‘It used to be, ‘What vintage year are you raising?’ Now it’s almost, ‘What vintage quarter are you raising?’” These words from the chief investment officer of a West Coast public pension are a tidy encapsulation of the mood among limited partners.

General partners are returning to market quicker than ever, often with steeply elevated targets. In May, the Carlyle Group launched its eighth flagship fund, targeting $22 billion just three years after raising $18.51 billion for its predecessor. This is almost pedestrian compared with Thoma Bravo: the software investor’s Fund XV, also targeting $22 billion, was launched just nine months after it held a $17.8 billion final close on Fund XIV, according to Private Equity International data.

In remarks reported by PEI, Carolin Blank, a managing director with Hamilton Lane, said that as of 1 December, there were 15 managers in market intending to raise at least $15 billion: “If those 15 managers only raise $15 billion, we will already be at 55 percent of all buyout fundraising in 2020.”

Private equity funds raised $733 billion in full-year 2021, edging out the previous record year, 2019, by about 2 percent, PEI found. For the first time since 2018, the number of funds to close also rose, from 1,313 last year to 1,384 this time around. The average fund size was $530 million, the highest level yet recorded and almost a full 50 percent up on 2017. GPs’ confidence in their fundraising potential is not without basis. Distributions totalled $715 billion in the year to 30 June, “by far a record” over a one-year period, according to research by Hamilton Lane’s head of private market analytics Bryan Jenkins.

“Unrealised [value] has gone up, GPs are coming back quicker… Private equity is a victim of its own success”

Yann Robard, Whitehorse Liquidity Partners

Distributions also set an all-time record of $246 billion in Q2 2021 alone. The 2021 calendar year is likely to break the record for exits as sponsors offloaded assets at the top of the market, he adds; the numbers were being finalised at the time of going to press.

“The first-order result is that some LPs may be getting more cash back in 2021 than they would otherwise expect. LPs will need to figure out how to redeploy that cash,” Jenkins wrote in Hamilton Lane’s Market Trends: A Surge in Distribution Activity. A “convenient solution”, he adds, would be to recycle those proceeds into the latest funds of their best-performing managers.

Danger ahead

While PE professionals can be forgiven for basking in this heady moment, the numbers deflect from issues that are likely to make fundraising a trickier prospect for many in 2022.

Private equity performed very well last year, in line with the spike in public market equivalents spurred by the post-covid recovery. The PE portfolio of Harvard Management Company returned 77 percent in the 12 months to June, with Duke University and the Massachusetts Institute of Technology returning 56 percent.

Similar results were achieved by public pensions, with California State Teachers’ Retirement System and Washington State Investment Board among several big private equity investors to exceed 50 percent returns in the last fiscal year.

Even with record distributions, many LPs are at or above their allocation limits just as a raft of established PE firms return to market asking for bigger cheques.

Some 23 percent of respondents to PEI’s LP Perspectives 2022 Study said they are over-allocated for this year, up from 13 percent in 2021 and the highest percentage since the first survey, in 2018.

“Private equity is a victim of its own success,” says Yann Robard, managing partner of Whitehorse Liquidity Partners, a preferred equity firm that came to market last year targeting $5 billion for its fifth fund in as many years.

“Unrealised [value] has gone up, GPs are coming back quicker… That is going to create a very challenging 2022 fundraising for GPs.”

For overallocated LPs, this means a more circumspect approach to deploying capital, which is likely to benefit the best-performing existing relationships, according to Partners Group chief executive officer David Layton.

His firm collected $25 billion of commitments in 2021, well ahead of the $19 billion-$22 billion guidance range it presented to shareholders in 2020. “If [LPs] do have less to allocate, they still want meaningful relationships, they still want to get co-investments and be relevant to their GPs… They’re saying, ‘Let’s concentrate allocations with three or four groups that we can do more with and be more relevant with’,” Layton says.

“Some LPs may be getting more cash back in 2021 than they would otherwise expect. [They] will need to figure out how to redeploy that cash”

Bryan Jenkins, Hamilton Lane

Still, even the largest groups cannot take anything for granted. Some LPs are limited in their ability to invest in multiple offerings from the same manager, so must extricate themselves from one fund before committing to the latest. Others are cutting back their ticket sizes to accommodate as many commitments as possible.

“We have a new phrase now – we have a commitment diet,” said Brian O’Neil, CIO of Robert Wood Johnson Foundation, speaking on a panel at the iConnections Global Alts 2022 conference in January. The healthcare-focused endowment with $3.57 billion in PE assets under management is only committing to existing managers and writing smaller cheques.

This approach does not workfor all. Some larger LPs feel that even slightly smaller cheques will diminish their ability to drive returns for the whole portfolio – they are already at their lower limit. Equally, cutting back doesn’t sit with some LPs’ strategy of being one of the most important investors for a small- or mid-sized GP.

“We’re on a lot of LPACs,” says the West Coast pension CIO, who manages a $2 billion portfolio. “In cases where we have a good relationship, where we would love to have re-upped but just don’t have the capital, it can be easier to skip a fund and come back [than to write a smaller cheque].”

Secondary solution

Some are using the secondaries market to free up capital for reinvestment. State Teachers Retirement System of Ohio and Harvard Management Company sold $1 billion-plus portfolios in 2021, while Florida Retirement System Trust Fund sold more than $2 billion. In January, affiliate title Secondaries Investor reported that California Public Employees’ Retirement System plans to sell up to $6 billion of PE stakes in what would be the largest ever portfolio sale.

“In cases… where we would love to have re-upped but just don’t have the capital, it can be easier to skip a fund and come back [than to write a smaller cheque]”

CIO of a West Coast public pension

Pricing for buyout funds shot up to 97 percent of net asset value in 2021, from 90 percent the year before, according to financial services firm Jefferies. The average price of a venture capital fund hit 88 percent of NAV, five percentage points higher than ever before. With pricing like this, the appeal of today’s secondaries market is obvious.

Gerald Cooper, a partner with secondary adviser Campbell Lutyens, believes we are witnessing a wave of LP deals driven by allocation pressures. Many are looking to sell a fraction of the funds in their portfolio, known in secondaries parlance as a strip sale, allowing them to maintain exposure while freeing up some liquidity.

GPs may also start to use more “creative ways” to boost fundraising, Cooper adds. This could mean the re-emergence of stapled tender offers, where a secondaries buyer purchases stakes in a fund and makes a primary commitment to a follow-up vehicle, creating liquidity for LPs while giving the GP a push across the line. These deals declined in popularity over recent years.

Jill Shaw, managing director and private investments specialist at Cambridge Associates, sounds a word of warning about selling on the market. Think carefully about what you’re giving up, she says. “You’re going to be selling at a discount, so your asset value is going to drop. You need to be sure that you can make that money back and then some, given how you plan to redeploy the cash that comes back from the sale.”

Feels like a bubble

The current conflict between high targets and squeezed allocations will pass eventually. Some firms will fail to hit their fundraising targets; others will have to use creative solutions to do so. But the speed with which firms are returning to market is causing alarm among LPs.

One Northern European insurer describes the step up in targets as “outrageous”, with some GPs having grown from mid-cap to mega-cap in less than a decade. These managers come to play a completely different role in the portfolio and must be underwritten according to different standards, he says.

Other are concerned about whether the opportunity set truly justifies raising larger funds, or whether firms will wander further from their core investment competencies and weaken their diligence standards to be able to put all the money to work. The higher cost of funding brought about by rising interest rates only adds fuel to the fire.

“I hear the same story… Our pipeline is just more robust, we can deploy more capital [to justify a bigger fund],” said Connecticut state treasurer Shawn Wooden at the iConnections conference. “As I told one manager, you know, it’s like musical chairs and the music is going to stop at some point.”

“To me, it’s a diligence question,” he added.

GPs have the comfort of knowing that, as frothy as the market gets, LPs must increase their allocations to alternatives if they are to meet their return expectations. But managers should not use this as an excuse to overextend themselves, weaken their due diligence or go to parts of the risk curve that they would once have avoided.

Emerging managers blues

Less-established firms meeting certain criteria are benefitting from new pockets of capital at a time when many of their peers are struggling to attract LP eyeballs, writes Alex Lynn.

LPs’ decision to double down on existing relationships has made fundraising even more difficult for emerging GPs or those with a story to explain away. PEI’s LP Perspectives survey found that 31 percent of respondents were “just as likely” to commit capital to new managers as to existing ones, compared with 38 percent in 2020. Forty-three percent said they do not invest at all in new managers, compared with 29 percent the year before.

Some managers are timing their fundraises so they will come under budgetary consideration this year and next, hopefully increasing their chances with an LP. All emerging managers are having to look to a broader range of potential LPs than before, increasingly without the help of an agent.

“The bar for placement agents to take on emerging managers has really increased,” says Niklas Amundsson, a partner at Monument Group, noting that although emerging managers accounted for about 50 percent of the firm’s new business prior to the pandemic, it did not accept any such mandates in 2020. “Last year was 90:10 established to emerging managers, and this year we’re looking at 80:20.”

Emerging managers aren’t the only ones feeling the pinch. Allocation issues among LPs have driven a greater number of established managers, many of which have spent years bringing their fundraising capabilities in-house, to seek help with their fundraise.

“GPs that would never have approached us – alarmingly large GPs with successful brands – have come to us and said, ‘We’ve got eight people internally, we’ve got 500 LPs, but we are worried we are not going to get the numbers we want’,” FirstPoint Equity co-founder Julian Pearson told PEI in our October Deep Dive.

Though the picture is a bleak one for newer ventures, a small pool of hopefuls are finding respite in buckets of capital earmarked for diverse or emerging managers. “Over the past 18 months, more pockets of capital for emerging situations have sprung up, particularly around diverse and minority-owned GPs,” Amundsson says. “A lot of what gets raised now has backing from those types of initiatives.”

New York-listed insurer Prudential Financial, for example, last year allocated $200 million to private equity funds managed by women and minority-owned GPs, while Northwestern Mutual said it would back Black and African American-owned GPs amid a wider push to support minority businesses.

‘Always on the lookout’

Make no mistake: successful fundraises aren’t off the cards altogether for those who wouldn’t qualify for these buckets. Case in point: US growth firm Ten Coves Capital, which spun out from Napier Park Global Capital in 2020, closed its first independent fund earlier this year at its $293 million hard-cap. More than 30 percent of this capital was committed by new LP relationships, co-founder Steve Piaker says.

“We certainly heard on more than one occasion how pressed many of the LPs were [and] are in the market due to the pace of re-ups,” he adds. “That said… most emphasised that they are always on the lookout for newer managers and smaller funds with a durable edge. You must have a business model supported by a strong partnership and experienced leadership team, a large, underserved target market, and a demonstrable edge in how you originate and add value.”

Becoming more committed

Increasing your target to alternatives while staying liquid enough in case of emergency is a fine balancing act, writes Carmela Mendoza.

Jill Shaw

If an LP doesn’t want to sit out or write smaller cheques, one solution is to increase allocations. Los Angeles County Employees’ Retirement Association increased its PE target allocation from 10 percent to 17 percent in 2021, while State of Wisconsin Investment Board increased its own from 9 percent to 11 percent. Massachusetts Pension Reserves Investment Management Board and Illinois Municipal Retirement Fund were among the other public pensions to do so. Jill Shaw, managing director and private investments specialist at Cambridge Associates, tells PEI what LPs should think about.

Have you seen many LPs increase their allocations as a response to being overallocated?

Over the last few years, we’ve been actively increasing the target allocations in portfolios that are well equipped to handle additional illiquidity to capitalise on the outperformance that private investments have consistently delivered. However, these long-term target increases aren’t just for those institutions that are overallocated today. We’re constantly reviewing the liquidity needs of groups that are still building to their long-term targets and have been recommending increases to those targets when warranted.

How easy is it for different types of institution to increase their PE allocations?

We work with some endowments and even a few public pensions that function with the same nimbleness as a family office. Their decision-making bodies are willing to gather quickly and as often as is needed for effective decision-making.

As a rule, family offices tend to be the most nimble and most comfortable adding additional risk, followed by endowments and foundations. Public pensions tend to have much more cumbersome governance procedures in place, but again, there’s a spectrum. Some meet only quarterly, and a target allocation increase may need six months or more of socialisation to get buy-in before implementation can begin, while others have designated a sub-set of decision-makers that meet every two weeks and can move very quickly.

What are the main things to consider when raising your allocation?

We believe that institutions should have as much allocated to private investments, as they are able to drive the highest returns for their portfolios. The key is determining what that number is. First and foremost, institutions need to ensure that they have sufficient liquid holdings to cover any annual spending needs in the event that there’s a market downturn and equities are severely depressed for a period of time. You don’t want to sell equities in a downturn, so you need to ensure that your ‘safety buckets’ – fixed income and other liquid sources of capital – are large enough to draw from to fund spending, pay capital calls and take advantage of rebalancing opportunities in an extended downturn.

How large should those buckets be?

How large depends on each institution’s own risk appetite: some are comfortable with one year of spend, others want three or four. One thing to note is that this is a long-term decision. Many of the institutions that are overallocated today are in that position because of a relatively recent run-up in their long-established venture portfolios.

What if those values prove to be inflated and fall over the next few years? Would you still want to be at a higher private investments allocation? If the answer is yes, then you should increase your target. If the answer is no, then perhaps the best course of action is to maintain your current target but allow for a larger acceptable range, which would let the allocation work itself out over time as values come down due either to declines or eventual distributions.