- LPs are concerned about the pace of fundraising, but are still ponying up new capital
- The current environment supports a wide variety of fund sizes and specialties
- First-time funds are finding willing investors
Investors in third-quarter 2018 were simultaneously frustrated by the power held by in-demand general partners and yet competing for their approval across a wide variety of fund types.
GPs raised $135.8 billion over the first three quarters of 2018, versus $174.9 billion in the year-earlier period.
While 2018 isn’t on pace to match 2017’s frenzied private equity fundraising, limited partners don’t feel as if the market is slowing.
And PE’s sustained popularity has encouraged new managers and approaches, giving investors access to a greater variety of fund types.
One common complaint is that GPs are coming back to market faster than before, often with significantly larger funds. This raises doubts about their ability to scale up effectively and about the speed at which investors’ capital will be put to work.
“LPs are a funny group,” says Scott Reed, co-head of PE at Aberdeen Standard Investments. “Out of one side of their mouth you’re going to hear them complaining vociferously about managers coming back too quickly raising too much capital, raising funds that are going to sit on the shelf for six months until they’re activated, and they’re expressing a lot of frustration around that.
“On the other side of their mouth they’re angling as hard as they can with those GPs for as much allocation as possible, which just feeds the beast.” he said.
Beyond the raw numbers, LPs are seeing in-demand managers come back to market quicker, raising some concern about GPs raising too much money too quickly, according to NEPC’s Sean Gill.
Successful GPs will often increase the size of a successor fund, sometimes dramatically, and LPs are skeptical whether strategies will scale up as neatly as GPs claim.
“Historically LPs see size as somewhat the enemy of performance,” Gill said. “As funds get bigger, conventional wisdom says that performance will deteriorate or move toward the average.”
By the numbers, 2018 has seen fewer allocations to megafunds, with $36.3 billion going to funds with a target size of $5 billion or more over the first three quarters. Compare that with 2017, a banner year for megafunds, when $95 billion went to the largest funds.
If 2018’s pace holds steady through year-end, about $50 billion would go to the largest funds, similar to 2016, and a bit below the average for the years from 2012 to 2015.
This year has seen a few huge funds close, however, including Carlyle Group’s seventh fund, which raised about $16.3 billion with an $18.5 billion hard cap, and GSO Capital Partners’ third Capital Solutions fund and American Securities’ eighth fund, both of which closed on $7 billion.
In contrast, 2018 has already exceeded 2017’s allocation to large funds that don’t crack the $5 billion threshold. Investors have poured $44.6 billion into funds that are between $1 billion and $4.99 billion, compared with $42.2 billion for all of 2017 and $45.7 billion for all of 2016.
Besides concern about performance, larger funds also shift the alignment of interest away from LPs. This shift occurs because GPs take in more money from management fees and may be more inclined to play it safe to maintain the value of the brand, rather than taking risks to maximize performance, Gill said.
The rapid fundraising environment also has LPs concerned about their ability to judge the performance of a previous fund, if it’s only had two years or so to make investments.
“There’s a feeling that there’s this enormous wave of dry powder, and with all of this dry powder chasing a finite number of opportunities, people are going to overpay, and that can cause performance to be somewhat underwhelming,” Gill said.
First-time funds have been popular, raising $5.26 billion so far in 2018. LPs say first-time funds are often staffed by experienced investment professionals who have learned hard lessons from frothy fundraising markets, leading to higher-quality debuts.
“We do like first-time funds, but we do not like first-time managers,” said Christian Kallen of Hamilton Lane. “The quality of the first-time funds coming out right now is good, and these are typically not first-time managers. These are people who may have 20 years or more experience investing in private equity and private markets.”
Investing with first-time funds can be a challenge for some LPs, since it requires more research to find promising opportunities, according to Aberdeen’s Reed.
“There’s never been a better time for private equity professionals to hang out their own shingle and raise a new pool of capital,” Reed said. “There’s more than enough money on the sidelines right now that is willing to take on the incremental risk of backing an emerging manager, particularly when it is a GP that has spun out of a credible and well-known institution.”
Lots of variety
One upside to the active fundraising environment is the wealth of choices available to investors.
“From an LP perspective, we like the current market environment because there are so many different kinds of funds out there,” Kallen said.
“You can be much more selective in what you do, and you can be much more targeted to what kind of exposure you want to get right now in the private market. There’s not just one healthcare fund out there, there are more like 20 healthcare funds, so obviously more selection is always better from an LP perspective who will make those choices.”
Aberdeen’s Reed agreed.
“We are seeing fund strategies of all shapes and sizes,” Reed said. “It’s hard to pin any particular trend down in terms of growth, value, distressed, etc. We’re seeing managers of all shapes and sizes coming back to market, and frankly, I think LP appetite continues to be broad-based. We’re seeing megafunds raise large portfolios very quickly, we’re seeing small-cap spinouts raise capital relatively quickly, and everything in between.”
The new-generation funds include the usual suspects, like technology and healthcare, sometimes with a new geographic focus. NEPC’s Gill said that European venture capital is one area where he’s seeing new interest.
“It’s a baby brother to North American VC, but it’s something that’s getting more interest and attention from some of our clients,” Gill said.
Going forward, GPs and LPs both seem to expect the market to slow down, and they may be rushing to get their funds and investments in place before it does.
“I think in part that’s driven by a view that GPs have some concern that the fundraising window may close at some point,” Reed said.
“But on average, it’s as good a time to raise private equity capital as there’s been in the cycle. The environment right now, particularly post-Labor Day, is about as active as I’ve seen it in some time.”