In recent months attention has focused on the potential demise of private equity resulting from the lack of leverage available to finance transactions.
But this isn’t the sole basis for concern within the private equity industry. Private equity managers are perturbed by the unwillingness of investors to make new commitments to the asset class. As a consequence it is becoming increasingly difficult for new funds to be raised, with many fund managers delaying their fundraisings or even postponing them indefinitely.
The reasons for the failure of investors to support new fundraisings are varied, although invariably they are connected to the current global financial crisis. They include:-
Credit squeeze on investors
Most investors are currently safeguarding cash. In some cases, this is to bolster their balance sheets to address concerns as to their solvency, in others it is because their access to credit has dried up and so they must rely on cash reserves rather than debt to fund their activities.
The denominator effect
Many investors operate under strict guidelines as to the proportion of their total assets which may be invested in different asset classes. As we see lower valuations of assets such as listed equities, bonds and mortgage backed securities, while valuations of private equity assets remain relatively static (at least for now), the value of investments in private equity rise as a percentage of investors’ total asset values.
In order to return private equity holdings to guideline levels, investors must freeze new investment in private equity and in some cases sell off existing holdings.
An environment to buy not sell
It should be remembered that at the time of any private equity fundraising, funds take pledges or commitments of cash. Instead, cash is only drawn down at the time that an investment is to be made by the fund (so maximising the internal rate of return / yield of the fund), commitments typically being drawn down over a 3-4 year period.
Private equity investors seek to predict the rate at which funds will return cash (through realisations of portfolio companies) and match that to their obligations to meet future drawdowns.
However, in the current cycle the expectations are that private equity managers are likely to be selling relatively few assets over the short to medium term. In anticipation of reduced outflows of cash, private equity investors are reluctant to make significant new commitments to funds.
Secondary markets become more popular
Those investors who are still looking to invest in private equity are seeing increased opportunities to buy secondary fund interests (i.e. interests in established funds rather than new funds), as current investors who are subject to a cash squeeze or the denominator effect look to reduce their private equity portfolios. In recent weeks major investors such as the Wellcome Trust, Duke University and Harvard Investment Company are reported to be intending to sell large private equity portfolios.
In many cases these secondary fund interests are being sold at significant discounts to net asset value. Access to heavily discounted secondary market opportunities obviously reduces the attractiveness of investing in new funds.
As a consequence, most private equity experts predict that 2009 will be a barren year for private equity fundraising.
So is this lack of interest in new private equity funds a temporary phenomenon or is it something more permanent? Perhaps surprisingly we believe that many of the reasons for the downturn in appetite will be the very reasons for a subsequent upturn in fundraising fortunes over the longer term. Specifically the denominator effect can work in reverse so that as the value of listed equity and bond portfolios start to rise then demand for private equity increases. So to some extent the private equity fundraising environment is correlated to the performance of the public equity markets.
And as private equity managers start to sell underlying investments, so investors have a desire to reinvest the proceeds.
Moreover there is a more fundamental reason for investors to return to private equity, namely its outperformance of listed stocks over the short, medium and long term. The British Private Equity and Venture Capital Association (“BVCA”) Private Equity and Venture Capital Performance Measurement Survey 2007 reported that to 31 December 2007, UK-based private equity funds outperformed the FTSE All-Share index over 3 years (38.8% return p.a. v 14.5%), 5 years (27.3% v 15.4%) and 10 years (20.1% v 6.2%). Of course lower levels of leverage are going to potentially reduce future private equity returns but as the BVCA performance summary suggests, the private equity industry should still be able to deliver significant outperformance over the public markets, even without such high levels of leverage.
In time there is no reason to think that the private equity industry can’t return to its glory days of the past, both in terms of fundraising and investing; in the meantime those few investors who wish to make commitments to new private equity funds will have considerable influence over the terms of those funds.
Jason Glover is a partner and Peter Olds a senior associate at Clifford Chance
For more on private equity, see the other two features in our private equity special report.