Fundraising special: Too much dry powder?

As well as the growing appreciation that investors globally have for the asset class, two factors have combined to create a stellar run of private equity fundraising in the last few years. It will not last.

The first of these factors is the six successive years of net distributions to LPs. Every year since 2011 — even in the face of rampant fundraising activity — net cashflows have been positive to LPs. On average for this six-year period, for every dollar that an LP has put into the asset class, it has received around $1.90 back, according to a February report produced by Bain & Company.

Second is the strength of public markets, which, after a volatile start to 2016, rebounded to perform surprisingly well.

Between them, these factors have conspired to make it very difficult for many investors to maintain their private equity exposure at anything like their target allocation.

In its February report, Bain & Company pointed to US pension fund Washington State Investment Board as an example of a long-time private equity investor that has felt this ‘reverse denominator’ effect keenly, seeing its private equity exposure (the ‘numerator’) shrink in relation to the rest of its assets (the ‘denominator’). According to PEI data, the pension has a target allocation to private equity of 25 percent. As of the end of the year its actual allocation was down to 16 percent.

Private equity firms have met excess demand by raising larger funds. A look back at the 20 largest funds closed in the last four months shows that, on average, firms have raised vehicles that are 40 percent larger than their predecessors, according to our data.

You could argue they are wise to do so; conditions will not remain benign forever. As the Bain report notes, a recession coupled with falling stock markets could soon erode the ‘denominator effect’ that has recently worked so emphatically in GPs’ favour.

Meanwhile, the run of distributions — which peaked by volume in 2014 — is abating. It was driven by the glut of investment that occurred in 2006 and 2007. In these two years alone, total global buyout value was nearly $1.4 trillion, according to Dealogic.

Today, very little of that capital remains in completely unrealised deals — less than 10 percent, says Cambridge Associates — although around 40 percent of these deals are only partially realised. “The proverbial elephant has now largely passed through the snake,” in the words of the Bain report author, and as a result the pace of distributions will normalise. The pressure on LPs to put capital back to work should become less intense. 

With dry powder reaching a record $1.47 trillion globally by the end of 2017, perhaps this is no bad thing.