Competition heats up as private equity funds seek new capital

Apr 10 2014, 3:26pm CDT | by

Signs of momentum that began to build in private equity (PE) fund-raising in 2013 look primed to gather force in 2014. Indeed, as we described in Bain & Company’s latest Global Private Equity Report, the dynamics that are coming into focus on the supply-and-demand front suggest that 2014 could be a year of transition, marking the end of one long PE cycle and the start of a new one.

Following successive lean years when payouts from their PE investments trickled in slowly, limited partners (LPs) now find themselves in an unaccustomed new situation. For a third successive year, the cash returned to LPs in 2013 has well exceeded the amount of capital general partners (GPs) called from them to fund new acquisitions. Cash distributions are set up for more of the same in 2014 as GPs continue to aggressively harvest the $2.4 trillion worth of unrealized investments in their portfolios. Barring a big spike in new acquisitions, we expect distributions to continue to outpace capital calls.

More cash flowing in than flowing out will leave an increasing number of LPs short of their target PE allocations. In fact, 39% of LPs surveyed by Preqin, a leading PE industry data source, last December reported that their PE holdings as a percentage of their total assets under management had fallen below target. Another 44% were at target, and based on current trends, more will be likely to slip below.

Many LPs that find themselves short of their target PE allocation will be eager to pick up the pace of new fund commitments to close the gap. PE fund-raising could see a big upswing. The rebound in PE returns that helped reinforce PE’s performance edge will add to yield-hungry LPs’ inclination to increase their PE exposure. Just how much LPs will increase new PE commitments to restore their PE holdings to the balance they aim for, however, will vary widely from investor to investor.

Meanwhile, on the supply side, there were already a large number of GPs on the road as the year began, offering some 2,050 funds and seeking to raise $740 billion. More GPs will be sure to join them throughout the year, looking to tap the currently receptive market.

However strong LP demand proves to be in 2014, it cannot accommodate this abundant level of supply. To grasp the dimensions of the oversupply, Bain compared the ratio of the amount of capital GPs sought to raise with the amount they actually managed to bring in over the years. Since the financial crisis, that ratio has hovered above three to one (see figure). Even with LP interest in committing to new offerings picking up, the ratio of the amount of capital GPs seek to raise to the amount they will actually manage to bring in during 2014 will be unlikely to fall much below the 2.6 to 1 it reached last year.

The crowded and intensely competitive environment will make for tough fund-raising conditions for all but the best GPs. Those that hope to succeed will need to withstand LPs’ more exacting winnowing process. The winners in the fund-raising race will be able to demonstrate a solid track record of success based on their ability to create value in their portfolio holdings. They will be led by a stable management team with a history of success working together and a clear succession plan that anticipates changes. They will be able to spot attractive market opportunities and articulate a compelling investment strategy to capitalize on them. They will nurture differentiated strengths that enable them to generate alpha, and they will hone a repeatable model that enables them to create value post-acquisition and demonstrate an ability to execute growth strategies.

Recognizing that fund-raising is and will remain more demanding and unpredictable, leading GPs are elevating their fund-raising game from a campaign mounted every few years into a set of five integrated core competencies they refine year-round. First, the leaders carefully flesh out their long- and short-term capital needs and map out their fund-raising schedule well in advance. Second, they build an objective fact base of where they stand with LPs, using the insights from this LP due diligence to fine-tune their approach. Third, they prequalify their target LPs, work to understand their needs, objectives and vetting procedures, and choreograph their optimal LP-portfolio mix. Fourth, they sharpen their sales pitch, making their investment angle clearer, more consistent and more compelling by backing it up with demonstrable facts and results. Finally, they strengthen their investor relations capabilities to become more transparent in their communications and better at reporting on the health of their investments. Firms that can bring these competencies to bear will be better positioned than their rivals to capitalize on the recent revival of LPs’ ability to make new fund commitments and to weather the future fund-raising droughts that will inevitably occur.

Read the full report: Global Private Equity Report 2014

Written by Hugh MacArthur, Graham Elton, Bill Halloran and Suvir Varma, leaders of Bain & Company’s Private Equity Group.

 
 

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