Fund raising for the buyout industry in 1998 might have gone through its last growth spurt and may now mature at a more steady pace.
General partners in 1998 shattered all prior records and raised $54.54 billion, 58% more than firms raised in 1997 and more than double what firms raised in 1996. But about 55% of the capital was raised in the first half of the year, and few sources believe that funds in the first half of 1999 will match the numbers registered in the first half of 1998.
While firms raised $23.6 billion in the second quarter of 1998, the apparent apex of the buyout fund-raising boom, groups raised a more modest $13.4 billion in the third quarter and $10.8 billion in the last quarter of the year. Once the stock market corrected itself in August, buyout fund raising slowed and never fully recovered.
Many limited partners have changed the way they view the buyout industry and are starting to see it as an established asset class that is connected to the public markets and that they need to approach more conservatively and carefully than before, G.P.s and L.P.s say. “Institutional investors will be more selective because the risks are higher and they will need to make sure they are with people that have an alignment of interests and experience, and there are few of those people around,” says William Quinn, president of the American Airlines Fixed Benefit Pension Plan.
Intermediaries also sense a change in the wind. “A correction in the public markets inevitably affects realizations; the correction gave L.P.s time to rethink things. My sense is they are showing a bit more caution now,” says David de Weese, a general partner at secondary investor Paul Capital Partners.
“I think there is still a lot of money available for investing, but I think 1998 might have been close to the top of the market, and I don’t think we’ll see the same expansion this year; if we stay at the same level, it will be a good year,” he adds.
Many of the more established buyout firms timed the fund-raising market well and raised large amounts of capital in the first half of 1998, guaranteeing plenty of capital to invest over the next two to four years. Some of the groups that marketed funds early in 1998 include E.M. Warburg, Pincus & Co., LLC, which wrapped the $5 billion Warburg, Pincus Equity Partners, L.P., the second largest private equity fund ever raised; Hicks, Muse, Tate & Furst Inc., which launched Hicks, Muse, Tate & Furst Equity Partners IV, L.P. and has closed on $4.2 billion; Apollo Advisors, L.P., which raised the $3.6 billion Apollo Investment IV, L.P.; Welsh, Carson, Anderson & Stowe, which wrapped the $3 billion WCAS VIII, L.P.; Goldman, Sachs & Co. raising both the $2.775 billion GS Capital Partners III, L.P. and $2 billion for its fund-of-funds vehicles; and Capital Z Partners, a firm backed by Zurich Insurance Group that includes some members of the former Insurance Partners team, which has closed on $1.7 billion for Capital Z Financial Services Fund II, L.P. and $1.5 billion for a fund-of-funds.
Also closing on between about $1 billion and $2 billion in the first half of 1998 were Credit Suisse First Boston, Greenwich Street Capital Partners, GTCR Golder Rauner, Kelso & Co. and Leonard Green & Partners.
Meanwhile, in the second half of the year, only three firms raised much of their billion dollar efforts: Clayton, Dubilier & Rice raising about $2 billion for CD&R Fund VI, L.P.; The Cypress Group, which is shopping the $2.25 billion Cypress Merchant Banking Partners II, L.P., and Madison Dearborn Partners, which is raising the $2 billion Madison Dearborn Capital Partners III, L.P.
Several G.P.s who raised capital in both the first and second halves of last year say there was a decidedly different feel in the final six months.
“If we caught up with investors at the end of the year, it was a harder sell,” says David Spuria, general counsel at Capital Z. He adds that Capital Z would have reached its fund-raising target even if it had launched its vehicle in the summer rather than the spring but believes the firm probably would not be paring L.P. commitments back as it is now.
L.P.s Become Wary After Correction
Some of the L.P. conservatism is the result of the volatility in the stock markets, and the buyout industry’s maturity has caused part of it.
Many L.P.s were caught off guard by the correction in the stock markets last fall. Fearing a bear market this year, several L.P.s say they have become concerned that the firms they commit capital to have the ability to invest in a bear market.
“I think it’s a good time to invest with people who have experience in many types of markets,” says Rosalie Wolf, treasurer at the Rockefeller Foundation. Other L.P.s voice similar concerns.
“I want to see that a group has shown the ability to get deals done in a difficult environment, and that means the partners need to have a 10-year history,” says Leo Chenette, who invests CIBC Oppenheimer Corp.’s fund-of-funds.
L.P.s are also thinking twice before making large commitments because they do not want to tie up too much capital in the event of a bear market.
“It seems to me, talking to L.P.s, that they are still committing to new funds but levels are often less than what they were,” says Richard Lichter, a partner at Lexington Partners.
Besides preparing for a downturn, many limited partners have simply reached their allocation levels and have enough fund managers in their portfolio, making them more cautious and slow to move with new investments.
“There’s only so much room in the world for so many LBO managers, so once you’ve reached the saturation point it is harder for L.P.s to commit to new firms,” says Phil Pool, who heads Donaldson, Lufkin & Jenrette’s placement agency.
Fund raising is becoming an asset allocation game, and L.P.s are starting to constrain themselves by renewing with existing fund managers and committing to funds that expose them to a new sector.
“It is becoming increasingly difficult for firms to attract new investors unless they are offering a window to deal flow that the L.P. does not already have through its existing managers,” Mr. Pool says.
This has led to the emergence of G.P.s launching specialized funds, which is a trend sources expect to continue well into the new year.
At DLJ, Mr. Pool says the agency last year marketed Willis Stein & Partners II, L.P. as a fund that offers L.P.s exposure to buyouts in the Midwest and Providence Equity Partners III, L.P. as a fund that has a media focus. He says several L.P.s that already are limiteds with Madison Dearborn did not commit to Willis Stein because both firms target the same geographic region, showing that institutional investors are becoming more conscious of diversity.
Groups ranging from Marsh & McLennan Risk Capital, raising a $1.5 billion fund targeting the insurance industry, to Leeds Equity Partners, launching a $300 million fund focusing on education, and NorthCastle Partners, marketing a $400 million fund to invest in the health, fitness and wellness industries, have catered to L.P.s by offering specialized funds.
“It is difficult to invest in a fund with a general strategy, except for the funds that have acquired the reputation that gives them a competitive advantage, because they go after deals that everyone can identify,” says a fund-of-funds manager who declined to speak on the record.
The result of L.P.s committing to niche-focused efforts will likely be that G.P.s will launch smaller funds (because most industry or geographic focused vehicles require less capital to invest).
Firms Take On an Institutional Air
At the same time many L.P.s are trying not to add new managers to their portfolios, several G.P.s are offering limiteds exposure to new areas by launching specialized funds alongside their domestic buyout vehicles.
At press time, Kohlberg Kravis Roberts & Co. has launched a European buyout fund with a $2.5 billion target so it, and its investors, can reach new markets (see story, p. 1). The master of the we-can-cater-to-your-needs approach is The Carlyle Group. It raised debut high-yield, Asia, Europe and venture capital funds in 1998 and later this year will launch a new billion-dollar-plus U.S. domestic buyout fund.
Blue-chip firms following suit included Bain Capital raising the $300 million Bain Capital Pacific Fund I, L.P., Hicks Muse wrapping the $960 million Hicks, Muse, Tate & Furst Latin American Partners, L.P. and Texas Pacific Group and Richard C. Blum & Associates, L.P. teaming up to raise funds targeting Asia and Latin America.
Several long-time followers of the buyout industry are uncomfortable with firms launching funds in new areas.
“Some managers are starting to develop an institutional view, and I find that troubling because that is what happened in the late 1980s when KKR, Wasserstein, Perella & Co. and JMB blew up when investing overseas,” says a funds-of-funds manager.
One source of capital that G.P.s will be able to count on this year is the funds-of-funds managers. In 1998, these managers raised no less than six billion-dollar funds-of-funds vehicles.
In all, L.P.s invested more than $9 billion in funds-of-funds last year, almost double the $4.9 billion they committed to funds-of-funds in 1997. Most of these L.P.s are individuals who invest through financial institution-sponsored funds-J.P. Morgan Investment Management raised about $2 billion, Goldman Sachs raised about $2 billion for two funds-of-funds, and DLJ Asset Management raised $1 billion for DLJ Private Equity Partners, L.P.-and several sources say there are many individual investors who would like to invest in private equity and still have not yet entered the asset class.
“It is becoming increasingly difficult for firms to attract new investors unless they are offering a window to deal flow that the L.P. does not already have.”
Sources add it does not take long for a financial institution to establish a team to invest a fund-of-funds. They add that they expect several more banks to launch efforts in 1999.
“We’re just at the beginning of bank sponsored fund-of-funds,” says Russell Pennoyer, a partner at Benedetto, Gartland & Co. “You can rent private equity experience like they did at Bank of New York or buy it like they did at J.P. Morgan,” he says, referring to Bank of New York’s hiring Abbott Capital Management, LLC to manage its vehicle and J.P. Morgan adding much of the team that invested AT&T Corp.’s portfolio in private equity.
These funds-of-funds commit capital to venture capital as well as buyout funds but still are representing a larger, and more important, source of capital to buyout partnerships.
Aside from private equity funds, buyout firms will soon have plenty of mezzanine capital to tap when making investments.
With the credit crunch that started in August, firms started launching and raising mezzanine funds at a rapid pace to fill the gap left by financial institutions. In the second half of the year, Capital Resource Partners and Hancock Mezzanine Investments, LLC raised $775 million for mezzanine funds, and in December DLJ launched its second mezzanine fund, targeting about $750 million.