The favorite expression industry observers have used to describe fund raising for the last three years was that the rising tide lifts all boats. Today, however, G.P.s suddenly are finding more constricted flows of capital, and, as a result, some of their partnerships are experiencing a slack tide in the fund-raising waters.
Firms raised $9.674 billion in the second quarter, according to BUYOUTS-amounting to only about 40% of the $23.64 billion they raised in the same period last year. And while the totals from the last three months beat the first quarter’s mark, few sources seem impressed with the haul.
However, the marked decrease in fund closings was not due to a lack of trying.
In the second and third quarters of 1998, 39 firms launched funds seeking $23.6 billion, thereby giving investors plenty of offerings to choose from in the last three months. Additionally, the market of potential investment opportunities was supplemented by 42 firms that launched funds seeking $25.4 billion in the fourth quarter of last year and the first quarter of 1999.
Sources say the disconnect may finally be a sign that L.P. appetite for buyouts may be satiated. Limited partners now seem most interested in renewing relationships with existing managers in their portfolios, while investing with a few groups that offer something new, G.P.s and L.P.s say.
Some sources believe last quarter’s lagging fund-raising numbers are simply a reflection of which firms have come to market, and they say the numbers will pick up next year when several of the more prominent groups return.
“I think there may be a little lull in fund raising for the next few quarters because so many of the big guys are focusing on deals and are not in the market,” says Leo Chenette, a partner who manages CIBC Oppenheimer Corp.’s fund-of-funds.
L.P.s believe Apollo Advisors, Charterhouse Group International, Thomas H. Lee Co. and Welsh, Carson, Anderson & Stowe all likely will return to market early next year with billion-dollar funds. More immediately, The Carlyle Group and Vestar Capital Partners will be marketing $2 billion to $3 billion efforts in the coming weeks.
Only 15 firms launched funds in the second quarter seeking a total of $4.035 billion, according to BUYOUTS.
Several state pension managers now say they take a more cautious approach when reviewing buyout funds, especially groups with which they have no prior relationship. “We cannot commit to every fund in the marketplace, and once we have a relationship, we’d rather stick with what we have as long as the firm is doing the job,” says Jay Fewel, the equities manager at Oregon State Treasury.
This outlook is leaving many new buyout groups out in the cold, sources say.
The situation becomes more perilous when managers of large pensions, such as David Locke at the $25 billion Los Angeles County Employees Retirement Association, announce they are looking to reduce the number of their buyout relationships so they can better manage their alternative assets portfolios. He says the pension will renew with some existing managers when they return to market but will not replace most of the others.
A G.P. who is currently out in the market with a middle-market fund believes the result in the next year will be that non-blue-chip middle-market firms will be forced to offer L.P.s incentives to invest. “Like in any business, what you’ll find is tertiary brands will get squeezed by big branded companies and innovative products,” the G.P. says. “You’ll see someone make contractual co-investments a big part of their fund, or you’ll see firms offering a 15% carry.”
To combat the growing lack of interest among the traditional private equity investors, some sources have seen G.P.s tapping commitments from non-traditional sources such as hedge fund managers that want to diversify into private equity and foreign institutions that want to co-invest in U.S. deals.
The sudden fund-raising slump has happened for several reasons, but most sources point to the maturity of the buyout industry as the primary driver.
Firms-including many of the most popular groups-raised $90 billion in 1997 and 1998. Yet firms invested only about $25 billion in equity in those two years. At this rate, buyout firms already have raised enough capital to make investments for at least the next five years without seeking additional funds. Limited partners-after going on a three-year feeding frenzy-have noticed the statistics and are not eager to invest more capital in the asset class, sources say.
“I sense firms are having a tough time putting money to work, and they are not investing the capital at the same pace as a percentage of their funds compared to when they raised smaller funds,” says Thomas Kelly, a partner at CHB Capital Partners, a Midwest buyout firm.
The result is an industry where supply now might be greater than demand.
Most of the sought-after firms already sopped up huge amounts of capital in the last three years, and they now are trying to invest-leaving the fund-raising market to a pool of less-than-familiar names.
In the second and third quarters of 1998, there is little question the quality of firms that launched funds was less spectacular than in the past, and this has contributed to the current state of affairs.
Firms launching funds for the first time and U.S.-based groups raising vehicles targeting emerging markets in the mid-quarters of 1998 represented more than one-third of the capital sought in launchings.
Most of these groups-ranging from Siguler Guff & Co., which launched the $500 million Russia Partners II, L.P., to Bear, Stearns & Co., which started pre-marketing a $1 billion buyout fund but never got the vehicle off the ground-have had difficulty raising capital.
Then there are the established middle-market firms that still have failed to generate much interest, representing almost another third of the capital sought in fund launches last summer. This group includes American Industrial Partners, which has yet to hold a first closing on its $850 million third fund, and Lincolnshire Management that has not yet closed on any capital for its $500 million second fund.
The theory several placement agents and other fund raisers held last year was that L.P.s would invest with groups they were unfamiliar with if they could not commit the capital they wanted in the more sought-after partnerships.
Some sources still believe this trickle-down theory, although they acknowledge it has yet to take hold. “I do think that eventually the money from the top has to spill down,” says Paul Rice, who built the private equity program at the Michigan Department of Treasury and now is managing a fund-of-funds at Mesirow Financial.
He says getting into the blue-chip funds already has become competitive and likely will become even more so in the coming year. “L.P.s are becoming a little more close to the vest because everyone is seeking a position in the partnerships that close quickly,” Mr. Rice says.
Even in a disappointing second quarter, one firm-Silver Lake Partners LLC-generated huge demand in the last three months by tapping into a popular niche with limited partners.
Silver Lake, a new firm formed by Glenn Hutchins, a former managing director with The Blackstone Group, and venture capital professionals, this winter began pre-marketing a $1 billion buyout fund to invest in subsidiaries of publicly traded technology companies (BUYOUTS Feb. 8, p. 1). The firm did not anticipate the interest it generated, according to sources close to the group.
After less than five months of fund raising, the group has closed on $1.8 billion and will wrap Silver Lake Partners, L.P. at $2.25 billion this quarter (BUYOUTS May 31, p. 1).
The logic behind the rush, in hindsight, is obvious, say G.P.s and L.P.s. Most state and corporate pension managers currently have only limited exposure to venture capital and have therefore missed out on the technology boom. Today’s established venture capital firms formed their key relationships with limited partners in the 1970s and 1980s, well before most investors in buyout funds started getting serious about committing capital to alternatives.
L.P.s-looking at a group of buyout funds that was less appealing than those in the market early last year-viewed this as a chance to invest capital in a vehicle that offered exposure to elements of an asset class in which they were very interested, a source close to Silver Lake says.
Silver Lake received commitments from half of the institutional investors it visited, the source says.
Unfortunately for G.P.s, the Silver Lake story does not bode well for most firms. It speaks to a bigger trend of institutional investors favoring venture capital partnerships instead of buyout funds.
Several limiteds spoke of the need to diversify and invest more in venture capital. Terry Blaney, the private equity director for Delta Airlines and a long-time investor in buyout funds when he managed Washington State Investment Board’s pension-in an earlier interview said he believes there are better opportunities in venture capital than buyouts in the short term (BUYOUTS June 21, p. 28).
Irwin Loud, the former private equity manager at the Florida State Board of Administration, says pension managers today are shifting their focus. “I think one of the reasons you’ll see a lot of interest in venture is there has not been a focus on it, and the private equity business is cyclical,” he says.
Some Successes, In Spite of Slow 2Q
In spite of the relatively low totals raised last quarter, several other firms besides Silver Lake also successfully raised capital in the last three months. Marsh & McLennan Risk Capital, which is raising a fund targeting the insurance industry, held two closings totaling $1.15 billion for Trident II. Meanwhile, Heritage Partners and Cypress Group L.L.C. raised $835 million and $400 million, respectively, in the quarter. Heritage launched its fund this spring setting a $750 million target (BUYOUTS April 5, p. 8) and managed to wrap the vehicle in less than four months (see story, p. 1).
If one is not fortunate enough to have the allure of Silver Lake, there are other options, sources say.
One new approach several firms are employing is including the potential for growth investments in their marketing pitches. Growth investments, which differ from venture capital investments because the companies being funded are well established, may have similar roots to the buy-and-build approach popularized a few years ago when firms found it difficult to make traditional leveraged buyout investments.
Limited partners such as California State Teachers’ Retirement System are making an effort to establish new partnerships with G.P.s that are targeting this newly popular equity strategy. Several G.P.s believe growth investments might be the logical next place for L.P.s to invest.
“Everyone went into these huge buyout funds, and now they are trying to pare managers back since they see they are overweighted in that one sector,” says John Pouschine, co-founder of Pouschine Cook Capital Management LLC, a private equity firm that likes to co-invest with other groups. “I think that the growth market is underserved, and it is logical that more firms will fill that space.”
Some of the larger buyout deals inked this year-the Apollo Advisors-and Blackstone-led $9.05 billion investment in Browning-Ferris Industries and the Apollo and Thomas H. Lee Co. $3.5 billion investment in Patriot American Hospitality-were growth investments and indicate that the trend has taken hold even among the largest buyout firms.
Additionally, Heritage Partners, which has been taking minority or growth positions in companies for years had a successful fund raising, and Ken Langone’s Invemed Associates last quarter raised $475 million for Invemed Catalyst Fund, L.P., which is a growth vehicle (BUYOUTS April 19, p. 1).
Emergence of Emerging Markets Funds
Several other U.S. firms have chosen to raise international funds claiming they are accessing a less crowded market. The largest such offering in the quarter came from Citicorp and CVC Capital Partners. They are launching the $750 million CVC Asia Pacific fund to give limiteds access to the distressed region (BUYOUTS June 21, p. 5).
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