Supply Of Funds Overwhelming Demand

When private equity professionals rang in the New Year, there wasn’t much nostalgia for 2011. But there didn’t seem to be all that much hope for a blockbuster 2012, either.

In the year that was, U.S. buyout and mezzanine firms raised $90.5 billion, 31 percent more than the relatively dismal $69.3 billion raised during 2010. Most fundraising gains came from buyout funds, which raised $82.6 billion, 33 percent more than the $61.9 billion raised during 2010. Mezzanine funds also saw a modest bump in fundraising in 2011, rising to $7.9 billion, a 7 percent gain over the $7.4 billion raised in 2010.

Despite these modest gains, fundraising overall remained down a monumental 70 percent from the record $301 billion raised in 2007, before the financial crisis crashed onshore. Figures from Buyouts include money raised from both interim and final fund closings.

The year started out with a burst of optimism as fundraising rose in the first quarter along with rising equity markets and a strengthening economy. That momentum continued into the second quarter, which ultimately turned out to be the best quarter for fundraising since 2008. But in the third quarter, investors pulled back, as the European debt crisis and a downgrade of America’s credit rating frightened investors, while economists once again wagered on the likelihood of a double-dip recession. Volatility eased somewhat in the fourth quarter, and fundraising rebounded, but by year end, it was still an open question whether the modest fundraising uptick would carry over into the New Year.

For 2012, most buyout executives and placement agents told Buyouts that they expected a modest rise in the amount of money available to invest. At the same time, they predicted even more of a scramble for that money from the growing number of firms that are now in the market. “The general fundraising environment is warming, but it’s not hot,” said Bill Barnum, a partner at Brentwood Associates, a consumer-industry buyout firm in Los Angeles that is looking to raise its fifth fund early this year. “2012 will be mildly better than 2011, but there are a lot of new funds out there,” he said.

Increasing competition is a recurring worry for many private equity firms. Despite a modestly better fundraising outlook, there are now 1,836 private equity funds in the market globally, compared to 1594 at the start of 2011, according to Preqin Ltd., the alternative asset data provider. And those funds, according to Preqin, are now targeting $728 billion, a 21 percent rise on the $602 billion that funds were seeking at the start of 2011. As a consequence, any growth in money available to invest is likely to be overwhelmed by an even greater expansion of the number of firms seeking those funds.

“There is a bit more money in the marketplace–not a ton, but a little,” said Kelly DePonte, a placement agent at Probitas Partners. “But there are a ton of GPs in the market now because they have to be. They’ve got to come back to market simply because they’re running out of money to invest.”

Power Shifts To LPs

Regardless of how much money is ultimately raised in 2012, the private equity world is increasingly becoming polarized between a few hugely successful funds, and the majority of funds, which are struggling to hit their fundraising targets.

“Ultimately, the fundraising market has become extremely bifurcated between funds getting raised and the rest of what’s out there,” said Jennifer Rinehart, a placement agent at MVision. “For 2012, I already see investors queueing up and short listing the funds they want on their list next year. Those names are going to be funded in a matter of weeks,” she said.

The flip side is that “in some cases, raising a fund is taking 18 to 24 months,” said Aaron Rudberg, director of investor relations at Baird Private Equity, a firm that focuses on the small end of the market. Ultimately, he said, “as many as 40 percent of the firms out there will not raise another fund.”

And except for a few top-decile firms that seem to be on every institutional investor’s shopping list, the industry’s increasing competition for money is keeping negotiating influence over fees and terms firmly with investors.

Firms clearly were more generous with fees and terms in 2011 than in the past. Among the more favorable terms offered to some LPs were 100 percent fee offsets and reductions in annual management fees to 1.5 percent from 2 percent, especially for early commitments. “We will continue to see pressure on fees,” said Baird’s Rudberg.

Warburg Pincus, which is trying to raise a huge $12 billion fund, has reportedly offered investors in Warburg Pincus Private Equity XI LP a discounted annual fee of 1.3 percent or 1.4 percent, depending on the amount invested. Discounts were also offered on a huge $1.8 billion commitment to The Blackstone Group by the New Jersey Division of Investment. On the separate accounts portion of New Jersey’s commitment, Blackstone will earn a 1 percent annual fee and a 15 percent carry.

Firms are also responding to the increased competition in other ways. Observed Brentwood’s Barnum: “A lot of funds have been getting smaller than their previous funds.” Examples of this include the latest fund from Providence Equity Partners, the Providence Equity Partners VII LP, which has a $6 billion target. That is exactly half the $12 billion that Providence raised for its last fund, which closed in 2007, the largest sector-focused fund ever raised. Another example is the latest flagship fund from Kohlberg Kravis Roberts & Co., which reportedly is seeking to raise $8 billion for its KKR North American XI Fund, less than half the $17.6 billion it raised for its previous fund, which closed in 2006.

Mega-Funds Lose Some Mega

One of the great nuggets of conventional wisdom in recent years has been that mega-buyout funds were fast losing popularity, as they struggled to post top-notch returns after the heady days before the financial crisis.

But the giant firms that run those mega-funds, and which built their reputations as private equity firms, were super busy transforming themselves during 2011. Most notably, Apollo Global Management had its IPO in late March and The Carlyle Group applied to go public, which it will probably do sometime during 2012.

But even as they struggled to raise new private equity funds, firms like Carlyle, Blackstone Group and KKR have been busy raising money in other ways. In early 2011, Carlyle bought AlpInvest, the world’s largest fund-of-funds manager, adding an additional $43 billion in private equity assets under Carlyle’s control. Meanwhile, Blackstone also bulked up, adding $28 billion in new assets, mostly in areas other than private equity.

As these mega firms moved to diversify their alternative strategies, they stood alone in being able to land the kinds of commitments made late last year with the Texas Teachers’ Retirement System ($3 billion each to KKR and Apollo) and the New Jersey Division of Investment (which pledged $1.8 billion to Blackstone). In each case, only part of the money is expected to be invested in each firm’s regular roster of private equity funds.

Said DePonte, “these huge commitments Texas Teachers’ and New Jersey are the beginning, not the end,” he said. And look out for the possibility of similar mega-commitments from the likes of the California Public Employees’ Retirement System, as well as China and Korea, he said.

But giant commitments to premier firms may not be enough to save many conventional mega-funds, such as KKR’s North American XI Fund. That fund, which has an $8 billion target, has been in the market for about a year, and through December, it only has been able to garner a few big checks from large U.S. pensions. So far, at least, those commitments are not nearly enough for the fund to reach its fundraising target.

The trend away from mega-buyout funds was clearly reflected in 2011’s fundraising data. Just $10.1 billion, or 11 percent, of the $90.5 billion raised during 2011 was raised by funds whose targets were at least $5 billion. These sluggish fundraising figures were reinforced by a recent study from Coller Capital, the secondary fund specialist, which reported that private equity investors were more than 10 times as likely to reduce their exposure to large buyout funds during 2012 as they were to raise that exposure.

Part of that, to be sure, reflects the relative paucity of mega-buyout funds in the marketplace. At the end of 2011, there were only eight funds that sought to raise at least $5 billion. Besides the funds already mentioned from Warburg Pincus, Providence and KKR, other mega-fund sponsors in the marketplace include The Blackstone Group, Global Infrastructure Partners, Leonard Green & Partners and Bain Capital.

By contrast, the next level of funds, those seeking between $1 billion and $5 billion, raised $49.7, or 55 percent, of all the money raised during 2011. Clearly, that was the sweet spot for fundraising, and data from the Coller survey confirms a more favorable investor attitude toward medium size funds. According to Coller, investors said they were three times more likely to raise their exposure to small and mid-market buyout funds during 2012 as they were to reduce that exposure.

Some of the most in-demand medium-sized funds that closed in 2011 were Berkshire Partners’ Berkshire Fund VIII LP, which closed above target having raised $4.5 billion, GTCR’s GTCR Fund X LP, which closed above target with $3.1 billion, and KSL Capital Partners’ KSL Capital Partners III LP, which closed above its target having raised $2 billion.

Rise Of The Mega-Sector Fund

While generalist mega-buyout funds may be out of favor, one trend definitely gathered steam in 2011: the mega-sector fund.

One reason sector funds have become more popular, placement agents said, was that they allow investors to better tailor diversification inside their private equity portfolios. Within the smaller universe of funds in each sector, star performers can more easily stand out, and it’s those funds, they said, that get funded quickly and ramp-up in size due to heavy demand.

Three such funds exemplified this trend in 2011. Consumer retail specialist Leonard Green & Partners has had a tremendous amount of momentum raising its latest fund, Green Equity Investors VI LP, which has a $5 billion target. The firm is known for investing in such famous retail brands as Neiman Marcus, RiteAid, Whole Foods, J. Crew and Petco. Green’s previous fund, Fund V, had generated a strong 18 percent IRR and 1.3x return multiple, according to June, 2011 return data from the Washington State Investment Board, one of Leonard Green’s investors. Other backers of the fund include the State of Wisconsin Investment Board, the Illinois Teachers’ Retirement System, the Ohio School Employees’ Retirement System, and the New Mexico State Investment Council.

Energy specialist Energy Capital Partners finished raising EnCap Energy Capital Fund VIII LP in early 2011. The firm raised $3.5 billion, which was more than its initial target, from such investors as the New Mexico Public Employees Retirement Association, the Minnesota State Board of Investments and the California State Teachers’ Retirement System.

Finally, software specialist Vista Equity Partners had a very strong fundraising year in 2011. Its latest fund, Vista Equity Partners Fund IV, has already exceeded its target of $2.5 billion and has snagged commitments from the New York State Common Retirement Fund, the Illinois Teachers’ Retirement System, the Massachusetts Pension Reserves Investment Management Board, the Oregon State Investment Council and the State of Wisconsin Investment Board.

But success for these mega-sector funds is not guaranteed. Performance from previous funds has to be strong, and the sectors that these firms specialize in have to be in favor. One firm that reportedly has had trouble raising money is media specialist Providence Equity Partners, which invests in such high-profile companies as the YES Network and Hulu, the video Web site. Even though its latest fund is targeting $6 billion, the firm has so far only been able to raise half that goal. Some say the firm’s current struggle has to do with its previous fund’s returns. Fund VI has so far generated a 4.9 percent IRR and a 1.1x return multiple, according to June data from the Washington State Investment Board, one of Providence’s backers. Besides Washington, backers of the new fund include the State of Wisconsin Investment Board and the Massachusetts Pension Reserves Investment Management Board.

Coming Back to Market

In the new year, several prominent firms are expected to come back to market seeking to raise new private equity funds. Among the big names likely to seek fresh capital are Silver Lake Partners, whose previous fund, the $9.3 billion Silver Lake Partners III LP, was substantially drawn down by early 2011. Another fund is likely to appear in 2012 from Apollo Global Management, whose last fund, Apollo Investment Fund VII LP, was substantially drawn down on the $14.9 billion that the firm had raised in 2008.

Two other firms likely to swing into fundraising mode during 2012 include CCMP Capital Advisors, which Buyouts confirmed was likely to come out with a new fund in the first quarter of 2012. The firm’s previous fund, CCMP Capital Investors II LP, raised $3.4 billion. Finally, Irving Place Capital, which has substantially drawn down most of the $2.7 billion it raised in 2006, is likely to return soon to fundraising table for its next fund.