs have seen an increase in private fund opportunities, a lack of liquidity has resulted in a severe imbalance of available LP capital compared to what general partners (GPs) are hoping to raise. Bain’s ‘Private Equity Midyear Report 2023’ notes that there is only $1 of LP capital available for every $3 of GP demand – an imbalance which has never been greater.

Given the turbulent macroeconomic environment, the capital that is available is being concentrated among existing relationships. Even then, over a third of LPs noted that committing lower amounts to existing relationships further emphasises the extreme capital constraints some allocators are currently facing.

GPs rethink fund targets and grapple with rough market conditions

After eight years of positive cash flows between 2011 and 2018, LPs have seen contributions to their PE portfolio outweigh distributions for the fourth time in the past five years. As cash flows have turned negative, and with LPs struggling with liquidity concerns, aggregate commitments to buyouts have fallen, causing many GPs to face significant fundraising headwinds, reshaping their fund size expectations. Not only have fund sizes been revised down but gone are the days of GPs wrapping up their fundraise within a year. The number of PE funds currently in the market has skyrocketed, and the average fundraising timelines for funds closed in 2022 were at an all-time high of 26 months, longer even than those experienced by GPs after the 2007-08 financial crisis. While there has been some reprieve with overall fundraising timelines coming down for funds closed so far in 2023, there has been a dramatic spike in the timeline of GPs reaching their first close, hitting a high of 11 months.

Over the past 10 years, median enterprise value (EV) to earnings before interest, taxes, depreciation, and amortisation (EBITDA) buyout multiples at entry have increased by 86 percent (from 7.9 times in 2013 compared to 14.8 times in 2022) while the same multiples at exit have risen at less than half that rate (11.4 times in 2013 compared to 15.8 times in 2022, an increase of only 39 percent). At the same time, GPs are operating with high levels of debt at the portfolio level with entry net debt to EBITDA at 5.8 times and exit net debt to EBITDA at 5.7 times hitting historic 20-plus year high-water marks. Consequently, with value-creation through financial engineering harder to come by, GPs are increasingly focusing efforts on increasing revenue and EBITDA organically via operational improvements.

It is unavoidable that rising interest rates and inflation will create headwinds for PE dealmaking. GPs face higher costs of borrowing (and therefore downward pressure on returns), lower valuations from the use of higher discount rates on future cash flows, and reduced profit margins as inflation impacts the price of goods and services. However, PE firms can adapt by focusing on sectors that are less impacted by inflation, such as healthcare, utilities and infrastructure, among others, while remaining disciplined around the use of debt at both the portfolio and fund levels.

The trajectory of inflation is notoriously difficult to predict, and for every analyst who expects inflation to stabilise or go down by the end of 2023, you are likely to find another who thinks it may remain elevated for a longer period. While the opinion of market analysts may differ, investors are of the same mind with interest rates and inflation at the top of their list of concerns for 2023. LPs will be keeping a close eye on how GPs structure their portfolios and whether they maintain investment discipline in the face of prolonged uncertainty. LPs can be easily scarred and are not quick to forget – over the next cycle, the best dealmakers may be the ones that end up protecting capital rather than shooting the lights out.

LP capital continues to flow out, but not back in

Despite a flurry of deal activity in 2021 and signs of market improvement going into H2 2023, both distributed capital and the real number of exits have continued their downward trends. LPs have been hit with a double whammy as the denominator effect continues to be affected by falling public markets, while their PE programmes call capital as normal.

Annual capital returned to LPs in 2022 was well below the long-term historical average, dropping to 14.6 percent (distributions as a percent of net asset value (NAV)), a level not seen since the aftermaths of the dotcom bubble in 2001-02 and the 2007-08 financial crisis. IT has seen the biggest drop in exit volume from 2022 ($157bn in 2022 vs. $28bn in the first six months of 2023), while consumer discretionary is on pace for the biggest relative decrease ($48bn last year versus $6bn through to the end of June).

Though M&A deal volumes in 2022 reached $1.6bn, near historical highs, activity in 2023 started sluggishly. In terms of distributions, 2023 got off to the second worst start (2.2 percent in Q1 2023) in the past three decades, second only to the 1.5 percent of Q1 2009.

For GPs, the current state of the exit market means that those who rely on a robust IPO market for realising assets will continue to face challenges, despite more favourable conditions beginning to emerge.

Flight to quality and scale

As markets stay volatile, investors look upmarket for downside protection. Within buyouts, larger funds are generally considered the ‘safer’ equity asset class as it provides a lower dispersion compared to smaller managers. Moreover, large- and mega-cap buyout funds have demonstrated their ability to protect capital on a relative basis through multiple cycles, making them more attractive in times of heightened volatility and a ‘risk-off’ attitude.

LPs continue to put a lot of emphasis on long-term performance, realised track records and the team or individuals that have generated these returns. A consistent application of fund strategy and the stability of the team are key factors to growing fund size over time. On the flip side, GPs that lack differentiation have mixed performance and those going through organisational or strategic changes are disproportionately and negatively affected in the current market.

All this has resulted in the largest PE firms taking an even bigger slice of the capital pie each year. As capital concentrates at the larger end of the market, we have seen a squeeze on those down below as coffer-rich GPs can more easily dominate sale processes for quality assets.

Creativity the name of the game for GPs

Amid this challenging fundraising market, GPs are offering preferential terms to compete for capital in a crowded market. Creative fee discounts remain an attractive opportunity, while investors are also turning to co-investments to add exposure and average down fees.

The flow of capital into co-investment funds has continued its upward trajectory with capital invested in deals and fundraising increasing by 11 times and three times respectively in the last decade. The rise of co-investment capital is mirrored in the importance LPs put on the availability of co-investment as part of their GP selection criteria. The vast majority of LPs (72 percent of those surveyed) reported that the availability of co-investment opportunities has become a key factor when evaluating a new GP relationship.

The takeaway from this is that GPs looking for ways to stay agile in the current climate and energise LPs into making new fund commitments would benefit from providing ample co-investment, and their resulting fee incentives, where they can.

 

Sunaina Sinha Haldea is global head of private capital advisory and Darius Craton is a director at Raymond James Private Capital Advisory.

© Financier Worldwide

BY

Sunaina Sinha Haldea and Darius Craton

Raymond James Private Capital Advisory

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