Private equity is getting acclimated to the new reality of funds closing under target.

For LPs, such a dynamic can be a nuanced affair. Common concerns can include whether a lengthened fundraise is likely to distract managers from deploying capital and managing legacy assets. Closing below target also means GPs will have less firepower on hand, thus becoming less competitive when presented with large deals.

Investors therefore prefer to be kept in the loop about fundraising processes; GPs can better manage expectations if they communicate with LPs early and frequently. While its rare that LPs would scale back the amount they have already committed, it also depends on how far the fund is from its initial target and if managers have effectively communicated this prospect with investors.

“If the GP has been transparent throughout the process, we – from the LP side – should have a good picture of where a [first] closing will pan out, [so] closing below target then shouldn’t be a surprise” one PE portfolio manager at an insurance company told Private Equity International on condition of anonymity. “However, if this does come as a surprise and the GP has painted a very optimistic picture, this will clearly impact the relationship with the manager.”

Is it a failure, or is it not?

LPs tend to have differing views towards whether funds missing targets should be considered a failure.

For some, misses are undoubtedly a bad thing. “Not hitting the target is a perceived failure and is difficult to spin into a positive outcome,” said Greg DeNinno, investment committee member at US multi-family office Pennington Partners. “Below maybe 75 percent of the target is not a good signal, especially if it took two-plus years to arrive at that amount.”

Others take a more sanguine view. Donny Lam, chairman of Hong Kong’s DL Family Office, welcomes funds that are more conservative in size. “[I ask GPs] why [do] you raise so big [of a] size? Do you think you can deploy all the money [in a] timely [fashion]?” he said. “Because we don’t want the GP to just for the sake of deploying to meet the limit like that.” Lam said it’s more economical for GPs to raise two smaller size funds in two years than one big strategy. “If you don’t [have] enough, then you raise another one,” he added. “If you use [it] up in two years, you can raise again, right?”

Between the two polarised sides, there is another camp that think “it depends”. Some LPs consider many factors before concluding whether a fund’s shortfall is a failure. This is highly dependent on market circumstances, the type of product, the scale of the shortfall, the scale and pace of deployment of the prior fund and the fundraising duration. For example, a listed firm’s flagship fund missing its target may be subjected to more shareholder scrutiny and thus more likely be perceived as a failure.

“If we invest into a fund that does not reach its target fundraise, the impact, and our resulting actions, will vary depending on the situation,” said Joana Rocha-Scaff, head of Europe private equity at Neuberger Berman. “We are most concerned with a manager’s ability to execute on their investment and value creation strategy for their current and previous funds.” Managers who are consistent with their strategy and deployment are more likely to gain trust from their investors during a challenging fundraising period.

A general rule of thumb for assessing the quality of a raise is how the scale of a fund compares to its predecessor.

“I think in this environment, as long as you have growth or as long as you raise kind of at or above your last fund, I think that’s already a good thing to do,” said the managing director at a Germany-based fund of funds. On the contrary, if LPs have expressed concern over the fund target and the manager remains overly optimistic about fundraising, it is more likely to be perceived as a failure should it close below target, the MD added.

The market is also witnessing longer fundraising periods – sometimes spanning two years – as GPs try to reach their targets. Pennington’s DeNinno said LPs are often lenient when approving these extensions. “LPs do not want to see a fund they have committed to have problems raising enough capital to execute the fund’s strategy, so the LPs are often lenient to approve extensions to the fundraise period,” he noted.

Implications for allocations

Reduced fund sizes can have implications for LPs with exposure limits to individual funds – a smaller fund can mean the LP ticket represents a larger proportion of the total. As an example, Sweden’s Skandia Asset Management has “no issue about ending up owning 5 percent or 8 percent of a fund”, said Daniel Winther, head of private equity and infrastructure. However, if there is a risk of its commitments in a fund being over 15 percent of the total, Skandia will stage commitments across various closes accordingly.

“Committing to a first close in a fund that will be on the fundraising road for an additional one to two years will imply that your early commitment is used to fund deals, but you will get diluted when new LPs commit and the reward is normally just a small interest payment – ie from new LPs to existing – as a compensation,” Winther said.

LPs committing substantial capital to smaller funds may wish to use caution. “If you’re a big ticket and invest in smaller funds, then you need to put your ticket into perspective and there’s a certain risk to it,” said the German fund of funds MD. That said, some LP commitments are not sizeable enough to be at risk of overexposure.

“Actually, it has no impact on our commitment policy as we commit fixed US dollar amounts and if you are an LP committing a low to mid double-digit amount, the percentage of the overall fund size you hold doesn’t vary really that much,” said Philippe Roesch, managing partner at European multi-family office RIAM Alternatives. “Of course, what is more worrying, is the fact that these small setbacks in fund raising reflect the current uncertainty in the investment world.”

In the event that a fund closes substantially below target, the LP likely has bigger concerns about the fund than just overexposure. “[In] a small cap fund, a huge fall-out of 30 percent… would be enormous; in my eyes the reasons for such a huge difference in the current [fundraising] market could probably only be explained in reason of issues [with] the GPs and his portfolios. To that extent, I do not think this is a fund RIAM would have been considering as all the funds we have looking at actually were at hard cap [and] oversubscribed,” Roesch said.

Some institutions have measures in place to avoid the risk of overexposure. Rocha-Scaff said Neuberger Berman sets conditions when making commitments to GPs which states the minimum fund size, and presses GPs “for not stringing along the fundraise once they’re close to or at target and not stretching for hard caps and avoiding fund strategy proliferation”. If the fund closes below the threshold, the institution may release its commitment entirely.

Silver linings

When valuations are down by 25 percent, increasing the fund size from $1 billion to $1.5 billion between vintages is equivalent to doubling the fund’s size. Together with the fact that prices in some market segments are also lower than one to two years ago, a fund below target size “could actually be more in line with the size of the companies’ enterprise value in your sweet spot”, said Skandia’s Winther.

The lengthened duration of fundraising can also be positive for LPs as it provides more visibility into the portfolio. “If the GP is investing the fund as it raises capital, LPs are able to commit to funds that are seeded with investments and can benefit from valuation mark-ups on these seasoned assets, which helps to mitigate the J-curve,” DeNinno said.

A GP struggling to meet target may also place more value on its LP relationships, which in turn increases the chances for co-investment opportunities. “We would never commit to a fund that we viewed as unviable at its ultimate closing size and are very comfortable in providing underwriting co-investment support to managers or funds at an earlier stage of their development,” said Merrick McKay, head of Europe private equity at abrdn. “Our overall commitment will always reflect the full range of fundraising possibilities”.

The universe of private equity investors is vast, as is the range of attitudes towards funds closing below target.

What ultimately matters most to all LPs, however, when gauging the success of an investment, is likely to be the return it generates.  For many funds, whether it is considered a success or a failure can only truly be determined when the returns are realised.

– Helen de Beer, Adam Le and Carmela Mendoza contributed to this report.