Distressed funds soar in strong Q2 fundraising environment

Winter is coming, perhaps?

LPs appear to be prepping for a downturn, pumping capital into turnaround and distressed funds. This strategy has raised more capital so far in 2016 than any other fund category tracked by Buyouts.

The nearly $16.9 billion circled by distressed/turnaround funds included $3 billion from Cerberus Capital Management VI and $1.5 billion from Kohlberg Kravis Roberts & Co’s new turnaround fund, KKR Special Situations Fund II.

“You want to have some dry powder in the hands of GPs who are going to be able to take advantage of the market dislocation when that happens,” said Scott Reed, head of U.S. private equity at Aberdeen Asset Management. “That’s the approach we’re taking now.”

Strong distressed fundraising helped drive a strong overall fundraising environment into the second quarter. U.S. firms raised about $47 billion in Q2, bringing total fundraising to $90.9 billion through the first six months, Buyouts data showed.

Several LP sources called the fundraising environment strong through the end of the first half. Total fundraising was likely bolstered by several top-performing managers marketing significantly larger funds, often shortly after final closes on their predecessors, sources said.

Enterprise-software giants Thoma Bravo and Vista Equity Partners are marketing megafunds less than two years after raising their previous flagship vehicles. In the middle market, LP demand enabled firms like Waud Capital Partners and Juggernaut Capital Partners to exceed their fund targets in the first half of 2016.

LP demand also reduced the time required to raise a new fund. As of April, it took less than 14 months on average for private equity firms to hit their fund targets, according to Preqin. That’s the average fundraise since 2007.

“You’re really seeing LPs trying to crowd in, and even accelerating their due-diligence process to try to fit in certain funds,” said Eric Zoller, founder of placement agent Sixpoint Partners. “LPs are willing to act more quickly, put other things aside, when they see something they really want.”

As the fundraising cycle turns

Some LPs are wary of general partners who return to market with much larger funds.

“The biggest frustration we have as LPs is when managers are coming back too quickly. Not because they need to, but because they can,” said Aberdeen’s Reed. “They want to lock down that next pool of capital before the cycle turns.”

Anecdotal evidence suggests the fundraising cycle may turn at some point over the next few quarters. As exit volumes decline, public pension LPs like Los Angeles City Employees’ Retirement System, Los Angeles County Employee Retirement System and Teachers’ Retirement System of Louisiana are starting to see capital calls catch up to distributions.

Positive cash flows, driven by the strong exit environment, helped propel fundraising over the past five years. If distributions decline, it could hurt fundraising over time, several LPs told Buyouts.

Public-market volatility also remains a concern. Any market downturn caused by political instability in Europe, the Brexit, the U.S. election or other factors could cause stock prices to fall. When public equity holdings lose value, private equity starts to eat up a larger percentage of the portfolio — a phenomenon known as the denominator effect. Investors tend to commit less to PE when this happens.

“Am I concerned? Yes,” one public pension LP told Buyouts. “But if I look at the funds I’ve gone into, I’m comfortable.”

A good year for megas

That sense of comfort largely benefited new megafunds, defined as vehicles targeting $5 billion or more, according to Buyouts data.

Megafunds raised $39.7 billion through Q2, with flagship offerings from Advent International ($13 billion), Leonard Green & Partners ($9.6 billion) and Ares Management ($7.85 million) accounting for nearly 77 percent of the total amount raised in the first half of 2016.

TPG also capped its flagship fund on $10.5 billion in the second quarter. TPG Partners VII raised $4 billion this year, according to a Buyouts analysis of SEC filings.

Small and midmarket funds appear on pace to match the amounts they raised in 2015, according to Buyouts data. Fundraising for large funds, defined as $1 billion to $4.99 billion vehicles, fell considerably from the $100 billion-plus raised in both 2014 and 2015, respectively. (See: LBO funds raised by target size.)

Download fundraising tables here:

•  Q2 2016 Fundraising Tables
• U.S. buyout and mezzanine fundraising
• Quarterly breakdown of amount raised by U.S.- based buyout and mezzanine firms
• Q2 2016 playbook for select LPs
• LBO funds raised by target size through Q2 2016
• Largest fundraisers in 2016 YTD
• Funds raised in Q2 2016
• Amount raised through Q2 2016 by fund type

Photo: A man stands in falling snow on West 42nd street in Times Square in New York, January 26, 2015. REUTERS/Mike Segar