Private equity fundraising is at its lowest ebb for several years. Yet some of the industry's most established brand names had no problem in 2002 raising their largest funds yet. This is last year's conundrum that makes 2003 one of the hardest years to call. However, be it feast or famine, no one doubts that it will be hard work.
If you believe the numbers, this task has never been harder. Fundraising all but collapsed in 2002, down from 2001, itself a relatively sober vintage. The European Private Equity and Venture Capital Association's fundraising figures for 2002 are still to be finalised. But according to its calculations, in the first nine months of the year Europe's private capital managers collected just €11bn compared to €38bn in 2001.
Venture capital fund managers, hardest hit by the technology bubble's burst, stayed at home, preoccupied with tending portfolio companies, releasing limited partners from commitments and cutting management fees. Typically accounting for around 50 per cent of the fundraisers by number, the VC specialists were down to just 28 per cent of the total, accounting for a mere 5 per cent of funds raised, according to a recent breakdown by AltAssets Research, which also said that a total of 57 European private equity funds held a final close in 2002 raising just over €27bn, half the amount of 2000. Almost half of all funds that did close in Europe in 2002 missed their target total and were forced to settle for less than they had initially targeted.
?Investors remember that the backbone of private equity was built on venture capital?
But those numbers present only half the story. A steady flow of well-known buyout players still closed large funds with apparent ease, though swan-like their ostensible calm belied a furious paddling beneath the surface. To name a few: Cinven closed at €4.4bn; Candover raised €2.7bn; and Barclays Private Equity filled its pockets with €1.25bn, thereby accepting third-party commitments for the first time.
In the US Blackstone Group and JPMorgan Partners even managed to raise the largest private equity funds in history. Blackstone closed at $6.45bn and JPMorgan at $8bn, though the majority of the bank's fund was balance sheet money and it was a long way off its original third-party target. Warburg Pincus closed its tenth fund at over $5bn. The fund-of-fund leviathans marched on as well. Goldman Sachs attracted $1.2bn to its coffers and HarbourVest gathered $2.8bn for its latest global vehicle.
Flight to brands
Barring any unforeseen disaster, 2003 will see more large funds close and new ones launch. Charterhouse Development Capital, the UK buyout firm advised by the placement group at Salomon Smith Barney, held a second closing in the first few days of the new year, at more than €2bn. Doughty Hanson (advised by Merrill Lynch) is also in the market, as is former Nomura kingpin Guy Hands, whose new firm Terra Firma is well on its way with €1bn under its belt (advised by both Salomon Smith Barney and Merrill Lynch). All three are targeting final closes of around €3bn. So what is driving such large sums into these high profile funds?
Jonathan Blake, head of private equity at SJ Berwin, who worked on the Barclays fundraising, says ?all funds are finding conditions tougher – and funds are taking longer to close – but established teams with good track records are raising substantial funds.?
The early indications are, however, that there are no immediate signs of fundraising becoming any easier. The reason is simple. ?A number of investors have lost significant amounts, it is only natural they would apply a more conservative approach,? says Blake. Plunging equity markets and more general economic uncertainty has wiped as much as $1,400bn from the value of global pension fund assets in 2002, according to Watson Wyatt, the investment consultant. The private equity asset class, which requires investors to commit a disproportionate amount of resource relative to its subordinate role in a balanced investment portfolio, naturally takes a back seat in that environment.
Some investors look for easier and safer choices. Cory Pulfrey, Pennsylvania-based managing director of Morgan Stanley Alternative Investment Partners, says: ?There has been and will continue to be a flight to brands. The risk profile of a lot of institutional investors is going to tend towards relative safety, because they have been burnt in the past.?
One critic of the big-brand, steady-as-she-goes mindset (remember: no one was ever fired for buying IBM) says: ?Investors will package up ten London-based European funds, all wrapped up in a nice bow for 12 years. I think this is misplaced ? those markets are now becoming relatively efficient.? Misplaced, perhaps, but understandable as long as investors are battling an IPO-free climate, which has robbed funds of exits and investors of hard performance data.
Assessing the performance of a fund that has not achieved any exits yet will require investors to roll up their sleeves and evaluate the underlying assets. This is a time-consuming exercise and is bound to produce subjective results ? one reason why many investors looking to make new allocations will tend to back managers they know. Long-established players such as Doughty Hanson will be grateful that this is the case. The recent postponement of theIPO of Rank Hovis McDougall still leaves the firm without a full exit from the portfolio acquired by its third fund, a $2.5bn vehicle raised in 1997. Nonetheless, after considerable soft marketing, fundraising for fund IV is underway.
But the focus on track record is unlikely to benefit all of the old favourites. Katja Salovaara, portfolio manager for private equity at the Ilmarinen Mutual Pension Insurance Company in Finland, says: ?You have really seen a flight to quality. But how have groups performed in the past three to five years, the more difficult years? Is the track record relevant to the strategy they are proposing; is it relevant to today's market??
In any event, track record, while certainly a proxy for quality, is not the only consideration. There are other issues to consider: team motivation and incentives, strategy and how a manager is being positioned in the market. Do the partners really still have the appetite or are they long in the tooth and heavy of wallet?
Another key criterion is expected return. To some limited partners the safe shores of the big buyout funds may be less appealing, especially when their focus is entirely on absolute performance. As Salovaara puts it: ?Country specific funds and smaller deals may produce higher returns than the large cap buyout funds but they could also be expected to have higher volatility. It all depends on what your risk tolerance is and what your return and risk expectations are going forward.?
But for many that tolerance is low. To be fair, so are their return expectations. Pulfrey says: ?Investing in large cap buyouts, the risks are lower and you can still generate returns above equities. For some investors 300 to 500 basis points above public equity is fine. It is starting to look like public equity plus.?
?You need tomorrow's managers for tomorrow, not yesterday's men?
In the past, too many limited partners were desperate to find a home for their money and paid the price of not really understanding who or what they were buying. Now they cannot afford not to know. Fortunately, in today's environment, LPs can take more time and assess all the options.
Paul Denning, founder and chief executive of San Francisco-based placement agent Denning and Company, says: ?The kneepads have changed. Investors were begging VCs to take the money and VCs were begging entrepreneurs to take the money and now it is the other way round. It is a buyers market and the limited partners are setting the pace.?
Due diligence is paramount and the process is timeconsuming. Roger Wilkins, private equity fund manager for Morley Fund Management, says: ?We want to do more comparisons. Lots of funds are raising in the same space and sector and you want to compare them, whereas in the old days it was easier to make a commitment sooner.? 2003 is unlikely to see any return to the fundraising pace of old.
Niche products and first timers
If a stampede into the safety of the large cap buyout fund is one of the themes to prevail in 2003, another is the appeal of more specialised products: country funds, middle market and small cap funds, distressed funds, mezzanine, secondaries and combinations of almost all of the above. Investors looking to build diversified programmes have eagerly been looking for gems in all of these categories, and will continue to do so going forward.
In the first days of 2003 CapMan, the Nordic private equity firm, closed its seventh fund at €253m with half the capital coming from new investors. Industria & Finanza had a successful fundraising for its domestic Italian buyout fund. Indigo Capital closed its fourth mezzanine fund at €475m in January this year. Nordic Mezzanine enjoyed a healthy first close of its second fund at €150m. Mezzanine Management branched out into Central and Eastern Europe with a dedicated fund last year.
In secondaries, Coller Capital rewrote the book in October 2002 with a $2.5bn mega-fund, while Pomona Capital offered a different scale of secondaries with its heavily oversubscribed $580m fund. Other players such as Lexington, Greenpark Capital or the Carlyle Group are also raising capital for secondaries. Says Pulfrey: ?You have two opportunities: one is participate with Coller, Landmark, Goldman, whoever. But that market is becoming efficient. The [other] opportunity is in smaller chunks, taking an existing general partner and buying out a limited partner who wants liquidity.? Whichever view you take, the market has no doubt that dedicated secondaries funds will be doing business going forward. The debate is whether it will be a tidal wave or a swell.
Another opportunity that many investors say they recognise is the first-time fund. Rod Selkirk, head of private equity at Hermes and poacher turned gamekeeper since he left Bridgepoint Capital, says: ?We should be backing the hungry managers. That is the challenge now. You need tomorrow's managers for tomorrow, not yesterday's men. You have to be more selective and some of the conventional wisdom needs to be challenged.? Hermes recently anchored a first-time middle market fund in France, managed by Activa Capital in Paris.
first time fund as added risk. Selkirk says: ?Investors have to be sure that the team chemistry is positive and the team will stick together long enough to generate returns – not just to invest the money.?
Placement agents can make an important difference when it comes to persuading investors that committing to a new manager is a risk worth taking. One investor says: ?If you are a placement agent for a big established fund, it is basically a signing exercise. But for a less well-known group in a less popular space, you will definitely earn your money. If you're raising money for an emerging market fund at the moment, you might as well kill yourself.?
Frank Hock, managing director of private equity start-up Barlage, Knoth & Cie in Munich, threw in the towel at the start of 2003, after a promising launch 12 months earlier. The German turnaround fund manager could not persuade enough investors to back its fledgling team, despite a wealth of experience of the partners involved. They had all worked together, but never in the format they were pitching to would-be backers. Hock says: ?[Only] a team that has proven its track record and takes its record with them stands a chance of building up a new company on the back of it. If this trend develops, it will not become easier for funds like Barlage, Knoth & Cie in the future.?
With or without a cornerstone
Roger Wilkins at Morley emphasises the paradox of firsttime funds: ?Managers have all got to start somewhere, but we would rarely back a first-time fund. Occasionally we would back a spin-out because you need new funds [in your portfolio].?
Perhaps the only viable model for a first-time fund in the current climate ? and one which many believe will develop in 2003, is the sponsored fund. Langholm Capital recently took Unilever and Rabobank as its cornerstone investors, whilst Terra Firma has Nomura.
But even the luxury of a cornerstone sponsor to set up a new private equity manager can be a mixed blessing. They tend to come at a direct cost to the economics of the fund, to compensate for the ? arguably significant ? additional risk of committing to a fund early. Langholm's founders are understood to have ceded as much as 5 per cent of the fund's carried interest to their sponsors. Alternatively, the management team can offer a stake in the management vehicle. Both arrangements can make other investors feel uncomfortable, either because they suspect their interests come behind those of the cornerstone investor and partowner, or because they fear the general partners' reduced compensation could affect their motivation and staying power.
Some newly established general partners may grant an investor a very prominent role in their fund. Dominic Shorthouse, the former Warburg Pincus executive, recently closed Englefield Capital, his first-time UK fund, at €660m. The bulk of the money, €495m, came from the Brenninkmeijer family, owners of clothing chain C&A, through Bregal Holdings.
Whatever the terms available to limited partners, all those that are committing capital at present are betting that 2003 will be a strong vintage year for private equity. This holds true across the spectrum of the asset class. According to practitioners, perhaps the most surprising fundraising trend to look forward to in 2003 is, whisper it, the gentle return of venture capital. Paul Denning says: ?The investors are beginning to remember that the backbone of private equity was built on venture capital and backing breakthrough technologies that drove the market.? And valuations are starting to look right.
So despite all the gloom, despite the shadow of war looming large, there are still reasons to be cheerful. As long as an investor retains an appetite for the asset class, there will be the funds to suit. To the casual observer it might seem as if private equity firms raise either mega funds or no funds. It is seemingly a case of billions or zeros. But the reality is that general partners both old and new are offering sophisticated products representing almost every point in between. Everyone has to have a compelling story though, because limited partners are calling the shots and they are being very careful with their money. Tough calls, tough going: Darwinian times.
Top tips for placement agents
Phil Pool has been raising private equity funds since 1983, when he led the formation of Kidder Peabody's private equity placement business. He went on to play a major role in establishing dominant placement businesses at Merrill Lynch and Donaldson, Lufkin & Jenrette, where his team helped raise some of the largest pools of private equity in history. He is now a partner in the New York office of Willis Stein & Partners, a Chicago-based leveraged buyout firm. We asked Phil to draw on his years in the placement business and put together a few pieces of advice for people on the fundraising trail. Here are his top tips.
•Never assume! The investor that you assumed would be a shoe-in for a fund may well say no, and the investor that you never dreamed would be interested may well say yes. ?There are always surprises regarding who invests and who doesn't invest,? says Pool.
•Let the GP do the talking. Even if you, the placement agent, feel you can add materially to the pitch, never take over the meeting. The investor wants to hear about the strategy directly from the person who is proposing to manage all that money. ?The placement agent is the catalyst for the meeting, but the investor wants to hear from the general partner,? says Pool.
•Don't send a boy to do a man's work. Do all you can to make sure the senior partners are at the first meeting, even if they want to send a junior professional in their stead. ?In my view, the sale is made in the first ten minutes of the first meeting,? says Pool. ?It's very hard to make up lost ground once investors have made up their minds; the senior partners should not take the view that they can send junior partners or the investor relations professional to warm up the prospect and then swoop in to make the close after the first few meetings.?
•Never raise a consortium fund. Avoid the headache of dealing with a vehicle that is controlled by more than one GP. This is a recipe for in-fighting and dissolution. Pool recalls with dismay one fund whose co-sponsors split with each other right after the capital was raised. ?It's a very fragile mix when you have multiple sponsors controlling the GP,? says Pool.
•Never raise a fund where the management team doesn't get at least 50 per cent of the carry. As with the scenario above, you don't want to take on a fund that will fall apart after the final close. A poorly incentivised management team is at risk of quitting during the life of the fund.
•Never, ever arrive at a meeting in a stretch limousine. Especially a white stretch limousine. This sends the wrong message. ?If the investor sees your GP pull up in a limo, all the guy thinks about is where the management fees are going,? says Pool.