August 2017 Issue
Private-equity managers are enjoying one of the best fundraising stretches of their lifetimes, but more and more investors appear to be bracing for a downswing in the economy.
Across a range of strategies, fundraising so far in 2017 echoes the frenzy of 2007. Private funds as a whole—including venture-capital, secondary and private-debt funds as well as funds of funds and others—collected $180.82 billion, a 12% increase over the first half of 2016 and the highest half-year total since the second half of 2007, according to LP Source, a data provider owned by Private Equity Analyst publisher Dow Jones & Co. Buyout funds raised $69.51 billion, the highest half-year sum since the first half of 2007.
However, with deal multiples setting new records and parts of the buyout market looking overheated, many limited partners are shifting into defensive strategies to guard against loss in case the markets turn. Strategies less correlated with broader markets, such as real assets, or designed to thrive in a downturn, such as special situations and distressed investing, enjoyed big fundraising bumps from the first half of last year.
"There's an element of some caution that we feel speaking with LPs," said Kelli Roiter, who leads the global private-capital group at Jefferies LLC, adding while LPs are keeping their commitments high, "we get the sense that they're also trying to hedge the future."
Corporate Finance Reaches Boom-Era Levels
Near-record fundraising totals for buyout strategies, combined with stronger demand for real-asset funds and restructuring funds, pushed fundraising for corporate-finance strategies toward all-time highs in the first half of the year. Buyout and corporate-finance funds raised $134.90 billion through the first six months of the year, 15% more than in the year-earlier period and the best half-year total since the second half of 2007.
The industry's strong performance in the first half wasn't just the product of established managers raising large funds, though this year has seen massive closings such as the $15 billion Silver Lake raised for Silver Lake Partners V LP and the nearly $11.1 billion Vista Equity Partners Management raised for Vista Equity Partners Fund VI LP.
In addition to large amounts of capital, the industry recorded a high number of closings, wrapping up a total of 252 corporate-finance funds, 52% more than in the first half of 2016. Within corporate-finance, growth-equity funds and co-investment funds also had substantially more fund closings, and raised substantially more money, than in the first half of 2016.
Amid fierce competition for buyout funds managed by large, well-established sponsors, many LPs often sprinkle their capital around with different managers and strategies to reinvest their distributions and meet their allocation targets, said Jeff Eaton, a partner with placement agent Eaton Partners LLC. This dynamic has increased demand for somewhat off-beat strategies, as well as for new managers and first-time funds, particularly those with sector specialization, he said.
Despite the buoyant fundraising market and improving economic indicators, demand seems to be shifting to more defensive strategies. Buyout funds, despite near-record fundraising totals, closed on just 2% more capital than in the first half of last year. Restructuring and distressed-debt funds raised almost $17 billion, a 45% increase, while real-asset funds, including infrastructure funds, raised $23.08 billion, representing a 33% increase.
Huge firms marketing their funds could make the second half of the year even bigger for infrastructure vehicles. Blackstone Group LP is raising its first infrastructure fund, which is seeking $40 billion, and Oaktree Capital Management in April said it would launch separate transportation and power infrastructure funds.
Distressed funds also could be primed for a big second half, with 3G Capital seeking $10 billion for its fifth special-situations fund and Blackstone's GSO Capital Partners unit seeking $6.5 billion for GSO Capital Solutions Fund III LP, a distressed-debt vehicle, according to data-tracker Preqin Ltd.
At first blush, rising demand for real-assets and distressed funds may seem a bit puzzling. Each of the strategies faces a simple headwind: for real assets, low commodity prices, and for distressed debt, low default rates. But in both cases, many sponsors have managed to switch up their approaches to get fundraising traction.
"Distressed funds are trying to color outside the lines and do something other than classic distress," said Tod Trabocco, co-head of credit investing with consultancy Cambridge Associates LLC. "We're seeing greater creativity."
The largest distressed fund to close in the first half was Cerberus Capital Management's $4 billion sixth fund. However, the demand for typical distressed-debt vehicles is generally tepid right now, placement agents and consultants said, because there has been little stress in the economy and few defaults outside the energy and retail sectors.
In addition, some investors expect if there were another economic downturn, central banks would follow the same loose-money policy they employed in the last recession, which would reduce the number of targets for typical distressed-debt investors, said Kelly DePonte, a managing director at placement agent Probitas Partners LP.
Some managers are getting around the problem of low default rates by raising funds that won't be turned on until a recession hits. Oaktree, for instance, is sitting on an $8.87 billion fund that was raised in 2015 but isn't expected to be activated—and won't charge fees—until next year.
Other sponsors have been finding fundraising success with less traditional special-situation funds, such as opportunistic credit and smaller distress-for-influence vehicles that target the midmarket. They also are
aiming for funds that invest flexibly, using a combination of debt and equity, in sectors that require complex operational knowledge, said Jeff Roberts, director of private-equity research for investment consultant NEPC LLC. Stabilis Capital Management, for one, wrapped up a special-situations fund with about $525 million during the first half.
Investors in these funds are betting not that a wave of defaults is coming, but that managers with experience in complex turnarounds and restructurings can find better value than standard buyout deal makers, he said.
"Buyouts are incredibly competitive and are priced to perfection, which is one reason why investors are drawn to managers who traffic in complexity," Mr. Roberts said.
He added that for their part, GPs "are trying to get ahead of a distressed cycle, if one were to happen, while raising money now in a very euphoric environment."
For real-asset managers, several years of low commodity prices have suppressed the demand for funds focused on raw materials and, especially, the energy sector. But real-asset strategies have benefitted from investors' increasing appetite for assets that aren't correlated with broader markets and that are seen as providing steady, reliable income, even without the upside of some buyout funds.
"Part of what's driving demand for real-asset funds is the sense that they offer some diversification and some income," said Meagan Nichols, who leads the real-assets investment group at Cambridge Associates.
Within real assets, investors still have strong interest in energy infrastructure, like power generation and transmission, as well as renewables, water and waste management, Mr. DePonte said.
Classic infrastructure such as transportation—investments in roads, ports, airports and the like—has had good fundraising momentum this year, as investors have embraced their lower risk profile and steady income stream. There also has been investor interest in the possibility President Donald Trump's administration could begin a big public-private infrastructure push in the U.S., which could offer a bonanza for investors. However, it isn't clear how much money actually has been wagered on that thesis.
"There's been a lot of talk about it but not a lot of investment," said Ms. Nichols.
Real-assets fundraising could have even more room to run in the second half if the Trump administration gets its infrastructure plans in order or if oil prices bounce back. But even if neither happens, the lower-risk, noncorrelated returns and diversification that real-asset funds offer are likely to remain popular with LPs that are worried the peak of this investment cycle has passed.
That doesn't mean there is any hint buyout investments are starting to flag, placement agents said. LPs are taking an "almost schizophrenic view" of the market, committing to growth investments and defensive investments at the same time, Ms. Roiter said.
Investors are saying, in effect, "I'm not going to bet against this market, but I'm going to protect myself," she said.
VC Dollars Drop as Fund Numbers Climb
Venture-capital firms raised $20.86 billion total in the first half across 302 funds, a roughly 18% decline from the amount of capital raised for such strategies in the first half of 2016, but a 31% year-over-year increase in the number of funds, according to LP Source data. The total number of VC funds raised through the first half is the largest number of funds ever raised during the first six months of any year since at least 2000.
"It's because of interest rates," said Atul Rustgi, a partner at fund-of-funds manager Accolade Partners, adding that low rates, combined with high asset valuations in the stock and real-estate markets, is prompting many investors to pour money into venture. "Until interest rates go up significantly, I don't see this dynamic changing."
Yet the amount of money going in far outdistances the amount coming out via liquidity, initial public offerings and sizable sales, Mr. Rustgi said.
Aside from low liquidity and the influx of new funds, more recent topics on the minds of LPs are the sexual harassment scandals that engulfed several venture funds and the emergence of fundraising by startups via cryptotoken sales as an alternative to venture capital, LPs said.
Late-stage funds attracted $7.22 billion during the first half, a 40% increase from the $5.15 billion raised during the first half of 2016. The largest of these was a $3.3 billion pool raised by New Enterprise Associates, now the largest venture fund on record.
Small, early-stage funds are continuing on a strong fundraising streak, although the total capital raised by early-stage funds declined by about 21% from the first half of 2016 to $8.18 billion, according to LP Source data. Even so, more than 100 early-stage fund closings took place in both quarters of this year—more than in any quarter on record except for the last quarter of 2000, when 143 such closings were logged. Early-stage funds accounted for 39% of the total capital raised by venture funds during the first half.
"A lot more LPs are recognizing that seed VC funds de facto represent early-stage VC investing and are starting to invest more in such funds," said Michael Kim, managing partner at Cendana Capital, a fund of funds that backs seed funds.
Of course, all of the managers that flooded the market now must prove they can successfully invest the capital they have raised, a task that isn't likely to be easy.
"The problem is that many of the new ones won't be able to compete against the incumbents," Mr. Kim said, referring to the crop of more established seed funds that emerged in the past few years or so and that have put away several funds by now.
Although the volume and number of venture funds collecting capital remains robust, some backers of venture funds said they don't believe it is more than the industry can absorb.
"It doesn't appear that we will have another tragedy of the commons like we had in the post-dot-com era," said Andrea Auerbach, who heads global private investment research at Cambridge Associates. "VCs, for the most part, are not over raising. Cooler heads are prevailing in this era."
Secondary Firms Post Another Strong Half
Secondary fundraising during the first half of the year declined sharply in dollar volume from the same period a year earlier, although it still outpaced first-half fundraising for both 2014 and 2015.
Buyers and intermediaries said a steady flow of capital into secondary strategies promises to support strong pricing for attractive assets that hit the market, at least in the near term.
Secondary firms in the U.S. and Europe closed on a total of $17.29 billion through the first half of the year, a drop from the $21.66 billion raised by secondary funds during the first half of 2016, according to LP Source data. However, this year's tally was spread across a total of 31 funds, roughly 48% more than the 21 funds that raised capital during the first half of 2016, when Ardian's $10.8 billion seventh secondary fund accounted for the lion's share of money raised. If Ardian's massive fund from last year's numbers is excluded, the total tally for this year represents a significant increase over the same period in 2016.
Private Equity Analyst aggregates U.S. and European data when calculating secondary fundraising statistics because those funds tend to invest throughout geographies.
Despite the decline in dollar numbers compared with last year, this year's first-half total outpaced the $7.3 billion raised for secondary funds during the first half of 2015 and the $15.82 billion raised in the first half of 2014.
A handful of large funds, including ones managed by AlpInvest Partners, Hamilton Lane, Goldman Sachs Group Inc. and Landmark Partners, accounted for a large portion of the money collected during the first half. AlpInvest, for example, closed its latest secondary offering with $6.5 billion, including its $3.3 billion co-mingled fund AlpInvest Secondaries Fund VI and $3.2 billion raised across separate accounts. Hamilton Lane closed its fourth secondary fund with $1.9 billion during the half.
However, a number of firms targeting midsize to smaller deals also attracted investor interest. Managers that collected capital for funds focused on smaller deals include U.S. firms Siguler Guff & Co. and StepStone Group and European firms Committed Advisors and Hollyport Capital.
Secondary firms are refueling amid heated competition and full pricing for many assets, leaving some concerned about the future returns from the strategy. Others point to the evolution of deal structures, including fund recapitalizations and preferred rights offerings that are broadening market opportunities.
"These sorts of innovations mean the scope for the industry to grow in terms of fundraising remains," said the head of the secondary unit at one large asset manager.
Strong Returns Lift Funds-of-Funds Ship
Healthy returns produced by the industry and heightened investor demand for access to good managers have helped drive capital raised for funds of funds to its highest first-half tally since 2009.
Funds of funds in the U.S. and Europe closed on $11.45 billion across 76 funds, up from $10.41 billion raised across 40 funds during the first half of 2016, according to LP Source data. As with secondary funds, Private Equity Analyst aggregates U.S. and European data when calculating capital raised by funds of funds because such vehicles often commit their capital across multiple geographies.
Funds of funds have faced pressure from investors over the past decade amid the heightened costs associated with the extra layer of fees they charge and the dampening effect those fees have on returns. Downward pressure on fees has driven fund-of-funds managers to devote more of their offerings to co-investments and secondary deals, which tend to produce higher returns and generate higher fees for managers.
"When I see a fund of funds, I try to find out what percentage the firm is really committing to funds and what is going to everything else," said Ms. Auerbach of Cambridge Associates.
However, as more investors add or increase allocations to private equity in their quest for returns, their appetite for experienced, high-performing managers has placed a premium on the relationships that fund-of-funds managers have with experienced general partners.
"For a new entrant, particularly a global client, building relationships with and gaining ‘access' to leading managers in this market where many managers are oversubscribed is not easy," said John Toomey, managing director at HarbourVest Partners.
Well-known firms such as Adams Street Partners and Hamilton Lane have reaped the benefits of the lengthy track records and vast networks of GP relationships they have built over the years to lock in fresh capital for new offerings during the first half.
Specialist funds of funds, particularly ones focused on venture capital, also captured their share of capital, as investors filled in specific investment strategies within their portfolios. Firms that closed on capital for venture-focused funds of funds during the first half include U.S. managers Accolade Partners, Cendana Capital, Greenspring Associates, Top Tier Capital Partners and Weathergage Capital.
"If you're below a certain flight deck and you're trying to get exposure to [that] flight deck, leveraging a fund of funds for access to a tier of the market you may not have the energy to go after yourself does make sense," Ms. Auerbach said.
A strong turnout for funds of funds bodes well for general partners hitting the fundraising trail over the next six to 12 months, as firms tend to commit these vehicles over multiple vintage years. Overall, however, the private-equity industry could see a slight decline in buyout fundraising volume during the second half, given that a high volume of the largest fund managers already have come through the market in the past 18 months, according to placement agents and consultants. Dollar volume often fluctuates based on the number of multibillion fund offerings that collect capital in a given period.
Ms. Auerbach likened the rapid velocity of fundraising to a game of musical chairs in which the longer the music plays, the faster the players race around the chairs. If the speed at which firms return to market seeking new funds continues to accelerate, even some of the largest fund managers could be back in the market sooner than anticipated.
"You have to watch the [megafunds], because they can change the game very quickly," she said.WSJ Pro: Private Equity Analyst