Never had it so good!

It’s undoubtedly a heady time for European buyout firms on the fundraising trail. Preliminary figures for 2005 show European buyout firms captured 76.6% of total funds raised last year, which works out at a whopping €25.329bn spread between 2,178 firms. Figures for 2004 were similar and already the pundits are predicting 2006 will at least match this success. Lisa Bushrod reports

When British Prime Minister Harold Macmillan said “we have never had it so good” in 1957 he was speaking at a time of rising consumer confidence (and inflation) against a backdrop of memories of World War II and just three short years after the end of food rationing. European buyout funds too are probably beginning to forget what it was like to face scarce funding resources while venture capital lapped up all the capital thrown at it, that is until 2002 (by which time the full effects of the venture frenzy were being felt) when the tide had turned away from venture capital and buyout funds were suddenly back in vogue.

Since 2002, when European buyout funds began to benefit from the switch of capital interest in venture back to buyout activity (see table Expected allocation of funds raised (%)), the fundraising environment for European buyouts has gone from strength to strength. The continued level of interest in buyout fundraising has surprised many market watchers, but more of the same is anticipated this year. Already Private Equity Intelligence has stated that it believes globally some US$250bn to US$300bn will be raised for investment across the private equity spectrum (encompassing both venture and buyout), and Almeida Capital put the figure in at a similar level of US$245bn globally, of which around US$60bn is expected to be raised for investment in Europe by European firms.

It’s not just that venture is ‘out’ and buyouts are ‘in’ with institutional investors, a group that defines in and out as those most likely to make good returns over the shortest space of time over those least likely to do so. A similar philosophy prevailed during the period when a three to five-year holding period for a buyout fund investment that, if performing well, might typically return between 15% to 25% IRR was perceived by many institutional investors as simply too pedestrian. Admittedly venture investments in Europe have been ‘out’ for longer than anyone feared and perhaps unfairly since their returns are now measurable and the so called wheat and chaff has been sifted. This extended period out in the cold is thanks not just to excesses and a repositioning of the European venture industry, but a set of circumstances that has served to preserve buyout funds’ dominance in the minds of institutional investors.

It essentially comes down to the fact that buyout funds are returning a lot of money to their investors and institutional investors, which make up the bulk of private equity’s capital source, have to recommit to funds in order to keep their asset allocations for the private equity asset class on track. Because there is so much money coming back to institutional investors they have to deploy much of that capital back into buyout funds. To deploy this money into venture funds takes more time because these funds raise less money (typically large European venture funds fall in the €300m to €500m range compared to €1bn+ for large buyout funds) so they have to commit in smaller amounts to venture funds but generally the due diligence time and costs on a fund commitment are the same, regardless of its size. Take that fact into account and the limited resources at the disposal of most institutional investors, plus the fact that buyouts are performing well and European venture is a patchy story performance-wise and it’s logical that buyout funds should be grabbing all of the attention.

Buyout funds are also back to exhibiting far shorter investment time horizons (three to five years at the outside) than venture. During the bubble of 1998 to 2001, venture funds investment time horizons shrunk from the typical five to seven years in technology investments (biotech and life sciences have tended to go on for longer, at the earliest stages) to as little as 18 months. But many buyout funds are returning committed capital to their investors’ way before the three-year typical minimum investment period is up. This is thanks to a highly liquid, and many would say over exuberant, debt market that buyout firms have been able to tap into over the past three years. Much of the activity during 2005 involved refinancings of existing private equity-backed businesses, which allowed buyout funds to return significant capital to their institutional investors.

Ratings agency Standard & Poor’s has held its hands up in disbelief over the pricing and covenant terms offered in the European market, which it says do not reflect distinctions in the quality of the credit of the security provided. According to Standard & Poor’s leverage loan index, as of January 31 this year, 72% of loans were rated B+ and B, a 19% increase from the end of 2004 and this doesn’t compare favourably in terms of risk/ rewards offered to lenders when taken in the context of the US market where just 41% of loans were rated B+ or B at the end of January. Market pundits have been predicting a slump in lenders’ willingness to operate on such thin margins for more than a year now, but while the overall macro economic environment throughout Europe has remained benign, including low interest rates, and the growth in investor appetite for European debt has skyrocketed (witness the shift from predominately banks holding paper to CLO, CDO funds emerging as the major buyers as they are in the US) little has changed.

What is clear, however, is that the ability of private equity funds to raise such large sums within relatively short time frames and the seeming unwillingness of corporates to tap the liquid debt markets to fund acquisitions, has placed buyout funds firmly above the parapet. Given all the talk of potential public-to-private deals during the first quarter of this year, surprisingly little activity actually occurred, some pundits putting this down to the fact that investors in public equity see that the buyout funds have very deep pockets right now and they want them to dig down into them. If they do and pay too much on the back of a currently overgenerous debt market, the exuberance surrounding buyout fundraisings may begin to melt away.