July 2017 Issue
The private equity (PE) industry is in good health. According to Preqin, as of June 2016, there were $2.49 trillion worth of PE assets under management – an all-time high. With record levels of dry powder held by funds – $820bn by December 2016 – the state of the industry has rarely looked better.
PE fundraising, too, has been on a sharp upward trend. Globally, funds have raised more than $500bn each year since 2013, showing little sign of slowing down. Each year, more funds are being opened with high targets. Though the fundraising landscape is currently crowded, there is still strong demand among institutional investors looking for healthy returns – which in recent years PE has been able to provide. According to Bain & Company, returns were strong throughout 2016, continuing to outperform public markets over both short-term and long-term horizons.
Interest in PE has spiked since the end of the global financial crisis. Though economic and geopolitical conditions have been unstable over the past two years, the PE industry has remained relatively unscathed. Belying doubts about the state of the global economy, fundraising remained resilient throughout Q1 2017, particularly in regions – such as the US – where uncertainty has been rife. Ninety-nine of the 175 funds that closed in Q1 2017 were primarily focused on investments in North America, according to Preqin. Despite concerns around the emerging economic and social policies of the Trump administration, US focused funds outstripped their European counterparts. Indeed, the 99 North America-focused funds raised $62bn in Q1, the most ever for a first quarter.
Over the last 12 months, Brexit and a number of elections across the European Union have affected the economic outlook, yet Europe focused funds have prospered. “The political uncertainty of 2016, and which continues now in Europe, does not seem to have affected appetite generally for PE investments,” explains Stephen Newby, a partner at Herbert Smith Freehills LLP. “Brexit is having an impact on some EU-based investors’ allocations to UK funds, but that is balanced by others who see an opportunity in the currency volatility we have experienced and the fact that investors take a long-term view of PE as an asset class. Certain investors have become very sophisticated in their allocations and we see GPs responding with very targeted investment strategies in some cases.”
Capital commitment gains
The positivity permeating the industry has translated into a more crowded marketplace, which, rather than strangle competition, has invigorated global fundraising efforts. According to Preqin, 1908 funds were seeking a record $635bn from investors in Q1 2017. On the heels of another strong year for fundraising, where GPs raised $589bn in 2016, down just 2 percent from 2015, managers are seeking and finding money despite the saturated market.
As the level of capital raised has grown, so too has the size of individual funds. Mega-funds have enjoyed a resurgence. According to Pitchbook, in 2016, 13 funds held final closes with commitments in excess of $5bn, the most since 2013 and the third most of any year in the last decade. Those 13 funds accounted for $103.1bn – 38.4 percent – of all dollar commitments to PE last year, compared to just 30.7 percent in 2015. Further, Q1 2017 saw fundraising reach $89bn across 175 PE vehicles, according to Preqin.
In recent years there has been a rush of capital out of public markets and into alternative asset classes, such as PE and real estate. This shift has been driven by the search for yield and return, according to Alex White, managing director and head of European M&A at Equiteq. PE has been chief beneficiary of this flow of capital, accounting for 57 percent of all private capital raised in 2016, up from 52 percent in 2015, according to Preqin.
“LPs make long term commitments to PE funds, and so major geo-political events, perspectives on long term political stability and economic performance directly influence regional allocations,” says Mr White. “Then, at the domestic lower and mid-market manager level, LPs are asking GPs how they support value creation in an environment when entry prices are high. At the large cap and international fund levels it is also about ability to allocate capital in different jurisdictions and leverage reach, not just firepower. For first time managers and even established players, offering co-investment opportunities outside of the fund commitment and being flexible on compensation structures, all come as standard.”
While North America has been a fertile area for the PE industry, Asia too has emerged as a fundraising hub. “Asia has been a strong source of capital for PE funds, with Asian LPs generally increasing PE allocations and forming new relationships with managers,” says Will McCosker, an international partner at King & Wood Mallesons. “In particular, Australian superannuation funds have been a good source of capital for PE funds. The recent tightening of restrictions on RMB flowing out of China has limited Chinese participation in offshore PE capital raisings this year. However, the domestic Chinese PE market is experiencing strong growth and PRC demand for offshore PE investments remains robust. When RMB exchange restrictions are loosened, we expect significant PRC capital flows to offshore PE funds.”
Though recent regulatory developments in China will have implications for the national economy, curtailing investment activity overseas, the wider Asian region will remain a focal point for PE and PE fundraising in the second half of 2017 and beyond. Three of the five largest PE funds are in Asia, according to Preqin. Further, though over half of all PE funds are focused on North America, Asia has overtaken Europe as the second most targeted region for PE investment. The Chinese state-owned Capital Venture Investment Fund, which has a target of $29bn, is the second largest PE fund globally. UOB Venture Management’s Sino-Singapore (Chongqing) Connectivity Private Equity Fund and China Ministry of Finance’s The China Internet Investment Fund, were also among the top five.
The launch of Japanese telecommunications giant Softbank’s $100bn hybrid fund, which has targeted the tech sector, is a landmark moment for PE tech-focused funds operating in both the US and Asia, and will likely have a transformative effect on fundraising and dealmaking in the tech sector moving forward. The closing of technology and media investment specialist Silver Lake Partners’ fifth buyout fund at $15bn, surpassing its initial target of $12.5bn, is also indicative of the strength of the fundraising space, particularly for funds targeting the tech industry.
Though much of the capital raised in Asia is being deployed there, Asian funds are also looking elsewhere, notes Mr Newby. “We continue to see a lot of interest from Asia and, in particular, China. Many of our Chinese clients are looking to access European markets through fund structures, though there is often a heavy emphasis on co-invest and a desire to form strategic partnerships or clubs around specific opportunities, rather than to invest in traditional blind pool.” Whether Chinese interest in overseas opportunities will survive the government’s pivot away from overseas investment remains to be seen.
Given the competition throughout the PE industry, it is unsurprising that dry powder is building. According to Preqin, funds from 2006 and earlier still hold more than $210bn in unrealised commitments, and this stockpile has had a dramatic effect on dealmaking in H1 2017. Undeployed capital has driven prices up and increased competition for assets, curtailing dealmaking in various industries. While LPs are concerned about high valuations in the market, to date, record asking prices have not weakened LP demand. This is likely because many LPs, most notably, pension funds, sovereign wealth funds and family offices, have remained satisfied with the industry’s performance in recent years. Accordingly, though funds are sitting on record levels of cash, they are still able to attract commitments.
In a saturated market, it can be difficult for some GPs to differentiate themselves. But, thanks to record distributions and positive net cash flows back to LPs, there is no shortage of LPs looking to invest.
For GPs, it is harder to stand out among the record number of funds already in, or planning to enter, the market in 2017. In order to attract LPs, GPs must ensure that they promote their investment strategy in a clear and concise way. In the current landscape, the importance of an attractive funding pitch cannot be underestimated, particularly as LPs can afford to be selective.
Most LPs are attracted to GPs with a proven track record. They are likely to prefer to invest with larger and more established fund managers – but the door is open to younger funds too. “Established managers are generally achieving targeted commitment levels, often on an accelerated basis. With strong competition for established blue chip PE funds, we are also seeing good fundraising opportunities for newer managers,” explains Mr McCosker. “As always, LPs are focused on proven track records, but we are also seeing some LPs willingness to back new managers as well as some more adventurous strategies. LPs are looking for GPs with a strong track record that can provide additional investment opportunities in a lower fees environment, particularly through co-investment.”
Co-investment is also ensuring that LP appetite for PE does not diminish, despite the overabundance of capital already committed to the market. “Given the evolution of funds and increasing focus on co-investment, club and other similar arrangements, some GPs and LPs are forming deeper relationships to make co-investing more efficient” says Mr McCosker. “LPs who can efficiently make decisions and work quickly during investment processes are in demand from GPs looking for good co-investment partners.”
LPs are also turning away from generalist funds toward those prioritising growth industries, such as healthcare, technology, consumer products, energy and distribution. These are likely to remain popular in the second half of 2017 and beyond. Geographic focus is another key driver of LP interest, which GPs are promoting when targeting investors.
For Mr White, the state of global markets is forcing LPs to look beyond their usual sectors for investment opportunities. “In the current markets, the need to pay high prices is driving managers to consider new sectors which offer good value, such as professional services and deals outside their traditional areas, be that smaller high growth business, deals in new jurisdictions, or new specialist funds with an angle like minority investing or social impact.”
Secondary market fundraising
Though less spectacular, the PE secondaries market also enjoyed a period of robust fundraising. 2016 saw the second-highest level of capital ever raised by the secondaries market, according to Preqin. Ardian Secondary Fund VII, which closed at $11bn, is the largest ever secondaries vehicle. Momentum in the secondaries space carried over into 2017, with several large secondary funds closing in Q1, including the $7.5bn Strategic Partners Fund VII, which became the fourth-largest secondaries vehicle of all time. “The successful closure of several mega PE secondaries vehicles through 2016 is indicative of the current investor confidence in the strategy,” says Patrick Adefuye, Head of Secondaries Products at Preqin. “Secondary investments have maintained their appeal to investors, which cite their attractive risk profiles, diversification benefits and mitigation of the J-curve effect as key draws. As a result, the market has seen sustained demand, and increasingly some investors are committing to secondaries from a discrete allocation.”
Regulatory developments, particularly in the US where there is talk of replacing the controversial Dodd-Frank Act, are among the biggest obstacles facing PE fund managers. In Europe, the implementation of the Alternative Investment Fund Managers Directive has also added complexity for smaller fund managers. “The increased regulatory focus on the asset management industry continues to provide challenges to smaller managers, for whom the compliance burden is significant,” says Mr Newby. “Service providers such as those offering AIFM hosting platforms have become much more commonplace and accepted in the industry, but for new managers wishing to establish their own operations, the time and cost involved presents a real barrier to entry.”
While it has been a boon for some, the crowded alternatives market will also complicate issues for the industry. “PE has to compete for allocation with the likes of real estate, commodities and hedge funds which have also opened up hugely. What was once a rather opaque market is increasingly dynamic and accessible with fund selection advisers playing a major role in helping investing institutions access and scrutinise GPs,” says Mr White.
Though competition for capital will be fierce between the PE space and other booming industries, the outlook for PE appears positive, particularly in the current low interest rate environment. Given prevalent economic conditions and the calibre of returns PE has offered investors in recent years, the asset class will continue to attract capital. While there are challenges to overcome, fundraising should continue at pace.
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