Fund Pool Deepens In Second Quarter –

Talk about a busy year. When they weren’t bidding on transactions, completing transactions or tending to portfolio companies, a good number of general partners used their small amounts of free time to raise funds. The second quarter saw 19 funds close, having collectively taken in a little more than $12 billion, and market pros say there’s more to come. At press time, Buyouts had confirmed $1.5 billion was actually raised in the second quarter alone, but that number is sure to grow as we qualify more information. Indeed, Q2 tells a story that buyout pros have been echoing for several months now: 2004 will be a big year for fund raising.

Part of that is simply a matter of timing, as many of the LBO vehicles raised in the heydays of 1998 to 2000 are just about dry. But clearly the more compelling reason to raise a fund has to do with the increase in M&A activity. Additionally, there’s no doubt that things are picking up. As Norwest Mezzanine Partners General Partner Mike Hall puts it, the fund raising environment had no choice but to get better. “Given the last couple of years and how hard it’s been for fund raising, it’s not hard to have an improvement. It’s like we’re bouncing off the bottom.”

He went on to say, “In the first and second quarters of this year, companies have been able to achieve 5x total leverage, a recent high not available since 1999 and 2000. People believe the recession is over,” Hall said.

Norwest closed on its latest fund Norwest Mezzanine Partners II last quarter with a $400 million commitment from Wells Fargo, the fund’s sole institutional investor. Perhaps proving that the markets are healthier, $400 million is a large increase compared to the bank’s $250 million investment it made in Norwest Mezzanine I, a 2000 vintage fund.

Other mezzanine fund raising action came from Lehman Brothers, which earlier this year closed its Lehman Brothers European Mezzanine Fund 2003 on target with EURO750 million, and Veronis Suhler Stevenson, which is still raising VSS Mezzanine Partners and has a target of $350 million. The firm has raised $100 million to date.

So while LPs are being friendly to the mezzanine players, they are also acting favorable toward middle-market vehicles. The emerging trend of smaller funds is a result of the now-common out-of-control bid-ups that take place when deep-pocketed firms compete at the auction block. “The tendency of syndicates of two or three buyout firms bidding against another syndicate of two or three firms and raising bids to excessively high amounts is something a lot of LPs find unattractive,” said Kelly DePonte, a partner with the San Francisco-based placement agency Probitas Partners. “There is a very strong limited partner interest in middle-market first-time funds and Roman-numeral-two funds because the middle-market is so much more fragmented. The smaller funds are more maneuverable, provide quicker returns, are less likely to be involved in bid-ups, and more likely to invest in less competitive-sometimes proprietary-deals.”

However, the trend is not blind. Limited partners are not just throwing money at smaller funds without a strategy. “You need to have some sort of secret sauce that makes you different and gives you an advantage over other firms,” said Peter Huff, a co-founder and general partner at Austin, Texas-based Blue Sage Capital, a private equity firm that focuses on the smaller end of the middle-market. The “secret sauce” is often a niche in a particular market or an exclusive operation in a fixed geographic area.

Blue Sage’s secret sauce is geography. The firm held an oversubscribed final close on its inaugural fund early in the second quarter. The vehicle, Blue Sage Capital LP, had a target of $100 million and closed oversubscribed with $170 million. Investors in the fund include Wells Fargo, Bank One and The LBJ Holding Co. It is earmarked for buyouts and recapitalizations in Texas and its bordering states.

Seemingly unphased by the middle-market trend are the large-market funds. Texas Pacific Group (TPG), whose past LPs include the University of Washington, Aetna Insurance Group and Lerner Investments LP, closed TPG Partners IV with $5.8 billion-the largest fund-closing so far this year. San Francisco-based Hellman & Friedman just closed their fifth fund with $3.5 billion of investor commitments. And Kelso & Co. closed its oversubscribed Kelso Investment Associates VII, L.P. fund with $2.1 billion.

The target-breaking TPG Partners IV was raised in just more than one year, holding its final close in March. But for the most part-same as last quarter and the year before-fund raising has been slower.

Blue Sage’s Huff said the market today feels like it did pre-1997 when every year there was a slow-but-steady increase in total-fund-dollars-raised. “Back then fundraising and deals took longer.”

Buyouts’ fundraising data does show a steady annual increase in the total number of dollars raised per year since 2002. The fundraising total in 2002 was $18 billion, and in 2003 the total was nearly $26 billion. To date, the disclosed 2004 fundraising total is $9.9 billion, but that number is expected to increase dramatically once more firms hold formal closings.