No Fundraising Pullback Expected in 2018, Despite the Fears of LPs; Limited partners plan to keep pouring capital into private equity, but are adjusting their strategies over fears of a downturn
By Chris Cumming
January 4, 2018
Limited partners may be expecting an economic downturn, but until one hits, they are likely to keep investing as though the good times will roll forever.
Coming off two back-to-back robust fundraising years, there is little sign limited partners are planning to call an end to the party. Private-equity investors are expected to funnel as much or more capital into the asset class in 2018, despite extreme apprehension, the days of classic private-equity returns are over, said LPs, consultants, placement agents and others in the market.
"We haven't seen a falling away of demand, or any indications of it," said Laurence Zage, a managing director at placement firm Monument Group. "Although investors are talking cautiously about pricing and risk, they still are receptive to what sponsors are offering."
Although high deal multiples and record dry powder are making LPs jittery, they are seldom slashing their allocations to private equity. Instead, they are shifting to smaller funds and alternative strategies such as credit and infrastructure, even as they continue to back massive buyout funds from name-brand firms.
The result is a barbell-shaped fundraising market, with the middle ground shrinking as the biggest funds absorb more money than ever and smaller funds attract attention as diversification plays.
"This hasn't been a fundraising environment where everybody's winning," said Kelly DePonte, a managing director at placement agent Probitas Partners. "There has been a concentration in the top end."
All told, private-equity funds closed on $409.2 billion world-wide through early December, edging out the $404.3 billion they collected for all of 2016, according to industry tracker Preqin Ltd. These figures don't account for the money deployed in co-investments and direct deals, which industry observers estimated would add another 25% or more to the total.
However, there was a drop-off in the number of funds that reached a final close in 2017: 838 funds closed in 2017 through Dec. 6, compared with 1,175 in 2016, and similarly high numbers the two previous years, according to Preqin.
That statistic suggests a trend that increasingly was noted by sponsors throughout 2017: Although LPs have been eager to invest, they also are apprehensive about the quality of sponsors on the market. A survey of LPs by Coller Capital found 89% think too many weak sponsors are being funded.
Distributions fell in 2017 from the near-record levels of the year before, but the run-up in the public markets over the last year—the S&P 500 was up nearly 20% in 2017 as of mid-December—has left many LPs struggling to stay at their allocation targets, as their overall assets have increased.
"LPs are still having trouble keeping up, but they don't want to lower the bar and invest in a subpar manager," said Jeff Eaton, a partner with placement agent Eaton Partners. "We are seeing more extensive due diligence and vetting than we've ever seen."
Part of the problem for LP due diligence has been the dizzying number of firms to choose from. The constant formation of new firms seeking capital, combined with established firms deploying capital and returning to market more quickly, has created a fundraising glut. There were 2,214 private-equity funds on the market seeking a combined $764.1 billion in 2017 as of Dec. 6, compared with 1,857 funds seeking $510 billion in total in the year-earlier period, according to Preqin.
Although many large firms raised capital in the last few years and likely won't be back in the market in 2018, there are a number of firms that raised large funds in 2014 or later that have called 50% or more of the funds, making them likely to come back to market soon.
On the largest end of the market, there may be less private-equity fundraising in 2018 simply because of timing. Many of the biggest firms, including Apollo Global Management LLC, Bain Capital, Blackstone Group LP, KKR and Silver Lake, raised multibillion dollar funds within the past three years.Carlyle Group LP, meanwhile, is pitching its seventh core buyout fund, which is expected to handily exceed its $15 billion goal, leaving TPG as one of only a handful of large buyout managers expected back on the fundraising trail in 2018.
Fortunately for general partners, there should be ample demand to match, if not exceed, the supply of funds on the market in 2018. Twenty-six percent of North American LPs plan to increase their allocation to private equity in the next twelve months, compared with 5% that plan to decrease their targets, according to the Coller Capital survey. The gap among European LPs is even wider, with 48% planning to increase and 2% to decrease.
Although they need to keep investing to hit their targets, LPs don't see great opportunities for bargains and are worried about the prices firms are paying in deals. A survey conducted by Probitas found that 71% of LPs think too much money is chasing too few good deals across all segments of the private-equity market, while 55% responded the current private-equity market feels like the top of a cycle.
"Investors are really conflicted about what's going on in the market," said Mr. DePonte. "They fear that we're at the top of the cycle, but they also don't see a lot of better places to put their money."
Expectations for private-equity returns have gone down, but still beat out many other types of investments. According to the Coller Capital survey, 60% of LPs think returns will decrease in the next five to 10 years.
Still, near-term expectations are bullish, with 82% of LPs expecting their private-equity portfolios to earn net returns of 11% or more over the next three to five years, according to the Coller Capital study.
That target might be unrealistic for the industry as a whole, considering the deal prices firms are paying. Acquisition multiples have never been so high for so long, and the last time they approached current levels, private-equity fund performance was severely dampened.
Through early December, the average multiple for U.S. private-equity buyouts was 11.1 times earnings before interest, taxes, depreciation and amortization, according to data tracker PitchBook Data Inc. That would be the highest full-year figure on record, edging out the 10.9-times Ebitda firms paid in 2006.
The track record of funds paying such high prices isn't good. Vintage-2006 funds had an average internal rate of return of 6.6% as of Dec. 1, according to PitchBook. Funds of 2005 vintage, when the average deal multiple was 9.1 times Ebitda, recorded an average IRR of 7.2%, as of the same date.
The comparison between the current high-multiple climate and the mid-2000s vintages isn't perfect. For one thing, those earlier deals tended to be much more heavily financed with debt, giving companies less room for error in a downturn. And, of course, the 2005 and 2006 vintages would have performed better if not for the economic downturn.
So far, the very early IRRs for investments made during the fundraising boom of the past few years have appeared to be good, but most of the returns are still unrealized and are based on high valuations in the public markets. If public markets fall, those valuations will too.
"The most recent vintages are trending positively, and they've been the beneficiaries of a strong market and high valuations," said Keirsten Lawton, who co-heads U.S. private equity research for consultant Cambridge Associates LLC. "The question is, how sustainable is it?"
LPs are aware of this history and are altering their investment strategies to avoid being caught in top-of-the-market deals. Many LPs "have become more cautious about backing managers based on the amount they're willing to pay," and have avoided reupping with sponsors they consider too aggressive, Ms. Lawton said.
Investors increasingly are aiming to back firms that have the operational, geographic or sector-specific expertise necessary to help them earn returns through revenue growth, since multiple arbitrage is much more difficult these days, she said. Also, firms increasingly are looking to back smaller deals, especially in the lower middle market, placement agents and other observers said.
The Los Angeles City Employees' Retirement System, for one, plans to emphasize midmarket and lower midmarket buyout funds in 2018, according to a document outlining the pension system's strategic plan for the year ahead.
Appetite for small buyout funds also has helped fuel demand for funds of funds focused on that end of the market, leaving them with plenty of money to back small buyout vehicles going forward. Siguler Guff & Co. collected $1.1 billion for its third small buyout fund of funds in 2017, and Private Advisors closed its seventh small company buyout fund of funds at its $350 million cap.
There has been a big expansion into credit funds—though the capital often is being shifted from LPs' allocations for credit rather than private equity—and infrastructure, along with an increase in interest in litigation financing, intellectual property and other off-beat strategies seen as less correlated with public markets.
Arizona State Retirement System, New Jersey State Investment Council and Vermont Pension Investment Committee are only a few of the LPs that have added dedicated alternative credit allocations or increased existing allocation targets in the past 12 months, giving them more room to back credit managers.
European buyouts, excluding ones in the U.K., have bounced back to favor as well, as Western European economies have improved and fears the European Union might break up have receded, placement agents said.
"Investors started to wake up this year and see that they've been ignoring Europe too long and are way underallocated," said Mr. Eaton.
There has been an shift within investment strategies, rather than a cutback to overall investment budgets, said Fraser Van Rensburg, a managing partner at placement agent Asante Capital Group. Some LPs may feel it is time to shift to a defensive posture, but won't do so before a correction comes.
In part, the momentum to keep investing is due to the nature of large institutions such as public pensions, which take a long time to change course, said Mr. Van Rensburg.
"We're already in [the] back end of a very long cycle," he said. "Some LPs are seeing it that way, but it takes a long time for the bureaucracy in an institution to take stock of reality."