In A World Of Reduced Appetites, Distressed Debt and Secondary Funds Come To The Fore

Every year, Probitas Partners surveys institutional LPs to determine how they perceive the market. This year’s survey attracted over 400 responses in the midst of the current market turmoil in late November and early December. Two of the most interesting questions for us where whether the impacts of the Denominator Effect were as bad as we were hearing and, given the market turmoil, whether investor’s interest in specific sectors of private equity had changed dramatically.

Over 60% of respondents were at or over their allocations, and while some were looking to increase allocations, more of them were looking to live within those guidelines. Chart I below provides the details, but it clearly shows a market where fundraising will be under pressure. On the bright side, there are clearly investors who are under allocated to private equity and are actively looking to expand their programs. (Most of those who fell into the “Other” category were either fund-of-funds dedicated to private equity or were consultants or institutions without a specific target allocation.)

Chart I: Current and Targeted Private Equity Allocations
“As far as our current private equity allocation…”


Though we hadn’t asked this question previously, on an anecdotal basis most investors would have been under their allocations in 2007, with most of those near their limits seeking to increase their allocations. There would have been very few respondents over-allocated to private equity.

In looking at the detailed breakdown of those institutions that responded that they were over-allocated now, they were much more likely to be headquartered in North America than in Europe or Asia. Given that private equity is more developed in North America amongst institutional investors and they are more likely to have significant legacy portfolios, this is exactly what one would expect. Within North America, Endowment and Foundation respondents were more likely to beat or over their allocations.

As far as sectors of interest to LPs, Chart II provides the details. 41% of investors plan on investing in distressed debt funds, with U.S. middle market buyouts, secondary funds and European middle market buyouts rounding out those sectors attracting interest of more than 25% of investors. There was also substantial interest in mezzanine, Asian and growth capital funds, but most notably was the ranking of distressed debt and secondary funds, higher than they have ever been in our survey. These answers reflect not only the current turmoil in the markets but also the expectation that 2009 is likely to be a better vintage year than 2007 or 2008 in the core middle markets as purchase price multiples decline.

Since over 50% of the LPs responding to the survey were based in the U.S. the preference for U.S. middle market buyout is driven a bit by that. In digging under the overall numbers, it is not surprising that the primary area of focus for Asianrespondents was for Asian funds or that for European LPs European middle market funds were the main area of focus. However, in the U.S. market distressed debt funds lead U.S. middle market funds, likely reflecting the depth of the distressed opportunity in the U.S. market at this time.

Interest in mega buyout funds fell to a new low in this year’s survey, attracting only 4% of respondents compared to 12% in last year’s survey; only European/ Israeli Venture had a lesser interest by investors. Mega buyouts have never secured positions of top interest in prior surveys, even as these funds successfully raised large amounts of money. This extremely low level of reported interest is supported by the slowing of fundraising for mega buyout funds in the market, with a few major fund managers already decreasing fund raising targets or returning capital.

U.S. venture capital is also an area that witnessed declining interest. In 2008 it was one of the core areas of interest, registering in fourth place out of thirteen and attracting the attention of 29% of investors. It has fallen to eighth place, with Asian and mezzanine funds leaping ahead, only garnering the focus of 13% of investors. Though not directly impacted by the credit crisis (as most venture backed companies use little leverage), the collapse of the IPO market during 2008 dramatically impacted the exit market for venture capital. The resulting protracted holding periods and continued economic weakness is likely to have significant impact on newly formed companies seeking profitability, and thus investor interest in the space.

Chart II: Key Areas of Interest
“I plan to focus my attention on investing in the following three sectors…”

2009 Expectations
The complete survey covers a number of other areas of interest. Anyone seeking a complete copy can contact me at