Only a few years ago, many European general partners were lucky if they were able to raise their funds in under a year. These days, many claim to be over-subscribed in a matter of weeks. To a certain extent, some of this is marketing – the more they claim to be turning away commitments, the more investors will want to commit to their funds. But for many of Europe’s buyout funds, the difficult task of turning away limited partner money has become a reality, much to the disappointment of many potential investors. “I’ve never seen a period quite like this in terms of fund raising,” says Rhonda Ryan, vice-president at the private equity funds group of AIG. “Seven years ago, access would never have been considered an issue for European funds.”
Permira reached a first close at €10bn – double the size of its previous fund – just three months after sending out its information memorandum. The fund was, the firm said in a statement, “significantly over-subscribed” and it is still finalising allocations for the remaining €1bn. Some LPs are bound to be disappointed. In the mid-market, Gresham reached a final close of £340m, an increase of £100m on its previous fund in a matter of four weeks and Chequers Capital claimed to be three times oversubscribed on its latest €600m fund – again, double the size of its last offering.
For the first time in European private equity history, investors appear to be scrambling to get into funds. “The fund raising market has been hot in terms of demand since the beginning of 2005 and access has been an issue whatever your position is in the LP community,” says Marc-Antoine Voisard of Unigestion. “It is disingenuous to say that you aren’t fighting for a place in many funds these days.” Or, as one gatekeeper puts it: “Access has become a real pain in the a***.”
“We are seeing scale-backs in virtually every fund we see,” says John Hess, CEO at Altius Associates. “Funds are rationed to new investors as we are seeing somewhere in the order of one and a half to three times more demand than the fund target for pretty much every opportunity we look at.”
In many ways, what we’re seeing in the European market is simply an extension of the experience in the US. For many years now, access to the top Silicon Valley VC funds has been near-impossible as many are raising smaller funds than previously, are inviting back only existing investors and are doing their bit for philanthropy by investing in charitable bodies. New LPs simply don’t stand a chance. Some US mid-market funds have also become invitation-only over the years as their past performance has attracted more investors – and more capital – than they can sensibly deal with.
So why are we seeing such a rush for European buyout funds now? Much of it has to do with the supply of capital. “This is being driven by the fact that institutions globally have decided to increase their allocations to private equity,” says Voisard. “We’ve seen an increase in investment from family offices and high net worth individuals, but the biggest change has been the investment in Europe by US LPs, many of which didn’t invest here before 2004. Many of them have €50m or €100m to invest per fund and it only takes four or five of these commitments to fill a mid-market fund.” Helen Steers, partner at Pantheon, is seeing similar developments. “There is a great deal more money coming into the asset class than there ever has been before as investors are increasingly searching for Alpha,” she says. “US investors are now looking at European buyouts. European investors are playing catch-up and increasing their allocations and the people who left the market are starting to come back.”
We are even seeing demand increase in the European venture capital space, although nowhere near to the same degree. Northzone V closed at €175m earlier this year, above its €150m target and with €255m of interest from investors, according to placement agent Patrick Petit of Global Private Equity. The vast majority of the money, he says, is coming from European investors.
And it seems as though LPs’ appetite for private equity will continue to increase. Nearly half of investors surveyed for Coller Capital’s summer 2006 Private Equity Barometer said they were planning to increase their allocations (48% against 44% six months earlier). Strategic allocations to private equity are set to reach record levels in 2007, according to research by Russell Investment Group, as US investors look to increase allocation to a mean of 7.6% next year, up from 7% in 2005, European LPs to 6.1% (up from 4.5% in 2005), Australian to 6.9% (from 4.7%) and Japanese to 4.5% from 2.4%.
Many of these investors will have been attracted by the stellar returns many funds, particularly those focusing on European buyouts, have achieved over the last few years. Nearly three-quarters of investors in the Coller survey reported returns of at least 11%, up from 52% in winter 2004-2005. “The years 2001-2003 were good investment periods, when funds were able to buy solid assets at low prices,” explains Ralph Aerni, senior partner and chief investment officer at Strategic Capital Management. “The years 2004 and 2005 saw an environment that many thought could not be better for exits – and 2006 is so far proving to be better still. Distributions have also been boosted by the high level of recaps we’ve seen as hot debt markets have allowed businesses to refinance on some very attractive terms.”
US investors, many of them with large chunks of capital to deploy, have also been drawn in by the increased maturity of the European market. Now that some of the larger funds have reached a certain critical mass, investing in Europe has become a much more realistic proposition for them. “We’re seeing a huge inflow of capital into Europe from large US institutions,” says Aerni. “They are attracted primarily by the returns, but also by the practical point that they can deploy much larger amounts to individual funds because they have increased in size so much over the last five years. The fact that they can write such large cheques doesn’t leave much room for anyone else.”
But size is only part of the picture. “US institutions are finding the European market easier to invest in these days,” says Ian Simpson, managing director at Helix. “Of those that used to invest here, most would commit only to a couple of the very largest funds or they would go through funds-of-funds. Now, many are able to invest directly because they have met, and are more familiar with, the GPs. The funds also have a longer track record and are able to produce better data for LPs to pore over.”
And things may well get worse for LPs – in the near term, at least. Demand has been at an all-time high at a time when fund raising has reached new records. European funds raised €71.8bn last year, a staggering increase from 2004’s figure of €27.4bn, according to EVCA. This year looks set to be similarly busy. Much of this has been mopped up by larger funds. LPs’ fund raising calendars look fairly slim in 2007 because most funds have been out on the road in the last couple of years, yet this is precisely the time when the Russell survey suggests that LP appetite will reach record levels. “Access may well become more of an issue in the near future,” says Voisard. “Next year will not be as hot as the last couple of years simply because most funds have been in the market since 2004.”
What does this mean for LPs with capital to deploy? Observers believe that some LPs are already settling for less than the best – and that suggests a potential fall-out a few years down the line. “Some people are going down to the next tier of managers,” says Ryan. “It’s a difficult question: if you have a certain amount of capital to deploy and you haven’t got the allocations you wanted with the managers you wanted to invest in, then what do you do? Do you sit on the sidelines? Clearly, some investors haven’t – there have been some funds recently that have surprised me in the speed with which they have raised.” Aerni agrees: “My impression – and it’s not one shared by every placement agent, many of whom argue that there are a lot of funds that don’t even get to the marketing stage – is that some LPs are starting to compromise on quality in order to deploy capital. In my opinion, some of the B managers have raised money much quicker than they might have done under different market conditions.”
It also means that newer investors will continue to have a harder time of it as they see the funds they would like to invest with raise money without even going out into the market. “Existing investors usually get the allocations they want,” says Aerni. “But newer investors are being cut by as much as 50%to 75%. These are the lucky ones – many can’t even get an appointment with the funds they’d like to invest in.”
To a certain extent, some investors are attempting to gain access through funds-of-funds – one of the main selling points of many managers of managers – and through secondaries, although this can only be on an opportunistic basis. But even here, LPs are far from guaranteed a seat at the table. “There are some funds that don’t want to be dominated by fund-of-funds investors,” says Simpson. “They don’t want investors that need to raise their own funds, although this is less of an issue with the well established, franchise funds-of-funds. Some GPs understandably want control of their own balance sheets.”
Indeed, with such great demand for their funds, GPs have been working out what they want from investors – a definite shift from a few years ago, when LPs were very much in the driving seat. Being an existing investor certainly helps. But GPs are looking at other issues, too. “GPs are looking for longevity,” says Ryan. “They want a committed investor base and they’re also seeking to diversify their sources of capital. Those that can choose are choosing by investor type and geography. But most of all, they are looking for LPs with whom they have had long-term relationships – and here it can be the relationship with the individual or the institution that counts. A lot of GPs are aware that fund raising may not be so easy next time around and so they want to have supportive investors.”
As a result, this is changing the relationships between LPs and GPs. For their part, many GPs have established dedicated investor relations teams to ensure a continuous communication with LPs. And investors have to ensure they have large enough teams to monitor their portfolio and relationship with their GPs. “LPs are starting to realise that investing in private equity means continuous assessment,” says Steers. “They are focusing more now on building a good, on-going relationship with managers so that they know when they are likely to raise more capital and can approach them in the pre-marketing phase and are not starting from zero. They are putting a lot of resources into this.”
Perhaps surprisingly, though, the demand for funds has not caused a huge shift in terms and conditions. There have been some changes, but many believe they are not deal-breakers. “We’ve seen the emergence of deal bydeal carry among some funds in Europe for the first time – this would never have been accepted by LPs here before,” says Aerni. “But some funds have a good argument for it: they are competing for the best people against the US-based funds that operate on a deal by deal carry basis.” Yet, on the whole, GPs are remaining mindful of the fact that fund raising may not be this easy in the future, say LPs, and so are not taking advantage of the current situation.
Most LPs can’t see access becoming less of an issue for them any time soon and that what we’re seeing is a permanent shift in favour of the best performing funds in Europe. “There is probably some element of cyclicality to this,” says Steers. “But I think we have to expect that the higher quality funds in Europe will remain hard to access, just as they have in the US.” There are a few lone voices, however, who believe we’re going through a similar period to the technology boom in the late 1990s and that we’ll see another fall-out, even if it is not so marked this time around. Aerni is one investor who subscribes to this view. “The market will change again,” he says. “This is a cyclical phenomenon. When public markets fall, some pension funds will be over-exposed to private equity because their overall allocations to public equity will decrease. In these situations, GPs will see whether their LPs behave in a cyclical manner or not. But it is almost certain that we will see, as we did in the 2001 downturn, investors leaving the asset class.”