Reports on the private equity market over the past few months have made for depressing reading for those in the fund raising industry.
From its heyday in Q1 of this year, there has been a steady downturn in fundraising across the globe, escalated in recent months by the turmoil in worldwide credit markets. Third quarter 2008 has seen a global decrease of 51% in private equity commitments raised in comparison with second quarter 2008 and a decrease of 42 per cent in comparison with first quarter 2008.
Although a slowdown in any third quarter period is to be expected, this year’s downturn is more significant that equivalent periods in previous years, culminating in global fund raisings reaching their lowest levels since first quarter 2005. The worldwide financial crisis and resulting paralysis in the M&A markets is placing the fund raising industry under serious pressures.
The slowdown in exits is causing a growing liquidity crunch for investors, who find themselves over-committed to existing funds, with defaults (historically unthinkable from a reputational point of view) looking increasingly likely for some. In addition, following the recent fall in value of public market securities, many investors have inadvertently found themselves over-allocated to private equity and therefore in the position of having to reduce their future commitments to private equity funds and even sell existing commitments (the “denominator” effect).
The absence of leverage, wider market uncertainty and reduced commitment levels are all combining to turn investors away from traditional buyout vehicles in a market where they face difficulties sourcing (and funding) deals.
Many funds in the market are reported to be struggling to reach their target size and others are postponing new fund launches at least for the time being. Inevitably, the fund raising process itself has slowed down, with funds taking significantly longer to close than in 2007 – an indicator of this being the steady increase throughout 2008 of funds in the market.
Despite these increasingly competitive and uncertain conditions, fund raising is still taking place and whilst a strong track record from an established manager is still an advantage, it is arguably an ability to adapt to the changing market and a reputation for creativity and flexibility that may offer an attractive safe-house for embattled investor allocations.
Diversification of geography is also an advantage. Although there has also been a downturn in the Asian fund raising market, it was less significant than the European and US slowdowns.
A number of US and European private equity firms have expanded their Asian operations to take advantage of emerging market growth opportunities and, for the first time, ‘rest of world’ funds raised (non-US and non-Europe) have exceeded those with a European focus.
One consequence of the recent over-allocation to private equity is the market that it creates for secondary transactions in existing funds.
Secondary investors have so far proved hesitant about buying secondary interests in a declining market, but as the third/fourth quarter portfolio valuations begin to filter through, this should provide clarification on the pricing of these interests with prospects looking good for the development of a strong secondaries market in 2009.
New opportunities will also emerge for co-investment funds, as houses struggle to fund new or follow-on investments out of existing commitments.
Other areas of anticipated growth include distressed debt and mezzanine funds, which offer potentially substantial returns in the current market. It is anticipated that US$50 billion will have been invested in distressed debt by the end of 2008, compared with US$39.7 billion in 2007.
Many existing funds with sufficiently broad investment parameters and executive experience are looking to capitalise on this market, either by investment in third party distressed debt or through the repurchase of existing portfolio debt.
The mid-market, which is less dependent on syndicated debt, has not been affected as significantly by the credit crisis and, perhaps as a result, mezzanine funds focusing on the mid-market have doubled in 2008 as compared with 2007.
Infrastructure funds also remain a significant component of the private funds market. A number of the larger infrastructure funds are currently being raised and, whilst the pressure on firs/second quarter 2009 allocations is intense, there is still clearly appetite for this asset class among investors.
As governments push significant amounts of money into infrastructure projects in an effort to boost local economies, we can expect investment opportunities to increase over the coming 18 months.
The US pension funds and state plans, battered by their exposure to traditional private equity, will be listening with particular interest as President-elect Obama outlines his aims for federal investment in US infrastructure on an unprecedented level.
Despite the problems facing the private equity industry today, fund raising is still taking place and the very public challenges faced by certain investors should not detract from the growth and development that we continue to see, especially within the mid-market and emerging economy sectors.
Ultimately, capital must be invested and will always find a home, as discussed, new opportunities are available for those in the private equity business who have the flexibility to adapt to this challenging market.
Previous fund vintages raised in economic downturns have often produced the best returns and the next few years are likely to produce more attractive equity valuations than we have seen for some time. It may be too early to speak of a recovery in the traditional private equity fund raising market and the mega-funds of recent years are not likely to be seen again, at least for some time, but in the meantime, appetite for private equity investment continues and it is hoped that emerging opportunities will make for a little less depressing reading in 2009.
Kate Downey is a partner and Alexandra Conroy an associate at Kirkland & Ellis International
For more private equity, see the other two features in our private equity special report.