Sell, sell, sell

Answer this question as quickly as possible and without thinking: What is a private equity firm’s most important function: doing deals or raising funds?

If you didn’t follow instructions, and instead took the time to come up with a nuanced, uncontroversial answer, it was probably along the lines of both dealmaking and fundraising being equally important with the success of each influencing the other, etc etc, yadda yadda.

But if forced to choose between one or the other, the gut-instinct answer is b) raising funds.

Deals are the privilege of the funded. A private equity firm that fails to raise the next fund ceases to exist (although its end-of-life period is impressively protracted). A private equity firm that fails to raise the right size of fund becomes a different firm, with fewer people and fewer offices by dint of a smaller income. It’s a disruptive step down.

David Snow

This analysis is worth bearing in mind as sprouts and blossoms begin to appear across the frozen tundra of the deal market. Transactions are indeed beginning to happen, but GPs appear to be hugely focused on scoring exits. A cynic would say that some of these exits have been put on the fast track in order to ensure a more successful follow-on fundraising in the near future.

Recent cash flow numbers tell an interesting story. According to State Street Private Equity Index, which tracks about $1.5 trillion in LP commitments  globally, the three-month period from February to April 2010 saw a surge in distributions. For the year-and-a-half up to January 2010, State Street’s distribution-to-drawdown ratio rarely exceeded 0.2, meaning that the anemic deal activity was exceeded only by the even more anemic distribution activity. But that changed dramatically in February, when the ratio jumped to 1.0 – in other words, distributions levels are on par with drawdown levels.

This thousand-foot view is confirmed by the experiences of many LPs in the market. One major private equity investor that is required to reveal these numbers is Conversus Capital, a publicly listed fund of funds with a portfolio of LP interests that is both diverse and mature. For the quarter ended 31 March, Conversus reported distributions worth $91 million: a welcome uptick. By contrast Conversus had capital calls equaling $33.4 million over the same time period. That’s nearly three dollars in distributions for every one dollar in capital calls.

It’s great to receive more than you give, but this ostensibly happy situation bears greater scrutiny. Why, on average, do GPs appear to be more eager to exit deals than to enter new ones?

First of all, it should be noted that private equity firms generally have a lot of money that needs to be put to work. State Street estimates that there is some $500 billion in dry powder awaiting capital calls: an historic high. And despite all the talk about recessions making good vintage years, GPs have been either reluctant or unable to deploy much capital recently. State Street notes that the capital-drawdown-to-commitment ratio – the measure of deal activity relative to commitments – remains at historic lows, hovering near 0.3 percent per month through April.

Perhaps the key to this riddle resides with the LPs, many of whom are cash strapped, over-allocated and possessed of an intense show-me mentality with regard to their GP relationships. Many of these LPs got into a bind in their private equity programmes in part because they built models that assumed certain levels of distributions from GPs would fund ongoing capital commitments to new funds. When distributions dried up during the Great Recession, so too did the ability of LPs to back new funds.

LPs today need plenty of convincing to commit to follow-on funds and nice fat cash distributions can speak louder than words. They show a GP’s ability to take portfolio companies on round trips and deliver cash-on-cash returns in the process. Well timed distributions bring liquidity to institutional private equity programmes just ahead of major new fundraising initiatives, when GPs will come back, hat in hand, asking for more money.

Of course it is possible to take an entirely positive view of the ongoing wave of distributions. Private equity firms are taking advantage of a revival in the M&A market in order to deliver realised returns to their LPs. But one has to wonder whether any GPs are simply selling their winners in the hopes of securing another 10 years of life afforded by a successful fundraising. It’s a question LPs should deeply ponder.