Law360: 5 PE Trends To Watch Out For In 2018 with insights from Gianluca D’Angelo
Private equity dealmaking and fundraising levels remained healthy in 2017, and there are a number of trends set to continue into the new year, such as the recent rise of megafunds and a blurring of the lines between PE and venture capital as fund managers increasingly seek to land promising technologies. There is no shortage of dry powder, nor is new investor capital in short supply, meaning private equity dealmakers and fundraisers in 2018 are likely to be equally as active as they have been in the last few years. Underneath the surface, however, the industry is shifting in ways that are shaking up the current norms. Here, Law360 explores five PE trends to watch out for in the new year. There Will Be More Megafunds The average size of private equity funds has been growing, reaching nearly $500 million this year, compared to around $346 million in 2016 and $300 million in 2015, according to data provided by research firm Preqin. The significant increase in average fund size directly correlates with the fact that there were five private equity funds that raked in more than $10 billion from investors this year, including the largest PE investment vehicle ever, a $24.7 billion fund raised by Apollo Global Management LLC. Meanwhile, there have been at least 10 PE funds that hit $7 billion or more in 2017. There’s no question that we are in the midst of a megafund resurgence, as fierce competition for deals and high public valuations have investors going with what works, and what works is committing capital to the largest and most accomplished fund managers. "The global, top-performing megafunds are able to use scale to differentiate themselves and often seek to consummate larger investments where perhaps there is more attractive pricing and a better long-term value proposition," said Peter H. Gilman, a partner with Simpson Thacher & Bartlett LLP. Fund managers that consistently net high returns for investors will only continue to attract more and more capital, meaning it wouldn’t be too surprising to see Apollo and its $24.7 billion fund usurped in 2018. "You’re going to see more investors throwing money at the very best PE houses, and they’re going to get bigger and bigger," said Howard Berkower, a partner with McCarter & English LLP’s corporate practice Weak GPs Will Be Weeded Out The private equity industry may be gearing up for some truly eye-popping fundraises, but there are two sides to every coin, and the harsh reality is that less-experienced fund managers who don’t already have an established track record will struggle to raise capital. "It’s going to be harder for the smaller PE houses that are just starting out, or are nowhere near the depth and track record of some of the big guys," Berkower said. That’s not just speculation: According to Preqin, only 816 private equity funds had held final closing as of Nov. 30, meaning 2017 saw more capital raised than ever before for a fewer number of funds than usual. For reference, 2012 was the last time there were not at least 1,000 clinched, with 993 holding final closes that year. "I’ve found that it certainly depends on the space," explained Jason S. Kaplan, an investment management partner with Schulte Roth & Zabel LLP. "For example, some smaller and middle-market managers that you would have thought should have no problem raising capital have struggled a bit. In part, it’s because of the megafunds that are considered, for lack of a better word, ‘safe’ by investors. Investors aren’t going to be second guessed for investing in a megafund." Longer Holding Periods Will Continue to Take Root As megafunds continue to dominate in the market, lesser experienced fund managers will be on the lookout for ways to make their investment terms more attractive than competitors. One way to do that is by offering investors unconventional fund terms, like investment vehicles that eschew the customary 10-year life span and five-year investment hold period that has been the industry standard for years. "The notion of longer holding periods is probably here to stay," Berkower said. That’s because fierce competition and high valuations have made it more difficult to find assets for reasonable prices, so private equity fund managers are operating with the belief that a longer holding period gives them more time to create value at a portfolio company. Then, after they’ve had enough time to build up a given asset to their liking, they can sell it off for the desired price tag. "They are holding assets longer in order to optimize the value to limited partners," said Carl D. Roston, a partner at Akerman LLP and co-chair of the firm’s M&A and private equity practice. Longer holding periods aren’t an overarching solution to the woes of PE fund managers, however, and they can be quite strategy dependent. Additionally, some longer-term funds actually offer investors the chance to get out within a typical investment timeline. "There are a few 20-year funds out there, though they do have some ways where the LPs were able to shorten that length under certain circumstances," Kaplan said. "So investors aren’t locked up for 20 years in all circumstances." Niche Strategies Will Become More Common As private equity professionals look to find ways to stand out in an increasingly crowded market for fundraising and dealmaking, they’ll continue to try strategies that are more and more niche. Funds focused on public or private debt, distressed assets and other formerly uncommon areas are becoming and more commonplace. "There’s more interest in specialized types of strategies rather than general buyout," said Gianluca D’Angelo, a managing director and head of Europe at placement agent Eaton Partners. That also includes strategies focused on emerging markets, or other areas of the world in which private equity hasn’t quite showcased its abilities just yet. "We have seen strong growth in several of the emerging markets, and I expect that to continue, though this growth is likely to be more pronounced in the midmarket than the megamarket for the foreseeable future," said Jonathan Adler, a partner with Debevoise & Plimpton LLP. Meanwhile, PE players have been showing a real commitment toward improving their sourcing capabilities, according to Roston. He told Law360 that fund managers and investment professionals are increasingly looking to develop sets of initiatives that are designed to improve their ability to source deals and entice investors. "They are becoming much more niche-oriented," he said. In a PE industry where it is becoming harder for lesser-established fund managers to raise money and make deals, it’s more important than ever for them to find a niche region, industry or sector and then focus on developing the right relationships that can position them to succeed. They can get to know key professionals in a given sector by attending industry conferences and participating in webinars, among other methods. "Large PE firms did this for many years," Roston said. "We’re seeing it creep into the lower middle market, where they are now developing such incredible industry relationships that they will know a lot about companies in their sectors of interest, and those companies’ management teams, before they come to market." PE Shops Will Continue to Try and Tap Into Tech Private equity’s interest in the realm of technology is no secret, but what some may not realize is that the lines between PE and venture capital have begun to blur. "Both industries are sort of converging with one another," Berkower said. The significant difference between the two remains that private equity is looking to invest in companies that are already generating revenue, while venture capital is always on the lookout to land to the next big thing. For the most part, PE professionals are sticking with the types of technology investments they are used to, with popular areas including software and information technology, but while private equity fund managers may not be interested in finding a business that is not yet making money but could one day be the next Google or Facebook, they are thinking transformatively. "While historically reserved for VC funds, the marriage of private equity and technology seems well-suited," Gilman said. For instance, he pointed to self-driving cars and virtual reality as examples of things that might seem more suited to the taste of venture capital players, but actually have private equity players salivating at the thought of potentially sky-high returns in the future. "Investments in these new products and nascent industries that require substantial capital infusions and have a compelling story may present opportunities for these PE firms not only to achieve attractive returns for investors, but also to diversify their product and invest base and create more durable, stable long term investment platforms," Gilman said. Adler, meanwhile, said Debevoise has witnessed PE clients express interest everything from consumer tech to fintech. "For example, we’ve recently had a number of discussions about how PE can take advantage of blockchain, bitcoin and related technology, not just through downstream investment but at the fund level," Adler told Law360. "I’m not sure we will see that breakthrough in the near future, but I think it is reflective of the current wave of interest."