NEWS & INSIGHTS


Dow Jones Private Equity News: Buyout Industry Shrugs Off Overcrowding Concerns

By Jennifer Bollen
May 22, 2017  

A few weeks ago, a dinner talk in Geneva turned to fund allocations: Ultra high-net worth individuals were looking to invest up to 10% of their portfolios in private equity—despite having steered clear of the asset class for the past decade.

Louis de Saint-Marcq, managing partner of placement agent Capstone Partners, said the about-turn was because the high returns that private-equity has delivered compared with other asset classes.

The trend underscores the enormous demand for buyout funds in a market where cash-rich investors under pressure to put capital to work are seeking higher relative returns in private equity amid disappointing fixed-income yields.

A first-quarter fundraising report published by data provider Preqin Ltd. in April showed private-equity funds globally were aiming to raise a record $635 billion by the start of that month, up from $526 billion in January. The number of funds on the road also rose to a record 1,908 by April, up from 1,834 in January.

Last year, private-equity firms globally raised $378 billion across 949 vehicles—the most capital raised annually since firms raised $406 billion across 1,028 funds in 2008.

The SoftBank Vision Fund, managed by Japanese telecommunications company SoftBank Group, accounts for $100 billion of the total capital sought by private-equity funds during the quarter. If it reaches its target, the Vision Fund will be the biggest private-equity fund on record, according to Preqin. Other large-cap funds in the market include the $29 billion Capital Venture Investment fund, owned by the Chinese state, and Apollo Global Management’s$20 billion vehicle.

Preqin said in its report that by disregarding such funds, “[General partners] are attempting to raise capital in a saturated market.”

The term has divided market participants. Capstone’s Mr. de Saint-Marcq said another downturn, with big questions hanging over its trigger, was inevitable: “It’s unsustainable and the wind will eventually blow in the other direction. Sometime in the next three years it will change and people will be surprised.”

Dan Aylott, a managing director at investment firm Cambridge Associates, said “saturation” implied the market had reached capacity but that he did not necessarily agree. He said: “The opportunities within private equity will continue to be there and will continue to expand as various markets become more developed in private equity.”

Janet Brooks, a managing director at placement agent Monument Group, said the industry would approach saturation point when private equity fails to attract investors with outperformance of other asset classes.

Graeme Gunn, who heads investment monitoring at investor SL Capital, added: “The overhang in capital has risen but is not yet beyond the investment capacity of the overall market. If there is a downturn or increased volatility at some point in this cycle then we would see it as an attractive time for the funds to deploy this capital.”

Demand

Investors, after receiving record distributions in recent years, are cash-rich and hungry to deploy capital into private equity. Managers distributed $441 billion to investors globally in 2016, according to a quarterly funds report published in December by private-equity advisory firm Triago, compared with $502 billion in 2015 and $477 billion in 2014.

The private-equity industry meanwhile made $309 billion of capital calls last year, down from $347 billion in 2015 and $321 billion in 2014. Rich cash distributions have followed a buoyant exit market, boosted in turn by large numbers of private-equity funds looking to put capital to work.

Investors are allocating significant sums to large funds in particular, according to Mr. de Saint-Marcq, because of the need to write large checks. He added that this had encouraged many buyout funds to return to market quickly. For instance, European buyout firm CVC Capital Partners is attempting to raise the region’s largest-ever buyout fund, with a €12.5 billion ($14.04 billion) target and €15 billion upper limit. The firm’s seventh fund follows its sixth vehicle, which raised more than €10.9 billion in 2014.

Success Rates

Despite the general partner-friendly climate, private-equity firms’ fundraising targets could be overly ambitious. Gianluca D’Angelo, a managing director at placement agent Eaton Partners, said: “I can’t believe all of those will be successful…There have been a lot of people try[ing] to…but don’t have the quality needed. There are going to be a few failed attempts but I also think there is a bigger request to find niche strategies.”

Their chances will continue to depend on the fundamentals that attract investors, according to Mr. Aylott: quality, talent and team stability, strategy and prior returns.

Antoine Dréan, founder of Triago, said that while a record number of funds had hit the fundraising trail, they faced rising competition from nontraditional structures such as separate accounts, co-investments and direct investments.

Triago said shadow capital globally reached a record $188 billion last year, compared with $161 billion for 2015 and $127 billion for 2014. In 2011, the figure stood at $36.8 billion. The private-equity fund advisory said the increase had come as more investors sought to improve performance.

Many investors opt for such nontraditional private-equity investment structures such as co-investment and separate accounts to avoid the drag on returns caused by fees paid to managers. Fees cause a drag on returns by making investments more expensive. For example, investors make less money by investing with a firm that charges high management fees and transaction fees.

Mr. Dréan said the movement had a negative impact on some funds. He said: “If one in four fundraisings were total flops a decade ago, today the mortality rate has probably climbed to something like one in three.”

Investors needing to allocate capital beyond the biggest brand names are heading to the next tier of private-equity firms, according to Mr. Gunn, who said such funds “are also being funded aggressively.”

He said: “In the midmarket and lower midmarket in Europe there remains solid demand and again investors are chasing this segment given the returns available. The issue is that many of these funds are closed to new investors so the temptation for the manager is to raise more from [existing investors] given the external demand.”

The smart managers in this corner of the market will keep fund sizes consistent to ensure they can deploy capital on schedule and retain a focused strategy.

He added: “Investors have been capturing the exposure and looking for the next five-year opportunity set so we expect fundraising will slow over the next few years as the funds switch to deployment from realization mode.”

A distinct edge will significantly help a firm’s cause, particularly among large-caps where buyout firms’ strategies are often similar. Mr. Dréan said the increased competition among funds had driven “the broadest diversification of fundraising offerings we’ve ever seen,” with generalists narrowing their focus to deals that play to their strengths and a greater number of specialist private-equity firms coming to market.

Mr. Gunn added: “Private equity has been good at stock picking in specific subsectors that can demonstrate fast growth, much better than larger listed companies. The North American market remains at least 10 years ahead of Europe in terms of sector specialization, but has less opportunity to compete regionally.”

The Consequences

The recent wave of fundraising raises questions about whether firms have the capacity to invest committed capital before their investment period ends, and what knock-on effect the glut of capital will have on deal valuations and subsequent returns.

The worst-case scenario is that firms will take longer to deploy capital, though this is not a major problem as long as managers can find good deal opportunities, according to Mr. Gunn. A rising trend toward longer life cycles would continue to feed greater annual transaction volumes in the secondaries market and lead to increasingly common fund restructurings.

Mr. Gunn expects returns to be lower than for 2010 to 2014-vintage vehicles. He said: “We don’t see that risk has increased, given leverage is conservative, it’s just that pricing is high and it will be tougher to deliver the same returns with that dynamic. The asset class will still outperform most others even in this environment.”

Cambridge Associates’ Mr. Aylott said: “We’ve expected private-equity returns to be coming down given where we are in the cycle for these vintage years. Whether we still think [private equity is] attractive versus other asset classes I think we certainly do. Some funds haven’t admitted to reducing their return targets during the period.”

Pressure Points

Some investors view markets, including the U.K. and the Nordics, in particular, as overcrowded, according to SL Capital’s Mr. Gunn, given there is so much capital chasing few deals.

“We are convinced that more funds generate more deals as they focus in on their own market advantages,” said Mr. Gunn. He added: “Are markets competitive? Absolutely—but it’s been that way for decades and the funds just have to continually evolve and improve to counter this.”

Capstone’s Mr. de Saint-Marcq said there is a shortage of deals in the Nordic region. “The Nordics continue to be one of the best areas in Europe but returns have eroded—the relative attractiveness of Nordic funds versus continental Europe has decreased over the last three years,” he said.

“[Earnings before interest, tax, depreciation and amortization] multiples paid in Scandinavia are much higher than in Southern Europe. There are not enough deals and they are strongly intermediated.”

Cambridge Associates’ Mr. Aylott said the U.K. has a deep market with plenty of opportunities, particularly in the lower midmarket space.

However, Preqin said appetite for European deals was already waning due to political uncertainty surrounding the future of the European Union and 2017 elections in major European economies. Since the beginning of the second quarter, North America accounted for the greatest proportion of capital targeted by funds in the market, which are seeking a combined $336 billion. Asia is seeking the second-largest volume of capital at $157 billion, while Europe-focused funds are in the market to raise $104 billion.

Europe-focused funds accounted for 39% of investors’ active fund searches in the first quarter, compared with 56% a year earlier.

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