Travers Smith: Traversing a tough fundraising market

This article is sponsored by Travers Smith.

How would you describe the current state of the fundraising market?

It is certainly more challenging to fundraise at the moment – it is a tighter market, and everybody is being a little bit more circumspect. That is, in part, down to investors not necessarily wanting to make their choices right now in Q1 or Q2; instead, they prefer to see what happens over the course of the year. 

We’re seeing the same macro challenges out there today that we all saw last year – namely, the impact of higher inflation, interest rate increases and the denominator effect for investors. All of those concepts are in play and feed into the markets being more constrained.

Private Equity International figures for last year show annual fundraising was down 12 percent year-on-year; there are others that are suggesting it may be down even more than that. But this is not the same level of decline as we saw during the global financial crisis a decade ago, when activity simply stopped for a period of time. Right now, there is still activity – funds are still being raised, but there are fewer fundraisings, and they are taking longer. So, we are seeing a tightening of the market, rather than a halt. 

From a GP perspective, the other reason why things are a bit slower is that funds don’t want to go out to the market if there is uncertainty – they want to wait until they know they will be able to raise. It is a big problem to be in the market for too long and not successfully raise capital, so fund managers are choosing their timing with a degree of prudence. 

Investors, meanwhile, are signalling a shift in preferred strategies towards yield generation or strategies that are seen to be a hedge to the current environment. There are signs of things easing compared with nine months ago, with a slight uptick in public markets making investors a bit more open to allocating capital. That said, nine months ago we had funds in market that had been launched prior to the invasion of Ukraine. Now, that overhang of activity has been worked through. We are expecting more activity in the second half of this year.

What sorts of strategies are GPs using to stand out in the current market?

The most obvious strategic shift on the part of GPs is towards sustainability and ESG. As a result of regulatory pressure, but also investor demand, GPs looking to fundraise today have to make some kind of statement on their sustainability approach, and they are seeing that as an opportunity. If economies have to shift from where we are now to net zero outcomes in a pretty short period of time, there is a meaningful business opportunity. That is reflected in the assets investors want.

For a private equity GP, or for those in credit, infrastructure and real estate, it is not just the strong arm of the regulator that is driving greater focus on ESG outcomes. GPs are burnishing their credentials and trying to show investors that they have a sensible, coherent understanding of the sustainability market and will be able to capitalise on the opportunities. Furthermore, there are additional pools of capital available for GPs to tap into if they have the right investment strategy with some kind of sustainability angle. 

The key here is not greenwashing any actions that have been taken, or the way credentials are described. There is a focus on this on the part of the regulator, and we have seen a number of enforcement actions undertaken by regulators both in the US and the UK where misleading statements on green credentials have been highlighted.

Going forward, we certainly expect to see more funds being raised specifically for ESG strategies. As a result, the energy transition now constitutes a new class of green assets that is not just about batteries or electric vehicles, but also the infrastructure surrounding all of this. We are seeing managers pursuing that strategy and identifying investable assets that are appealing to LPs.

What tools are available to support fundraising in this climate?

We are seeing funds stapling some other investment opportunities to the new fund being raised – for example, that could be a GP-led transaction, which provides liquidity to the existing investors and allows them to go into the new fund so that the capital is recycled.

On those GP-led deals, there will be a number of investors underwriting the transaction by providing commitments to the continuation vehicle. We are seeing a requirement on those lead investors to also make a commitment to the new fund being raised – for example, the new flagship buyout fund.

We are also seeing similar deals on co-investments, where a manager trying to raise a fund might dangle a bit of co-investment on slightly more profitable economic arrangements in front of investors. Here, the only way to get access to that opportunity is to also make a stapled commitment to the main fund.

Finally, we are seeing more cross-fund trades. You may have a portfolio company that needs additional capital to thrive in its next stage of development, and the existing fund doesn’t have capital remaining to provide that support, so a GP will either transfer that asset to a new flagship fund or allow that new flagship fund to make an additional investment into that company. This provides comfort as some of the blind pool risk is removed for certain investors, allowing them to see one of the investments that is going to be held in the new fund.

Clearly, there are challenges with all of these tools, particularly around conflicts of interest. GPs have to think carefully about how they are going to deal with those. But, provided they can do that in a reasonable manner, there are a lot of opportunities available to support fundraising.

One encouraging trend we do see is that there is serious engagement between LPs and GPs to find the right solutions to these situations. Fifteen years ago, everyone was just fulfilling their own roles in the market; today, there is a more collaborative approach. LPs are more sophisticated and understand the market in a pretty deep way. They can see there are actual opportunities to deploy capital and make a positive contribution to their returns overall.

What do you expect the big fundraising themes to be in 2023?

Over the course of this year, the main themes will be around a real sense of the fundraising market returning. The annual data for 2023 will be a bit lower than the level of fundraising activity we have come to expect in recent years, but, by the end of the year, there will be more of an uptick in activity. In the meantime, there is going to be more of a focus on the portfolios that current funds have, right-sizing those portfolios, tidying them up and making them look attractive as managers prepare for new investments or exits when M&A markets come back. All of that housekeeping will help generate good returns so that managers will be in a better place to fundraise next year.

In the immediate future, GPs will be preparing themselves with internal admin, getting their houses in order, making sure they have all the people they need in all the right roles and ensuring they are in good shape to take advantage of the next cycle. Then, looking further ahead, the themes for the next cycle are going to be around secondaries and how those can play into the wider fundraising market, and also tapping into new pools of capital. 

People have been talking about the retailisation of private equity for some time – this is about funds looking to tap not just pure retail investment, but also ultra-high-net-worth individuals and mass affluent wealth platforms. There will be a longer term trend towards helping those investors get access and developing the structures and strategies that those investors find attractive.

Finally, on ESG, we expect to see a number of specialist funds coming to market that will be able to demonstrate their credentials and strengths in identifying the right kind of green assets. It won’t be sufficient for everyone to be chasing the same sustainable opportunities, so specialists will emerge, and investors will increasingly migrate towards those strategies.

Have you observed any notable changes to fund terms?

The interesting point here is that there is not a significant shift in fund terms at the moment. We often expect, in times like these, that the challenges in the fundraising market will shift terms in favour of the LPs. But we are not really seeing that in any meaningful way today. That may be because GPs have been a bit more careful about when they launch in order to get access to the market.

It is also true that over the last decade we have seen a growing understanding of how to create alignment between GPs and LPs. That still plays out now, even though the market is tighter. During the global financial crisis, we saw this pressure towards early-bird discounts to create momentum in fundraising, for example – we haven’t seen that yet this time. Today, the way to create momentum is with the tools we discussed around the structure of a particular transaction, rather than a reduction in fees.