The Size of Limited Partner Icebergs

General partners in private equity funds claim that a variety of global regulations — Basel III, Solvency II, the “Volcker rule” and the European Alternative Investments Fund Manager Directive — will severely restrict available fund capital, thus decreasing the amount of financing available to non-listed businesses. Not a good thing for economic growth, particularly when small businesses already are having trouble securing bank loans.

However, the situation is not as obvious as general partners describe it. First, funds are the emerged part of the iceberg in terms of private equity: Family offices, corporations (listed or not), sovereign wealth funds, individuals… a significant group of economic actors are indeed doing non-listed investments. This does not necessarily get into the figures reported by the professional associations (such as the NVCA, EVCA and others). In fact, they only gather statistics from their members, who are general partners in private equity funds.

This means that they are not capturing all the transactions: Small LBO is notoriously under-evaluated, and secondary operations largely ignored. Then, statistics are only aggregating what is communicated by the members: Uncooperative members and non-members are not submitting any data, which means that there is no way to know precisely the size of the private equity sector. In the US, there is hardly any association equivalent to the NVCA tracking LBO, mezzanine, turn-around, distressed debt and other private equity transactions.

Nevertheless, a small calculation helps to put the role of private equity fund managers in perspective. According to the latest statistics of the EVCA (European Private Equity and Venture Capital Association), European family offices have provided 4.2% of the 16.1 billion euro collected in 2009 (versus 4% of the 81.4% collected in 2008). This means that family offices have contributed up to 0.6 and 3.2 billion euro to the private equity fundraising in 2009 and 2008, respectively.

Swiss private equity fund managers have collected 907 million and 3.2 billion euro in 2009 and in 2008. Assuming that family offices contribute in Switzerland by the same percentage that they do in the rest of Europe (roughly 4%), they have invested an amount of 36.3 and 128 million euro in 2009 and 2008. According to Highworth Research, there was 355 declared family offices in Switzerland. Assuming that they were managing at least a 50 million euro wealth per family office (at least), this represents an aggregated 17.8 billion euro under management.

Four percent of this amount represents around 710 million euro allocated to private equity. Assuming that that is renewed every five years (which is the duration of the investment period of a private equity fund), then 130 million euros is invested every year in private equity (which is the amount roughly calculated for the Swiss family offices above, for the year 2008). However, family offices are in fact investing between 25 to 35% of the amounts under management to private equity according the the different surveys (that is to say 0.88 to 1.24 billion euro per year).

For sure, Swiss family offices are exporting capital towards the rest of the world, but this represents a substantial part of the amounts collected in Europe (aside from other family offices which are based in the UK, France, Germany and other European countries). This means that the amounts invested in funds represent only a small part of the total invested in private equity in Switzerland. An identical calculation could be made with sovereign wealth funds.

What are the consequences of this reasoning? For sure, regulation will increase the costs of general partners, at a time when limited partners are putting pressure on management fees. GP margins will decrease and the investment teams will have to restructure. Their expertise will concentrate. However, as some limited partners have discovered, this expertise is difficult to replicate. In particular, general partners have an access to a higher quality of deal flow, and they have refined methodes of analysis which lack to the non experts. Expertise and know-how will be the differentiating factors between the teams which will survive and the ones which will disappear during the coming private equity cycle – not necessarily IRRs and multiples.

This is due to the fact that limited partners do not necessarily want the highest (and more volatile) returns, but a more steady and predictable stream of results. One option is to team up with general partners through schemes which have so far proved unsatisfactory: Fee reduction mechanisms are discriminatory; whereas co-investment schemes are producing biased portfolio strategy investments. Reviewing the future cooperation between general partners and limited partners will imply understanding the differences of their asset allocation constraints and return expectations. That may also mean the end of the private equity fund structures as we know them today.

Cyril Demaria is the author of “Introduction to private equity”, The Wiley Finance Series, Wiley & Sons, June 2010

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