GPs Rethink Course Amid Fund-Raising Lull –

If 1998 can be viewed as the year that LBO fund raising finally put itself on the map, then last year can be regarded as the year that both LBO firms and their investors took a breather to redefine their approaches and their programs.

The total for buyout funds raised two years ago reached a peak for the 1990s, with more than $55.39 billion garnered in the course of a year. However, 1999’s total failed to live up to expectations (much like all the Y2K hype), pulling in only a little more than $33.279 billion, according to BUYOUTS. Adding insult to injury, last year’s slowdown for buyout firms on the trail of capital was capped off by an abysmal fourth quarter, in which a mere $6.7 billion was raised. This compares poorly to the approximately $11 billion raised in 1998’s fourth quarter.

While some industry observers might be tempted to throw up their hands, seeing 1998’s fund-raising spike as the exception to the private equity rule, most sources believe 1999’s slowdown can be seen merely as the calm before a coming fund-raising storm, as several major firms either launch new vehicles in the beginning of the year or plan efforts to be unveiled in the second half.

“It just so happens that there was a cluster of multi-billion dollar funds that came to market in 1998, and they obviously wouldn’t be in the market in 1999,” says Ben Sullivan, a managing director in the private placement group at Merrill Lynch & Co. “Also, the venture numbers appear to have gone up pretty markedly in the past year, even though the absolute dollars in venture is nowhere near the dollar amount of LBOs.”

The year just passed did see a few marquee names hold huge fund closings, including Vestar Capital Partners, Hicks, Muse, Tate & Furst, and Clayton, Dubilier & Rice, which together raised more than $10 billion in 1999. But 1999 saw far fewer billion-dollar buyout funds being raised than in 1998. That year, groups such as Thomas H. Lee Co., Apollo Advisors, Welsh, Carson, Anderson & Stowe and E.M. Warburg, Pincus & Co. LLC together raised more than $15 billion for their mega-fund coffers.

In addition to the dearth of billion-plus offerings in 1999, sources say that increased investor interest in venture capital-spurred by the more than 80% returns seen by the Nasdaq composite last year, and the increased size of many second- or third-generation venture capital groups, have diverted some of the capital that had been going to buyout partnerships.

This trend has prompted a slew of buyout groups, known more for their ability to buy established manufacturing and service companies with a high degree of leverage, to begin making investments that more closely resemble the work of venture capitalists.

“The whole line between buyout and VC is blurring,” says Tom Bell, an attorney at Simpson, Thacher & Bartlett who works in the formation of private equity partnerships. “There’s traditionally been polar tracks between Silicon Valley and Boston VC groups and the Wall Street types. Ten years ago, what a buyout fund looked like was a lot different than a VC fund.”

Examples of this trend abound, with The Blackstone Group’s recently launched telecommunications fund, which features a target of approximately $2 billion (see story, p. 3), leading the charge. Other examples include Washington, D.C.-based The Carlyle Group’s fourth-quarter decision to launch a separate private equity fund that will target Internet-related opportunities and Hicks Muse’s move to raise a “stapled fund” this year that will invest in technology deals alongside its fifth buyout partnership.

According to Dan Blanks, a managing director at Dallas-based Hicks Muse, the decision to offer the technology fund, tentatively named the New Economy Fund, was based largely on limited partner demand and the group’s recent track record investing in tech deals. “Fund IV is going to have 25% of its capital invested in new technology and Fund V should be the same,” Blanks says. “We thought our investors wanted this exposure, and we have a parallel fund where we can give more exposure to those L.P.s that want it, without forcing others to buy in.”

Texas Pacific Group will employ a similar strategy as Hicks Muse: The group last year announced plans to raise its third buyout fund, which likely will target $2.5 billion, and a technology fund of as much as $1 billion that will invest alongside the main fund on technology deals (BUYOUTS Sept. 27, 1999, p. 1).

Some of the interest, no doubt, is based on the speed with which Menlo Park-based Silver Lake Partners LLC managed to raise $2.2 billion for its debut effort, which will attempt to scribe the methodology of the traditional LBO deal-including relatively large chunks of debt-over the less traditional technology sector.

LBOs Follow Clicks

There were also a few cases last year of more bricks-and-mortar oriented LBO shops crossing over to invest in technology or telecommunications deals from their more traditional LBO funds. Last month, New York-based Forstmann Little & Co. agreed to invest $850 million in Nextlink Communications Inc., a broadband communications provider, in a move that will culminate in the firm investing some $1.9 billion in total equity for communications-related deals over 1999 (BUYOUTS Dec. 20, 1999, p. 1). Although partners at Forstmann Little have remained mum on whether they will follow the lead of their LBO brethren in raising a dedicated vehicle for telecommunications or technology investments, several sources speculated that the firm’s recent activity may be a harbinger for such an event in the coming year.

And the trend that has awarded the fund raisings of more specialized or focused LBO funds has not been limited to just the tech realm. Last year also saw successful fund raisings by such groups as VS&A Communications Partners, which pulled in $1 billion for its media fund; The Leeds Group, which held a first closing on $150 million for a vehicle that will invest in educational companies and charter schools; Questor Partners, which closed on $880 million for a turnaround fund; and Marsh & McLennan Risk Capital that has raised more than $1.62 billion for Trident II, which will invest in the financial and insurance sectors.

Specialization as an element of LBO fund raising was not limited just to industries in 1999. The year also saw a deluge of geographically focused offerings, with European partnerships leading the charge, followed closely by Asia-focused vehicles.

“There has been an increasing demonstration through 1999 that the business is a global business, particularly with Europe showing itself to be increasingly important in the formation of private equity partnerships,” Merrill Lynch’s Sullivan says.

Two stalwarts of traditional U.S.-focused buyouts both opted to launch fund raisings for European vehicles in 1999. Kohlberg Kravis Roberts & Co. early last year set out to raise between $2 billion and $3 billion for European buyouts, while Hicks Muse has nearly completed raising its $1.5 billion European fund that will follow the same modus operandi.

Asia, including Japan, has attracted more than its share of interest in the LBO community, especially after private equity offerings for the region had all but dried up during the economic hardships the region felt in 1997 and 1998. Chase Capital Partners in conjunction with International Finance Corp. last year launched and held a quick closing on Chase Asia Investment Partners, a private equity fund that will look to capitalize on an anticipated wave of divestitures and consolidations that could sweep the region (BUYOUTS April 5, 1999, p. 1). The Carlyle Group, continuing to diversify its private equity offerings, held a $725 million final closing on Carlyle Asia Partners LP.

Other groups that caught the Asian bug in 1999 include Citicorp Capital Asia and CVC Capital Partners, which are co-marketing the $750 million CVC Asia Pacific.

But the international flavor of LBO fund raising was not only witnessed in what regions partnerships targeted, but also where groups were raising their capital. Sources note that, with continued interest by such investors as Swiss and Dutch pension funds, Scandinavian financial companies and German and French insurance companies, LBO fund raising in 2000 might make it back to the lofty levels it achieved in 1998. “European institutional investors are funding private equity around the world,” Sullivan says. “Europe will be a growing factor in both where to invest capital and where to get capital over the next five years.”

Mezz Funds Burst Onto Scene

Last year also saw an increased number and size of mezzanine funds on the market, driven largely by a high-yield market that was inaccessible to all but the largest and most high-profile LBO deals. According to Portfolio Management Data LLC, the average percentage of high-yield bonds that comprised LBOs of $250 million or greater fell to 12.4% in the second half of last year, compared with an average of 23.8% for the first half of 1998. The gap is being filled by increased amounts of equity, senior debt, and an increasing reliance on mezzanine capital, and a number of groups have raised vehicles to put themselves at the front of the queue for the demand. Most notably, Donaldson, Lufkin & Jenrette last year capped its DLJ Investment Partners II, L.P. at $1.6 billion, notching the largest mezzanine fund in history, Blackstone has raised $677 million of the $750 million it has targeted for its debut mezzanine effort.

While sources predict that 2000 will see a return to the market by several established firms that raised mega-funds in 1998, including Hicks Muse, Thomas H. Lee Co., Apollo, Blackstone and Willis Stein-and that this interest will pump this year’s fund raising totals to a comparable level to 1998-few believe that any group will manage to break the $5.7 billion mark set by KKR.

While interest in private equity remains strong for groups with an established track record, most sources say the marketplace has undergone such rapid change that a fund of nearly $6 billion could be viewed as too cumbersome. “I don’t see anyone trying to raise KKR’s level of money because they don’t see any advantage to it because they might be compelled to target larger deals and have to invest at a faster pace,” Simpson Thacher’s Bell notes. “There can be a lot of repercussions.”

It is a sentiment that even some G.P.s echo. “Five or six years ago, we would have thought it would be easy to raise a $7 billion fund, but the market has shown itself to be less receptive today,” Hicks Muse’s Blanks says. “The marketplace has a strange aversion to very large funds. They love the idea that KKR can raise $5.7 billion and they can have their money tied up for five years, but they hate the management fees. We don’t want to get into that.”