Flight of the phoenix

Private equity activity has been reborn, with a bevy of new challenges and opportunities for those who provide the legal expertise. By Richard Addlestone

As the cinders of the financial crisis cool, a revitalised ­private equity industry is arising, phoenix-like, from the ashes. There is a sense of a re-emergence from the financial crisis into a world of new challenges and opportunities for the private equity market and the firms that service it.
Some of the challenges affecting industry players include fundraising, the increased negotiating power in the hands of investors, how to refinance sponsor-friendly debt as it matures and the lack of debt finance. There are also the regulatory challenges of the Dodd-Frank Act and the Alternative ­Investment Fund Managers Directive (AIFMD). At the same time, the rise of emerging markets present new investment opportunities, while recovering stock ­markets afford the opportunity for long-awaited exits by IPOs.

Cayman on song

In recent months there has been a clear and sustained uptick in fund formation activity in the offshore world, and especially in the Cayman Islands, which is one of the main jurisdictions for US private equity firms wishing to establish vehicles for non-US and US tax-exempt investors.

The Carlyle Group’s acquisition of ­AlpInvest is interesting in several ways, not least because of the implications the deal has for fundraising. Although the transaction included an undertaking from AlpInvest’s previous owners APG and PGGM to commit e10bn (£8.77bn) of investment over the next four years, financial institutions are increasingly looking to have more control over their private equity investments.

To this end they are pursuing both direct investments and co-investments. This is partly because the returns from the asset class in recent years have fallen and, in spite of this, fees are still being charged. US pensions fund CalPERS Investments and other major US financial institutions increasingly turning to this approach, as are sovereign wealth funds.

One of the ways they can attract ­commitments is to align their interests more closely with those of investors. Many are offering incentives to entice investors, such as lower fees for those participating in the first close. Faced with an increasing trend of investors cutting down on their relationships, a tougher selection process in a drive for quality in order to minimise risk, and competition from alternatives such as ­secondaries, there is the increasing prospect of many investment houses folding and new entrants failing to get off the ground.

Government money

The rise of sovereign wealth funds as investors in the asset class also brings ­complex challenges to fundraising. They have a specific set of expectations and demands, for example increased transparency and ­governance. In an interesting move recently, both TPG and Apax Partners have obtained sovereign wealth finance – the former from Government of Singapore Investment Corporation and Kuwait Investment Authority and the latter from Singapore’s GIC, China Investment Corporation and Australia’s Future Fund – rather than tap the public markets as most of their rivals are doing.

During the years of the financial crisis investors have been in a more commanding negotiating position leading to more investor-friendly terms. Whereas ­previously investor demands had largely been ignored, far more focus is being given to specifically negotiated terms, often in side letters, extending the fundraising process.

As to whether the Institutional Limited Partners Association (ILPA) guidelines, which were recently amended, become the market ­standard remains to be seen. ­However, as a possible portent of what is to come, just recently some of the major private equity houses, including First Reserve and ­Oaktree, have signed up to them.

All this said, there is still a lot of dry ­powder from which to raise funds. Private equity houses may need to extend ­investment periods to make use of this or, as in the case of Oaktree, simply return unspent funds to investors. There is pressure on investors to invest given the low interest rate environment.

According to Dealogic data, there is an estimated $800bn (£490.71bn) of sponsor-friendly debt that will come up for ­refinancing in the next four to five years. This is particularly challenging given that many banks have withdrawn from the asset class and those remaining have more stringent capital reserve requirements. Cheap debt, which fuelled the boom years, is largely unavailable, making investors seek alternatives, such as more equity financing and a greater focus on operational improvement techniques – a back to basics approach.

The deals of industry

Certainly, there is a new air of optimism. Deals are being done. M&A activity has increased. Exits are returning, so oiling the cycle of returning funds to investors, who in turn can reinvest back into new funds. Asia, Africa and Latin America are seen as ­opportunities and firms are rushing to set up there in order to leverage relationships with banks and sovereign wealth funds in those countries. BC Partners raised the first mega-fund to come to market since the financial ­crisis began. As the founders of some of the larger houses look ahead to their exits, KKR has already gone public, followed by Apollo, with Carlyle Group looking likely to be next. This will mean a sea change in atmosphere and approach, as what was formerly a close-knit entrepreneurial environment takes on formal governance obligations and pressure from shareholders to diversify.

In emerging from the ashes of the credit crisis, the private equity industry has evolved. Dodd-Frank has spawned ­acquisitions of investment banks’ asset ­divisions – Apollo, for example, acquired Citigroup’s real estate investment division. The offshore world needs to keep abreast of the industry’s ­continuing evolution. In ­Cayman, a limited partnership tends to be the vehicle of choice and, in recognition of the need for Cayman’s legislation to evolve along with the industry and updated market norms, an amended exempted limited partnership law is due to be finalised soon. The revised law will address some of the issues arising from the credit crisis, give more contractual ­sovereignty to the parties and preserve ­Cayman as one of the top domiciles of choice for offshore private equity.

Richard Addlestone is a partner in ­Appleby’s Cayman corporate practice