‘Something is going to give’

What’s your outlook on private equity in 2011?

The biggest theme we’re keeping our eyes on this year is how the fundraising environment evolves over the next 12 months.  Unless the level of LP commitment activity increases significantly over the next 12 to 24 months, a very large restructuring of the asset class’s infrastructure and capacity is going to be required.

What are the consequences of a depressed fundraising environment?

There over 4,000 active firms currently employing more than 60,000 people in our industry. That’s a lot of careers, offices and infrastructure that was built and based on an annual commitment volume somewhere north of $275 billion to $300 billion. Now we’ve had two consecutive years of less than $200 billion. Something is going to give.

What will drive institutional investor appetite?

Historically, you have needed two things: strong distribution activity and total asset appreciation. Deal activity fuels distributions to LPs, which typically, but not always, reinforces demand for additional commitments and a recycling of distributions in into new commitments. In addition, a significant increase in total asset value in the broad equity and fixed income markets would create additional capacity for investors already allocated to private equity. You need a material increase in both of these factors over the next 18-24 months in order to drive commitment activity levels higher. 

Do you see this happening?

I have no ability to predict how global asset markets are going to behave over the next two years, but in our view it is a pretty optimistic scenario for asset markets and deal volume to increase significantly, so we are preparing for the alternative paths.  

What are your thoughts on private equity performance?

This is the part of the conversation where we have to talk about the dreaded “overhang”. The problem nobody is talking about is not the amount of the overhang; every post-recession vintage has an overhang. The real problem has to do with timing. If you look at the overhangs that existed in 1992 and 2002, the amount of uncalled money for funds that had investment periods expiring within 24 months was 25 percent. At the end of 2010, the amount of uncalled money for funds that have to deploy within 24 months was over 40 percent. This means that the high entry multiples we saw last year, almost 10 percent above the decade average, aren’t an anomaly and they’re going to persist at least through 2012.

The overhang pressure is creating unprecedented pricing pressure in the mid-market. There isn’t enough leverage to complete the large public-to-private deals that drove transaction volume from 2004 to 2008, so all of that capital has to be deployed in the mid-market. That is why you saw a large increase in sponsor-to-sponsor transactions last year. The only good news is that LPs who don’t want to reward GPs who have benefitted from multiple expansion don’t need to worry, because we don’t expect much aggregate multiple expansion from the new deals completed from 2010-2012.

We don’t think returns are going to be exceptional. We’re preparing for a scenario where the fundraising market doesn’t approach $300 billion at year. And if it doesn’t approach that level, [we are preparing for] a significant restructuring of the US and European mid-market buyout markets.

What will that restructuring look like?

You’re going to start hearing names in mid-market buyout who are struggling to raise capital, just like in 2001 and 2004 you started hearing brand name venture firms being tossed out, people who you would have never questioned their viability. Those venture firms are gone today. The same thing will happen in the mid-market LBO community.

What does this mean for limited partners?

LPs who are not constrained in any way will be significantly advantaged in building relationships and getting access to alpha generators, if they can find them. LPs that are constrained by either allocation or liquidity issues, or both, will have a hard time improving their GP roster. The just simply won’t be able to participate with the next decade’s leading firms to improve their overall long-term performance.

LPs who are constrained and exposed to the large end of the market, particularly in their unfunded commitments, will underperform their peer group for the at least the next three to five years. This is a great time to own small and mid-market assets, because you can sell into the overhang pressure and excessively high entry multiples.

However, it is a stressful time to have unfunded exposure to the mid- and large-end of the LBO industry, because you are probably a source for someone else’s liquidity every time your large market managers make a capital call.