The private equity market is off to a positive start in 2004, and market players are already predicting that the year will mark a turnaround in the fortunes of the sector, but that doesn’t necessarily mean the pendulum of power has swung all the way back to general partners from limiteds.
Money is set to flow into private equity from investors that have been sitting on their cash for too long, and now have to put it to work in a hurry. If it flows in as expected, that will come as a relief to fund managers who have struggled to attract investors during one of the worst fund raising periods in the history of the market. Exits from private equity investments are also on the upswing, and the equity market rally has only added to the feel-good factor.
“When we’ve had money in our pocket, the store shelves have been bare, and when the store’s been well-stocked, we’ve been out of cash,” said one West coast-based fund manager, characterizing his last two years in the business. Now, he says, he has money to spend, targets in mind and his telephone is ringing off the hook.
That’s a dream scenario for a general partner who claims to have had a ratio of one callback for every 20 calls made to limited partners in 2003. With all these good omens, it is tempting to suggest that the pendulum of power is swinging back in the direction of GPs, who found themselves increasingly at the mercy of their limited partner investors in recent years. But there is one vital element missing for this to be the case, say the pros: returns.
After nine straight quarters of negative average returns, few fund managers have the kind of performance figures that would enable them to be more selective about whom they let in to their latest fund. And the upsurge in fund-raising activity and investment opportunities will only serve to increase competition among GPs.
“There are a lot of other options out there, so if you’re playing hard to get, investors will simply go to a different fund manager,” said David Watson, a partner at Boston-based law firm Goodwin Procter LLP.
This means that GPs will still have to be prepared to court investors and perhaps make concessions to retain their interest. In the last two years, LPs have pushed back on such sensitive issues as carried interest, clawbacks and fund governance, and private equity players expect them to continue to do so in 2004.
“Consensus seems to be that you have to go into the process with an open mind,” said a portfolio manager who has already made concessions on two of these issues in the past year.
Certainly the last two years have marked a general movement away from the bubble-era trend of GPs paying themselves a share of their profits, or carry, before they’ve paid back their investors in full. While most have cut back the amount they award themselves, the majority of funds still engage in this practice. But without a recent track record, some are succumbing to pressure to stop pocketing profits in this way.
And turnaround or no, LPs say they will continue to pressure their GPs to be more forthcoming in terms of disclosure. Too many investors have now had the experience of finding out that a fund was performing badly when it’s too late for them to do something about it, and players say it will be a long time before they can trust the data their GPs provide them with again. This is bad news for the GPs, many of which grudgingly agreed to publicly disclose fund performance last year, fervently hoping it was no more than a passing fad.
So is this turnaround that some private equity players are predicting just a case of wishful thinking? The feeling of optimism is so widespread in the market today that it is hard to dismiss it as such. It is, however, probably a touch premature.
“The market’s been so bad for so long that GPs are bound to get excited at the first bit of good news,” said the West coast-based fund manager.