While 2012 was predicted to see private equity’s return to form, dealmaking disappointed many under the weight of expectation. PE firms may have weathered the turbulence of the financial crisis, but the outlook for 2013 is mixed. Some banks are more willing to lend and a number of large LBO funds are in the market, but fundraising is a challenge and regulatory uncertainty is a major concern. As July approaches, thoughts are turning to the potential impact of the AIFMD, and general partners are taking the necessary steps to thrive in the new PE landscape.
FW: How would you describe the present state of private equity? To what extent are macroeconomic, financing and regulatory challenges weighing heavily on the asset class?
Williams: From our perspective the private equity industry remains buoyant, but is not without challenge. We have continued to see significant downstream spend activity as the leading private equity houses take advantage of distressed situations, in particular in Europe and the Americas. There also continues to be strong interest in the emerging markets where the pursuit of economic opportunities from untapped or new sources of wealth is attractive, provided that there is the appetite, patience and capability to handle the political and corruption risks that can be associated with doing business in the emerging markets. IPO activity has started to increase. Over the course of 2012 we saw the IPOs of some leading private equity houses come to market. Since the financial crisis there have been new regulatory initiatives introduced in both Europe and the Americas. The increased obligations and accompanying enhanced focus on compliance and due diligence has added to the cost of doing business. With July rapidly approaching, all eyes and minds are on the potential impact of the AIFM Directive on private equity and the key concern for managers is what can they do, and what can they not do, as a result of the AIFM Directive.
Penn: The current environment is favourable for private equity funds to invest, despite an uncertain outlook in the near term. Political and regulatory uncertainty challenges have created high uncertainty, and fundraising for all but the largest funds has been very challenging. Still, there are opportunities in the US and Western Europe.
Guild: The industry is very active and appears to be evolving in interesting ways. Generally, private equity is a beneficiary of the macroeconomic environment, and yet hindered by it as well. Broadly speaking, low interest rates have created a very challenging traditional investing environment, especially on the debt side of the equation. The demand for returns therefore requires increasing investment risk, making private equity a more favourable alternative investment choice for a broader range of the investing public than it once was. This has produced an increase in the front-end fundraising side for private equity firms. For example, we have seen an increase in capital to large private equity funds from institutions such as public pensions, endowments or sovereign wealth funds (as determined by Assets under Management, AUM). That being said, the ability to monetise the investments via a traditional exit strategy has become less consistent and firms are no longer following the traditional initial public offering route, leading to a reliance on alternative exit strategies such as dividend recapitalisations, secondary sales and the like. While this may affect long-term internal rate of return, it has yet to manifest itself in overall performance metrics, but it is an area we consult and review regularly.
Khosla: The economic downturn has led to a sharp decline in the level of private equity deal activity. However, due to reduced funding from banks and a lack of IPO prospects, PE funding remains an important source of funds for companies looking to raise capital in India. The current trend seems to point towards a more realistic approach to valuing investments. Recently, with signs of the markets picking up, there has been an increase in the number of PE deals, albeit with a new-found sense of scepticism. Macroeconomic indicators suggest that PE firms are concerned about preservation of capital and realisation of expected returns on investment. Moreover, uncertainty in interpretation and implementation of regulations by multiple regulators continues to remain a source of unease for PE investors.
FW: Could you comment on recent deal activity involving PE firms in your region? Which key sectors are PE firms targeting and why?
Guild: In our discussions with private equity firms in the US, there is a common theme of reluctance to invest aggressively in any single industry viewed by some as ‘high risk’. This seems based at least partially on the US government’s brinksmanship the past few years and the generally delicate nature of the US economic recovery. Staple industries such as energy, infrastructure and technology are therefore the most attractive. It seems as if these industries have compelling short- and long-term prospects, especially in the US. Add in the potential upside to each of these industries and this appears to be a well considered investment, with minimal long-term downside.
Khosla: Traditionally, PE in India has been focused largely on the technology sector, and the real estate and infrastructure sectors, which require large amounts of capital and where there is scope for vast development. However, of late there has been a shift in PE activity to non-traditional sectors such as education, healthcare and renewable energy. Notable deals include investment by Morgan Stanley in Continuum Wind Energy and Advent International Corp investment in Hyderabad-based hospital chain Quality Care India Ltd. PE firms perhaps see an opportunity for making good returns in these sectors which remain underdeveloped in India. Further, with the relaxing of FDI norms in single-brand retail, as well as broadcasting, we can expect to see an increased inflow of foreign funds through PE in these sectors.
Penn: Although deal volume was at its lowest level since 2009, US private equity deal flow turned upward toward the end of the year. Middle market deals made up nearly 80 percent of capital invested over the last three years. Lower middle market deals also increased with the median buyout size falling by 23 percent in 2012. Secondary buyout activities jumped to a record percentage of total PE deal flow in 2012 – an increase to four times the 2009 activity level – as PE firms increasingly turned to each other for deal flow and exit sourcing. There seems to be growth in business products and service and information technology within the US markets. As the political and macroeconomic uncertainties subside, deals are getting done.
Williams: We have noted considerable interest in the telecommunications sector in Latin America, reflecting the burgeoning middle class in that region. By way of example, at the end of last year Telefonica SA finalised the sale of its customer relationship management (CRM) business Atento to Bain Capital LLC. Acquisitions are also being sought in the consumer, infrastructure, energy, health, education and food sectors. In Europe and the Americas, distressed investing, real estate and the aircraft sector also feature. The emerging markets are likely to be a promising growth area in the near future, as investors regain confidence in global market stability, amid the perception that returns in developed markets are becoming ‘maxed out’. In this regard Africa has been catching the imagination and attention of both mid-market and the larger private equity houses. KKR, for example, has recently added to its number to enhance its effectiveness in relation to the region.
FW: What trends are you seeing in bank financing for leveraged backed PE deals?
Penn: It seems banks are much more willing to lend than they have been over the last couple of years. Debt levels have rebounded in 2012 as a result of the renewed availability for debt financing for transactions. In addition to low interest rates, financing is characterised by lighter covenants and fewer restrictions. The market for financing appears to be in an uptrend right now.
Williams: In the current climate, banks are keen to lend to institutions provided that they are happy with their assessment of the borrower’s ability to repay. This is not a new approach. However, private equity houses and private equity funds are attractive to banks for two main reasons. First, the level of due diligence required is less because transaction risk is viewed by looking at the quality of the limited partners with uncalled capital commitments, rather than having to undertake detailed due diligence on assets held, as would be the case with hedge funds and corporates. Secondly, as a result, the pricing and transaction costs are lower for both banks and borrowers. Overall, we are seeing a greater number of lenders in the market keen to finance PE funds and houses, with no increase in charges or any additional requirements being imposed.
Khosla: Due to the restrictions imposed by the Reserve Bank of India on lending by banks for the purpose of acquisition of shares of Indian companies, as well as the provisions of the Companies Act, 1956 which prohibit public companies from rendering financial assistance in relation to the purchase of their own shares, leveraged PE deals are not common in India. Most PE deals fall under the category of ‘growth deals’ where the PE firm acquires a minority stake in a portfolio company and plays a relatively passive role as compared to a leveraged buyout scenario.
Guild: Any light I can shed on this is based only on anecdotal evidence because, while we do ask during our visits with private equity firms, we do not have access to the full depth of information on each transaction, dividend or recapitalisation executed within private equity. That said, we have not seen a consistent stream of significantly leveraged deals recently. Maybe it is because within the lower- to mid-market size deals that have been executed, bank financing has been readily available at attractive rates. But again, it seems that this discipline is mostly based on internal policy of the private equity funds that we are not necessarily privy to, but they do seem to be utilising leverage moderately during the acquisition, taking a second (or third) tranche for dividends or overall recapitalisation.
FW: Are PE firms employing any particular strategies or techniques to complete deals in the current market?
Khosla: Entry valuations have corrected to more realistic levels and PE funds seem to have lowered their expectations of returns to reflect the change in market conditions. Many funds are also resorting to innovative exit mechanisms like share swaps with other group entities of the target, moving away from relying solely on traditional exit structures such as IPOs. Funds also look to provide additional value by generating synergies with their other portfolio companies. A greater commitment is being seen by PE funds towards their portfolio companies with a clear intention to foster development, with the shift in focus from revenue growth alone to value creation. PE firms have also begun to demonstrate a greater interest in late stage deals and in funding inorganic growth.
Guild: From what we have seen and heard, spotting the opportunity has become more difficult; not because the number of companies who want to sell isn’t a relatively stable number, but because the more attractive targets are those companies that have no intention of selling and therefore have to be convinced to sell. So it seems to be a game of ‘creating the deal’. In creating the deal, of course, financing and access to operational expertise are an important part of strategy and technique. Every private equity firm that we have met with has full researchers on staff, compiling industry books as well as proprietary analysis of specifically targeted companies. That requires significant data management and analysis. So what we are seeing are quiet negotiations by one PE firm to one potential target, generally long-term negotiations to convince a target to sell. Additionally, in a few instances we have seen a handful of private equity firms competing on a known acquisition opportunity, but nothing to the degree of the halcyon days of 2005-07. In such situations, the winning formula appears to include not only the research and soft skill set noted above but also strong financing capabilities; assurances of continued employment and operation; we have even seen funds use insurance to its advantage – utilising an M&A insurance product instead of a traditional seller’s escrow requirement – which frees up more funds to the seller faster, arguably making that bid more attractive.
Williams: In the wake of the global financial crisis and in an extremely competitive market environment, from a transactional perspective there has been a prominent increase in the appreciation and desire on the part of managers to structure complex transactions efficiently in international financial centres such as the Cayman Islands. In particular, with the growing complexity of cross-border private equity investment, Cayman provides an ideal solution with a flexible legal framework and tax neutrality. This enables deals to be structured and managed effectively and efficiently with numerous investors and multiple layers of debt and equity, with great flexibility from a commercial standpoint. Meanwhile, lenders are very comfortable and familiar with the jurisdiction and appreciate the level of protection that is provided by the certainty of UK common law, which is persuasive in the Cayman Islands in the absence of specific Cayman authority.
Penn: Acquiring secondary shares from existing investors is offering an opportunity for ‘fresh start’ and increase ramp for companies. The secondary direct market has matured and now offers a routine exit opportunity for sellers. Sellers are still adjusting to the new valuation landscape and deals are starting to get done.
FW: What legal and regulatory issues are shaping the PE industry at present? What impact will these developments have going forward?
Williams: The current regulatory environment has become more stringent with the implementation of the Volcker Rule and spectre of the AIFM Directive looming. However, much of this change has been anticipated for some time. Private equity as an industry is used to change, both effecting it and responding to opportunities as a result of it, and has always adapted and evolved to manage change and new market conditions. By way of example, we have already seen many spin outs of new start-up managers from former proprietary trading desks due to the Volcker Rule and there are some banks that have been watching and waiting and which are likely to spin out their private equity interests in the near future. Regulation is not necessarily a dirty word; it can simultaneously create opportunity and obligations.
Guild: Regulatory scrutiny of private equity is increasing and is expected to accelerate in the coming years. Whether due to a result of more public pension money in private equity, the recent US presidential election campaign’s negative characterisation of private equity or myriad other potential reasons, the private equity industry has garnered the attention of regulatory agencies, all looking to peel back some of the layers of private equity and create what they call ‘more transparency’. For example, SEC oversight has become far more robust recently and it has indicated additional resources are being allocated to monitor the private equity industry. State attorneys general are also taking a closer look at the private equity industry. Both authorities appear to be reviewing valuation practices within the fund, disclosures of that valuation practice as well as relationships between the fund and its portfolio entities. Fee arrangements, fee waiver agreements and general fundraising also seem to be of concern to regulators. The cumulative effect of this attention will likely be more transparency for investors but likely some increased costs to manage the new regulatory requirements. This should not materially affect the ability of the private equity industry to function efficiently, but increased regulatory requirements will almost certainly add a new layer of costs in managing that will need to either be absorbed by the private equity firms or passed through to the limited partners. Another interesting thing to consider: if increased regulatory scrutiny leads private equity funds to a level of oversight comparable to a public company anyway, will this lead more private equity firms to go public as a means of generating additional capital for the firm and liquidity for the firm’s employees? While increased regulatory scrutiny creates many challenges, some may view it as opening up prospects for different levels of investment from different levels of investors.
Penn: Currently, the uncertainty regarding how regulatory issues will pan out is a major concern for both LPs and GPs. From the GP perspective, the looming tax changes and their implications are a major concern. As regulators expand their reach to smaller funds, the bar for compliance will be harder to reach. This will create a barbell effect in the industry, further reducing the number of firms able to continue.
Khosla: There is some uncertainty around the regulatory framework for the PE industry in India. For instance, PE firms have traditionally favoured the use of put options as an alternative exit mechanism. The Reserve Bank of India has, however, viewed these put options as a means of ensuring a fixed return on investment and therefore akin to debt investments, requiring compliance with regulations applicable to external commercial borrowings, causing concern to the PE industry for some time now. The ambiguity around the taxability of capital gains – where shares of an offshore entity, holding a stake in an Indian company are transferred – remains another area of unease. Further, the Alternate Investment Fund (AIF) Regulations promulgated by the Securities Exchange Board of India (SEBI) has brought about a change to a mandatory registration regime – as opposed to the erstwhile facilitative regime – wherein private pools of capital will have to register as one of the three broad categories of funds and will be subject to regulation by the SEBI. However, there are positive developments as well, such as a proposal to amend the Income Tax Act, 1961 to provide a pass through status to funds registered with SEBI and exempt the income from their investments under new AIF Regulations. The AIF Regulations also seek to reduce market inefficiencies and draw a larger amount of funds into the market within their regulatory ambit and have the potential to give impetus to the efficient development of alternate asset classes in India.
FW: In your opinion, what are the major challenges currently facing fund managers? How are factors such as regulatory compliance, risk management and enhanced disclosure shaping their operations?
Penn: Fundraising seems to be an issue, especially as the SEC requirements reach a broader selection of fund managers. Funds without proper infrastructure and compliance procedures are having a hard time remaining compliant and thus attracting capital. The impact is gravitation towards larger fund managers with resources to meet requirements.
Khosla: A lack of viable exit options, and too few investment opportunities being chased by too many PE funds, are the major challenges facing fund managers. It’s a promoters market which makes it difficult for funds to contribute on strategy and operations. Besides, valuations remain high even today. Although PE funds assume this is a cost of operating in India, it is an expensive market and hence, they are looking for deals that give them proportionately high returns. The new AIF Regulations may prove to be a challenge to fund managers, as they impose restrictions such as with respect to minimum fund size, tenure and use of borrowed funds. Further, the onerous reporting obligations and other investor protection measures, such as the requirement of appointing a custodian, would increase the operating costs for the funds. These regulations have also made it mandatory for fund managers to seek the approval of investors in certain operating matters.
Williams: In addition to navigating and understanding the waves of new regulation, fund managers are also facing greater costs of compliance. We have seen the increased regulatory and risk management requirements result in fund managers expanding the size of their in-house legal and compliance teams or enhancing their use of external advisers focused on regulatory and compliance matters. Risk management is fundamental to any business and private equity is no exception. With more private equity houses dedicating time and resources to investing in the emerging markets, the management of corruption and political risk is at the forefront of all decision making. The mismanagement of risk not only has the potential to give rise to financial loss, irreparable damage to a manager’s brand and personal reputations, but may also run foul of the US Foreign Corrupt Practices Act, the UK Bribery Act and other equivalent legislation.
FW: With regard to portfolio management, what can PE firms do to build value across the portfolio and reduce the associated risks?
Khosla: The Indian PE industry differs from most developed countries in that it does not follow the traditional leveraged buyout model where the PE firm takes over the company, turns it around and then seeks to exit by sale of the company or an IPO. Rather, in India, the existing promoters retain control of the portfolio company and provide returns to the PE firm – which holds a minority stake and remains relatively passive – by means of an exit a few years down the line. Increased involvement of the PE firm in the portfolio company through provision of management support, expertise, and aid in increasing the efficiency of the operating model, could prove to be a significant value addition which would help the PE firms to secure their expected returns.
Williams: In order to build value across the portfolio whilst minimising associated risks, which is the very essence of private equity activity, private equity firms need to ensure that they have the right talent in place. Without the correct people at the helm, it will not be possible to fully understand and manage the assets that are being or have been acquired. When dealing with emerging markets, there are also local laws and customs to consider, making it vital to have relationships with sophisticated and like minded people so that corruption and political risks may be countered. It is also important for succession planning to be given priority. Loss of expertise and leadership without a plan can be detrimental, even to the strongest of brands.
Penn: Significant PE returns are the result of creating operating value. Firms start by building an objective fact base, and then scrutinise strategy, product demand, customers, competitive dynamics, environmental trends and the details of how money is actually made. Only then do they pursue a few core initiatives to reach full potential. They turn the few core initiatives into results, choreographing actions from standing start to the finish line, monitoring a few key metrics. PE firms create the right incentives for employees to act like owners, and they assemble decisive and efficient boards.
FW: Are PE firms achieving expected returns from available exit routes? How would you describe the outlook for trade sales, secondary buyouts and IPOs in 2013?
Guild: From our research and discussions, the returns for the 2006, 2007 and 2008 vintages have been difficult (at best), to the point where achieving any positive internal rate of return may be considered a strong performance. Additionally, international funds within that same vintage have generally been even more challenging, many of them showing double digit losses for investors. What we are seeing in terms of expected returns/exit routes is that the initial public offering exit strategy has been inconsistent for at least the last three years, caused partly by overall economic concerns but also by some pretty desultory offerings, leaving many prospective investors underwhelmed. However, an interesting statistic is that “the inventory of private equity-backed companies at the midyear (of 2012) is at a record high of 6,278 …[e]ven taking into account the accelerated pace at which they are exiting companies, private equity firms will need about nine years to sell off all of their extra inventory”, according to the 2012 Private Equity Exits Report from Pitchbook and Grant Thornton. So the maturity of the funds holding these companies combined with the multitude of exit options available makes the outlook for trade sales, secondary buyouts and initial public offerings in 2013 seem positive.
Penn: Secondary buyouts have been on the increase since mid-2011, driven by a number of factors including tentative public markets, an overhang of capital raised during the buyout boom era, and pressure on private equity firms to return capital to their investors. Secondary buyouts are an attractive investment opportunity for PE firms, providing a means of adding value to a familiar asset held by another firm. Using industry knowledge, networks and contacts to grow the company, or by implementing a different debt or management strategy, firms can scale up the target, adding value and taking it to the next level of development. Secondary buyouts remain attractive to many within the buyout community. From January through to the end of Q3 2012, some 242 secondary deals were announced globally. Further, the $27.6bn generated by secondary buyouts in Q3 2012 nears the all-time peak of $30.5bn in secondary buyouts in Q3 2007, and represents the highest aggregate quarterly value of secondary buyout deals since the onset of the financial crisis. With a turbulent public equity market, it is likely that IPOs will remain largely out of bounds for PE firms exiting in the near future, leaving trade sales and secondary buyouts as the primary exit route for PE sellers. While the $360bn in dry powder that PE firms have waiting to be put to work has contributed to the increase in secondary buyout activity, the fact that there are over 3300 PE-backed portfolio companies waiting to be exited, freeing up more cash, will provide a catalyst for continuing secondary buyout activity going forward.
Williams: With survey evidence indicating that the vast majority of limited partners are having more vocal discussions with GPs due to fund performance, there is a sharp focus on expected returns from available exit routes. Performance has dipped over the last few years, in particular on LBOs executed during private equity’s pinnacle years. Since 2007, the industry’s average return has been 6 percent, which falls short of the 7.5 percent that many pension funds need to pay retirees and is significantly below the private equity industry’s historic average of approximately 13 percent. We anticipate that there will be significant secondary buyout activity in 2013 in light of the difficulty that managers have been facing pursuing traditional private equity exit routes. Given our broad client base we have been fortunate to be exposed to much of the limited IPO activity that the market has seen over the last year or so. However, notwithstanding the increased activity that we have been a part of, as a general trend, we expect that IPO activity will continue to be at a low ebb during 2013.
Khosla: Returns being received by the PE firms are, most often, significantly lower than their expected returns at the time of investment. The economic downturn has significantly affected the IPO market, which has traditionally been the primary exit route for most PE investments, and funds that are reaching maturity and looking for an exit are largely forced to look at alternate exit routes such as sales to other PE firms, sales to strategic buyers or sale to the promoters. Trade sales are not common in India as the existing promoters who retain control of the portfolio company are usually uncooperative. Thus, it appears that the most common exit route in the near future would be a sale to another financial investor, such as a PE firm, or to the promoters.
FW: How has the relationship between general partners (GPs) and limited partners (LPs) evolved in recent years? What are LPs now demanding in terms of insight and transparency?
Williams: Rather than accepting industry-standard terms, major investors have been keen to ensure that the overall terms and conditions provide a balance between their interests and those of the GP. While ILPA’s guidelines have been broadly endorsed by the market, certain obstacles continue to emerge surrounding issues such as the power of advisory committees, GP clawbacks and waterfall mechanics. The guidelines provide a good baseline for the negotiations which will ultimately shape the terms of a fund. Overall the balance of power remains weighted in favour of general partners in the case of the leading institutional private equity houses. Limited partners are likely to have more success tipping the balance in their favour where dealing with start ups and mid-market managers. There has been an increased level of dialogue between private equity houses and their investors, with a particular focus on transparency and information sharing, without breaching confidentiality obligations. Private equity managers are facing a competitive environment in 2013 and manager mystique is not enough to keep investors loyal. Transparency is critical. One of the legacies of the financial crisis has been a greater demand for better communication where valuations are concerned. It is important to have an appropriate valuation process in place and it has been suggested that legal challenges to valuations cannot be ruled out in the future.
Guild: Limited partners are certainly expressing themselves more than in the past. Fundraising, the lifeblood of private equity, appears to be stratifying – for example, typical limited partners in low- to mid-market funds are diversifying their investments a bit, pushing on management fees and carry costs. All this is typical of a maturing market. The more interesting aspect is the increase in investment into private equity by large public pensions, representing municipal and government employees and unions, which is ironic considering that during the recent US presidential campaign private equity was characterised as a job killer while public pensions, representing the investments of individuals labelled as ‘in harm’s way’, has continued to increase its monetary commitment to PE. In any event, and perhaps in response to this concern, these public pensions are very vocal about how closely they intend to oversee their separately managed accounts at private equity firms. Depending upon how closely the investments are supervised by the public pensions and how much discussion there is between the parties, the issue becomes: when does a public pension as a limited partner lose its passive investor status, thereby becoming a general partner in the fund? We are not aware of this issue having become a problem just yet, but it is an interesting prospective risk assessment we consider and is illustrative of how involved limited partners appear to be getting in the investment decisions of the funds, let alone the updating of its performance.
Khosla: Demand for insight and transparency is increasing. LPs now expect active reporting and engagement. While they are looking for GPs to stick to their core strengths, they also want to work with nimble GPs. But LPs don’t like surprises. If GPs are changing their investment strategy or trying a new model – for example, doing PIPE investments when the fund was raised for only private investments – LPs want to be informed and kept abreast. The new AIF Regulations have been adopted with a view to providing increased transparency and protection to limited partners. Earlier, operating matters and reporting to limited partners was largely unregulated and left to be determined by the bargaining power of the parties. However, with the advent of the AIF Regulations, all funds are mandatorily required to be registered with the SEBI and are subject to rather stringent reporting and disclosure requirements, as well as the requirement to take the consent of limited partners on certain operating issues.
Penn: Relationships between limited partners and general partners in the private equity industry have changed more over the past five years than over the prior 50. These changes have been driven by a number of forces: the unprecedented run-up in the sizes and activities of private equity funds to 2007; the subsequent crash and the unexpected liquidity pressures suffered by some of the LPs of longest standing; the persistent underperformance – relative to public markets and expectations – suffered by venture capital funds since the NASDAQ crash; and the decisions of some major buyout funds to go public, among them. Such developments have influenced the nature of the industry in ways that are still evolving and still being understood.
FW: How has private equity fundraising fared in the last 12 months? What characteristics are limited partners looking for when committing funds?
Khosla: India has witnessed some economic pressure in the recent past with political burdens, a sluggish pace in policy making and a depreciating rupee having adversely impacted investor sentiment. PE investments decreased in both the number of deals and deal volume in 2012. LPs are treading cautiously when committing funds as returns are not matching up to previous expectations and exit options are limited at present. However, LPs committed to India are staying focused and have adjusted their exit strategies accordingly. They appreciate that the exit environment is tough and are staying the course with GPs. However, this means they are becoming choosy in picking their GPs in the first place. They understand this relationship is going to be longer than the typical three or four years. They believe the Indian PE market is overcrowded and a number of very large funds were raised in the past that couldn’t be fully or properly deployed. A number of LPs now believe the right fund size for an Indian GP is $150m to $200m, as opposed to the half billion dollar funds that were previously being raised.
Penn: To fix what’s broken in the LP investment model, institutional investors will need to become more selective and more disciplined investors in venture capital funds. The best investors will negotiate better alignment, transparency, governance, and terms that take into account the skewed distribution of VC fund returns. Characteristics that LPs look for include: investment directly in a small portfolio of new companies, avoiding being saddled by high fees and carry; co-investing in later-round deals side-by-side with seasoned investors; and moving a portion of capital invested in VC into the public markets. There are not enough strong VC investors with above-market returns to absorb the investment capital.
Williams: Fundraising has been quite fragmented over the past few years in the wake of the economic downturn. However, in the past year we have seen a number of the big LBO funds either entering the market with new funds or about to do so, which is a significant development for the industry. Investment periods on older funds raised between 2006 and 2008 are reaching the end of their investment periods. Private equity managers need to start raising new funds to generate capital to execute new deals and maintain fee income. The uptick in fund formation has been focused on the large institutional private equity houses at the top end of the market. However, at the other end of the scale, we have seen a few new start-ups as well as some traditional hedge fund houses start their first private equity fund. The key factor driving limited partners when committing funds remains the quality of the manager’s track record and tenure. Investors are looking for healthy returns on their investment and not all managers are able to provide this in the current economic climate.
FW: Can you provide some insight into the secondary market? Has there been a rise in limited partners looking to sell their interests, adjust their portfolios and rebalance their alternative asset allocations?
Penn: The secondary market has long lost the stigma of providing liquidity solutions only to the most desperate. With private equity’s spectacular growth in recent years has come similar expansion in the secondary market of the asset class as well. Small, nascent and with limited credibility among investors until just a few years ago, the secondary market has become a large, well-diversified segment of the private equity business in its own right. Dedicated secondary funds currently have some $32bn of investable capital at their disposal; an additional $27bn is expected to be raised this year. In addition to size, the secondary market has also evolved in terms of breadth and depth. It is a market where dedicated, highly specialist acquirers of partially-funded limited partnership interests operate alongside other, more generalist types of private equity investors, who also have grown accustomed to buying and selling LP stakes in secondary transactions. Both types of buyers are also active in so-called ‘direct secondaries’, in which whole portfolios of companies owned by one private equity backer are sold to another. Most importantly perhaps, from the point of view of those coming to the market as sellers, secondaries have lost their traditional stigma of being liquidity solutions of last resort, a place where only the most desperate owners of limited partnership stakes will go to sell their holdings at knock-down valuations. Instead, limited partners nowadays use the secondary market for a wide variety of reasons, many of which are strategic.
Khosla: We are witnessing the advent of ‘secondary funds’, which are funds looking to purchase the stake of an LP in a fund. This will ease the pressure on private equity funds to return capital through profitable exits and give LPs looking to exit an opportunity to do so. LP to LP sales should continue to grow in the coming years. Given the lack of exit options, secondary funds like Paul Capital, Harbour Vest Capital and Pantheon Ventures are on the lookout for funds maturing in India. Some of the largest exits through the secondary route last year were ICICI Ventures’ sale of its stake in Sahyadri Hospitals to IDFC Alternatives, and Evolvence India Life Sciences Fund’s sale of its stake in Sutures India to CX Partners.
Williams: Although not as prolific as the activity that we saw immediately after the financial crisis, we continue to see activity in the secondary market. We have seen leading private equity fund of funds continue to focus on the secondary market in order to pursue successful investment strategies and form new funds. NewGlobe Capital Partners and Vanterra Capital recently announced that they will be joining forces to acquire interests in end-of-life and zombie funds in order to release liquidity to limited partners of the funds in question and reset the investment time frame for general partners and their portfolio companies. Secondary fundraising had an excellent 2012, more than doubling the aggregate capital raised in 2011 ($9.6bn) by raising $20.8bn in 2012.
FW: Overall, what do you predict for the private equity asset class through 2013 and beyond?
Guild: In our estimation, the traditional J-curve model will continue to be the bulwark of the industry. Additionally, we anticipate further allocation of capital into more general ‘opportunity’ funds, for example, dislocations in credit spreads, energy costs, secured business loans, more of a broader asset management suite of services within its various funds.
Williams: The outlook for the private equity as an asset class through 2013 and beyond is positive. However, this observation is not without a caveat. The outlook varies from region to region, with a buoyant mood pervading in the Americas, especially Latin America, whilst less so in Southern Europe and China. Anecdotal survey evidence has shown limited partners are optimistic towards the asset class and plan to increase their allocations, with funds in the US and parts of Europe identified as beneficiaries.
Khosla: The market should and will shrink. There are too many GPs with large funds that still need to be invested. The industry has already started shrinking because investment opportunities have dwindled. Unsuccessful players will be weeded out before successful players can raise new funds or go for larger fund sizes. The recent impetus given by the government’s positive attitude towards investment is likely to improve investor sentiment, and recent deal reporting suggests that interest in preferred sectors is expected to continue to grow in 2013.
Penn: Investors benefited in 2012 with positive performance across most asset classes, even in the shadows of the eurozone crisis, softening growth in China, and ongoing US fiscal problems. We can thank the expansion of global monetary policy accommodation for the disconnect between financial market performance and these more challenging fundamental issues. For 2013, it seems the worst consequences of the US fiscal problems can be avoided. As such, we expect slow but positive growth in the US, another tough year for Europe, but improving conditions in emerging markets. In the near term, volatility will likely remain high, but conditions may gradually improve as more clarity emerges.
David Guild is a Senior Vice President in AIG Financial Lines’ Financial Institutions division, overseeing the Insurance Company and Private Equity Practice Groups. Mr Guild joined AIG in 2000 with the Corporate Accounts group and relocated to the Los Angeles Region, ultimately returning to the Home Office in December 2008 helping to rebuild and oversee the National Accounts division. He graduated with honours from the University of Connecticut and attended The George Washington University Law School.
Lawrence E. Penn III is a managing director at The Camelot Group. Previously he was an investment banker at Lazard and a portfolio manager in the private equity group of JP Morgan where he managed in excess of $500m in committed and invested capital and served on the advisory boards of several private equity groups.
Sita Khosla is a partner in the corporate law practice at Dua Associates. She has advised domestic and international clients on a wide range of issues including corporate governance, regulatory compliance, mergers and acquisitions, private equity transactions, corporate restructurings and foreign investment. She has extensive knowledge of a variety of business sectors including aviation, real estate and financial services.
Caroline Williams is based in Walkers’ Cayman Islands office and is a partner in the firm’s Global Investment Funds and Global Corporate Groups. She has a broad private funds practice specialising in both hedge funds and private equity. Ms Williams has extensive experience advising private equity fund sponsors on the structuring and formation of funds and co-investment and alternative investment vehicles and the completion of transactions undertaken by them.
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Lawrence E. Penn III
The Camelot Group