Friday Letter the year of reckoning

GPs that rose with the credit bubble and fell when it burst, and that are coming to market this year to raise funds, are unlikely to gain the kind of support necessary to hit their targets.

This year according to fundraising sources, an estimated 1,500 private equity firms are coming to market to raise funds and the hard reality is many of those funds should not exist. And, if many private equity fundraising experts are to be believed, many of those funds simply won’t get raised, leaving the managers with few options for the future.

As Private Equity International has reported in the April issue of the magazine, 2011 could be a year of consolidation in the industry, in which many managers will be forced to close up shop as they fail to attract any support for new funds.

This kind of leveling would be a great thing for the private equity industry. A reckoning needs to take place, in which managers whose success was based too much on the credit bubble disappear, leaving only the best performers in the market – those that bring true operational improvements to the companies they buy and generate real value for their limited partners.

LPs this year will work hard to better identify the quality firms that produce real-life, hard-earned returns and those managers who simply rose with the credit bubble and fell when it popped.

In 2006 and 2007, private equity managers had no problem raising capital from LPs looking to carve out big allocations to the asset class. Capital was abundant; fund sizes exploded and managers flush with capital fought for deals, which drove up prices.

Managers have done a variety of things since the credit crisis erupted. Many turned inward, tended to their portfolios and hung on for dear life as the markets slowly turned. Some invested fresh capital in the bottom of the downturn, found cheap prices for quality assets and will come out looking very smart.

Other firms were battered in the downturn and are still struggling to emerge from the wreckage with any kind of success to tout to LPs as they prepare new funds for market. These firms won’t hit their targets. In fact, firms that are getting their LPs modest returns may not even survive.

Even long-time relationships are likely to end in cases where the manager – even if he has made money for the LP in the past – had a tough time in the downturn. And the re-ups that do happen will probably represent smaller commitments than in the past.

The fundraising environment this year will be a merciless place, but ultimately the reckoning will be a good thing for the industry, clearing out those funds that don't deserve to exist and forcing all managers to play at the top of their game.