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Editor’s Letter: Preparing for the worst

One theme we’ll be watching in 2017 involves limited partners’ due diligence of new managers.

LPs appear to have shifted their thinking slightly to prepare for a downturn. They’re doing this mostly when they assess potential new managers, several LPs told Buyouts in recent interviews.

“That’s what I keep telling our investment committee: start thinking about tomorrow,” said a fund-of-funds LP. “Are people planning for a downturn?”

This translates into more focus on determining how a manager would fare in a downturn. In better markets this factor might be further down the list of due-diligence questions; but these days, it’s the first or second question, one LP said.

Some ways to determine managers’ prowess in weathering a downturn include studying their track records in prior corrections. If they invested in 2006 and 2007, how did those investments fare? “I have a lot higher level of confidence in that venture manager whose track record goes back to 1995 and the team is still intact,” a second LP said. “Flawed or not, our thesis is, that group has a better chance of navigating a tumultuous environment.”

Another important factor: What kind of prices did the managers pay in frothy environments? Did they maintain price discipline, and if not, why? If, for example, a manager historically paid 6x EBITDA and he’s now paying 9x, he better have a good explanation for the change.

LPs expect lower returns from their private equity investments. PE’s cash-on-cash returns flourished over the past half-decade as sponsors sold off their crisis-era assets. That pipeline is starting to dry up, and institutions like California Public Employees’ Retirement System and State of Michigan Retirement Systems have signaled they expect distributions to fall in the near term.

“The sell side has largely played out and distributions appear to have peaked. In addition, increased regulation aimed at limiting risky lending by Wall Street banks has reduced the amount of debt available, forcing private equity firms to contribute more equity,” Michigan investment staff wrote in a recent memo. “These headwinds will likely impact private equity returns.”

This could make it harder for emerging managers, and especially first-time funds, to attract capital next year. This is what happened in 2015, when, after a few years of strong fundraising for emerging managers, fundraising started to taper off.

This is because in an environment that many believe is at or near a peak, LPs aren’t willing to take first-time-fund risk. Rather, they stick with known and trusted managers. So as emerging managers have a harder time attracting capital, the handful of top-performing firms have more demand than they can handle.

As I say, we’ll be carefully watching and reporting on these developments. Even in the strong fundraising environment — and every source I’ve talked to expects another strong fundraising year, barring some sort of catastrophic event — LPs are preparing for the worst.

Private Equity Editor Chris Witkowsky reflects at home. Photo by Wendy Witkowsky