Reversal of Fortune

Real Deals

For the best part of a decade, an elite group of the world's biggest buyout houses was embroiled in an arms race that saw fund sizes rocket to $20bn and above. Capital under management soared with each vintage, in some cases by close to 100 per cent. But demand for these Midas moneymen was so great that targets were meaningless, hard caps were smashed, and still LPs were left clamouring at their doors.

Permira's decision to effectively shrink its latest €11bn warchest by running a "managed default" process in December was, then, the clearest signal yet that the tide has turned. The firm is allowing its limited partners to slash their commitments by up to 40 per cent. The penalty for cutting back is a 25 per cent reduction in entitlement to distributions. LPs will also be required to continue paying management fees proportionate with their original investment.

"The Permira situation is very real," says one LP. "We have still not decided if we are going to take them up. The financial penalty is clear. But the alternative is not. It could be we have no choice."

Permira's situation was precipitated by a distressed cornerstone investor, SVG Capital. But every indication suggests the firm will be the first of many. Anecdotally, LPs are firing off letters to managers in all segments of the market, informing them that they will not be honouring capital calls. In one instance, the LP involved represents 50 per cent of the total fund.

The world's largest private equity investor CalPERS, meanwhile, has asked GPs to delay call downs. Harvard and the Wellcome Trust have put vast portfolios on the secondaries market as they embark on large-scale pricing exercises. The Carlyle Group has told limited partners that it will "work with them" and has pleaded with investors not to default, and GPs everywhere are locked in talks with their lawyers as they try to find "innovative solutions" to unfunded commitments.

The message is clear. The pendulum of power has swung in LPs' favour and default is no longer considered a legal, or even a reputational risk for investors. The onus is now entirely on GPs as they struggle to stabilise their capital base in the short term, and as they ready themselves for arduous fundraising conditions in the years ahead.

Bleak houses
In an environment where large numbers of LPs are unable to honour the investments that they have already made, the prospects for new fundraisings are bleak. According to Coller Capital's latest Global Private Equity Barometer, two-thirds of investors will have little or no headroom for new fund commitments by this time next year.

"For those poor souls who start fundraising in 2009, conditions are likely to be dire," says Neil MacDougall, managing partner at Silverfleet Capital.

"The fundraising environment will be tough," adds Close Growth Capital managing director Bill Crossan. "Investors are not immune from the crunch and may have their own liquidity problems."

Liquidity is just one of the challenges facing LPs, however. Others have been hit by the denominator effect. As public markets have slumped and distributions dried up, investors have suddenly found themselves over-allocated to the asset class. "Some LPs may still have plenty of cash across their investment pools but are technically over-allocated to private equity," says Thomas Liaudet, principal at placement agent and secondaries adviser Campbell Lutyens, citing examples of pension funds whose five per cent allocation has now soared to 20 per cent.

"Institutional investors previously struggled to reach their allocations, which is why listed private equity was so attractive," adds Bob Long, president and chief executive at Conversus Capital. "That situation has reversed very quickly."

This problem has been exacerbated by the overcommitment strategies employed by many LPs in the bull market. Investors attempting to scale up their private equity programmes previously struggled to get close to their target allocations because of the speed of distributions. In order to combat this, they committed more than their allocation in the belief the model would be self funding. They also had debt facilities in place to bridge any temporary shortfall. These leverage facilities have now been withdrawn.

The suddenness with which the financial health of many LPs has deteriorated has placed a singular emphasis on investor diversification. Those GPs heavily weighted to individual groups of LPs have put themselves most at risk.

Endowments, for example, which used to be at the top of most GPs' wish lists, were particularly aggressive in their private equity strategies and have been hard hit by overcommitment problems. One GP has raised capital exclusively from endowments, and has already received signals from over half that they will not be participating in the firm's next fund.

But even dedicated private equity investors, such as funds of funds, are not immune. Not only do these investors have their own potential defaulting LPs to contend with, but some have also fallen foul of the overcommitment curse.

"We are speaking to a fund of funds at the moment that raised €120m but has committed €180m," says secondaries specialist Paul Ward, principal at Pantheon Ventures.

"Funds of funds were the last of the Mohicans," adds Liaudet. "They were the last breed still actively investing. But even they are now slowing down as they realise their own fundraisings are going to be very difficult."

According to Alexander Apponyi, European partner at placement agent Berchwood Partners, over-commitment pressures may be partially eased early next year, when December writedowns of private equity portfolios go some way towards rebalancing the equation.

Pension funds and insurance companies, in particular, however, are also likely to run into regulatory pressures in the year ahead, limiting their ability to invest. For others, it is simply that their internal decision-making processes have broken down because the assumptions investment models were built on have collapsed.

Still other LPs have neither allocation, liquidity or governance issues, but remain unwilling to make commitments while uncertainty reigns. "Institutions have suffered unfathomable paper losses and until the market hits the bottom, LPs are going to remain disorientated," says Mounir Guen, chief executive of placement agent MVision.

"We are being very cautious, particularly at the large cap end of the market," adds Vincent Gombault, head of fund investments at Axa Private Equity. "We are waiting to get a better view of what is going on before deploying any money at all."

Hopes that sovereign wealth funds will be available to plug holes have also been dashed. "I initially expected SWFs to fill the gap," says Peter Laib, managing director at Adveq. "But the drop in oil price means commodity-driven SWFs feel pressure to refocus on their domestic markets."

Swimming against the current
Of course, there are investors who will continue to make commitments and private equity firms that will continue to defy the odds. In many cases, recent successful fund closes have been the result of momentum built up earlier in the year – for example, Bridgepoint, which put the finishing touches on its €4.8bn mini mega fund in November. However, ECI Partners closed its ninth fund on £430m in December, surpassing its £400m target and £255m predecessor, after just three months on the road.

And many are confident that the majority of mega buyout houses will still raise sizeable vehicles. In particular, there are those who believe that bravado will prevent these firms scaling back dramatically. Long believes $10bn will prove an important psychological barrier that big buyout firms will struggle to cross at all costs.

And Laib, for one, believes that maintaining commitment pace, and therefore diversification over time, is one of the golden maxims of institutional investment in private equity, although he concedes that many investors are now bending those rules. "It is reasonable to assume that Ebitda multiples will come down to between four and five times and that earnings will not be more than 50 to 70 per cent of 2006/2007 levels," he says. "There will be some very good deals done over the next few years, so it is hard to argue why not to invest."

Indeed, Laib believes the current crisis could provide a real opportunity for those LPs that have previously been unable to gain access to top-tier private equity firms. Coller's Barometer also appears to show that LP belief in the private equity model has not wavered. More than half of LPs expect to maintain their commitment level in 2009, while 40 per cent intend to increase it.

It is unclear, however, how many of these LP respondents have been forced to increase their targets to avoid over-allocation issues.

And despite these apparent displays of confidence, it now seems inevitable that funds will take substantially longer to raise, that many firms – particularly in the mega buyout industry – will be forced to raise smaller funds, and that some will fail to raise their next funds at all.

"There are currently over 1,600 funds on the road raising a total of $1trn," says Tim Friedman, head of publications and marketing at research house Preqin. "But we expect the total raised to fall below $400bn next year."

"Until we hit the bottom, investors will be cautious and fundraising will be difficult," adds Guen. "This is a year for survival."

Timing is all
Timing of individual house's fundraising cycles will be particularly important in determining their future success. Returns from funds invested exclusively in 2006 and 2007 are likely to be disastrous, while funds that began investing in 2005 may escape with merely average results.

Equally, funds that still have money to spare – providing they are not forced to return it – have the opportunity to make some stellar investments in the year ahead. However, dramatically extended holding periods are likely to mean these companies will not be exited in time to impress LPs the next time the firms go on the road.

Meanwhile, the length of a firm's track record will also be crucial. Provided it has shown multiple strong vintages prior to its "blip", investors may be forgiving. Newer houses, including those that spun out of well-established firms, will struggle, just as the European venture industry was capsized by the dotcom crash, while the more mature US venture industry managed to right itself relatively quickly.

Amazingly, a fresh spate of new entrants is understood to be flooding the market and looking for cash – the unexpectedly unemployed, and those seeking to put their industry backgrounds to use to buy distressed assets. Their fundraising prospects are bleak in the extreme, although most are focusing on wealthy individual backers and maverick institutions.

Ironically, statistics run internally by some LPs show that if they do manage to cobble together capital, firms created at the bottom of the cycle are odds on to be success stories of the future. Conversely, the long-term futures of the enormous number of new private equity houses that have been launched over the past two years, at the peak of the bull run, are far from secure.

Size of fund, and size of target company, will also impact a firm's ability to raise funds, as will investment strategy. There has been a marked shift in appetite away from the mega sphere. Operational turnaround investors, meanwhile, are in vogue. However, it is widely believed that Europe is thinly stocked in experienced turnaround managers, and the spate of new arrivals in the segment are being treated with scepticism.

Distressed debt has also increased in appeal, as has mezzanine, although to a lesser extent. The role that mezzanine will play in the funding of deals over the next few years is clearly recognised, but many LPs have concerns over the emphasis on IRRs, rather than multiples.

"Private equity is a very expensive asset class and I want to see real dollar multiplications rather than a nice IRR," says Stefan Hepp, chief executive at SCM Strategic Capital Management.Secondaries are also rapidly climbing the LP popularity charts.

Dog eat dog
But while some firms will undoubtedly manage to raise funds, it is clear that competition for rapidly diminishing pools of capital will be at an all-time high. Limited partners are thus in the unique position of being able to influence private equity terms and conditions. Much of the pressure that LPs are looking to exert involves unfunded capital. Permira's renegotiation of contracts is the most extreme resolution offered, but elsewhere private equity firms that are close to fully invested are offering their LPs an olive branch in terms of early release.

And institutional investors are also gaining more bite elsewhere, particularly those LPs that come into a fund before first close. Those investors brave enough to back funds early will have significant clout, as many will hold off for fear the fund falls short and they end up with an uncomfortably large slice of the pie.

One particular bone of contention for LPs looking to flex their muscles involves deal fees. Investors are keen to rebalance these costs, or even to eradicate them altogether. "These fees crept into the economic stream, particularly with the mega funds," says Long. "There is real LP pressure there, and I think LPs will be successful."

Apponyi, meanwhile, believes that LP push-back will be wide-ranging. Areas of dispute will include, he says, corporate governance protection, adjustment for writedowns and write-offs, over-paid carry rules, including claw-back and escrow, advisory board and voting rights, the right to remove GPs and broader and deeper application of key man clauses.

Opinion on the likely impact of the shift in balance of power on the two and 20 standard management fee and carry model is, however, divided. Some LPs, such as Markus Pauli of the Finnish Local Government Pensions Institution, believe the firms that cut fees will face a perception problem that lowers demand – the Veblen effect – and Llaudet agrees the fundamental economics won't change. "There won't be any real shift in terms; LPs will be more active in enforcing them," he says, citing strategy drift, which could be used as a pretext for defaulting.

And it is this apparent willingness to back out of commitments that is the most worrying spectre on the fundraising horizon – particularly when combined with the precedent set by Permira. Historically, private equity firms only withered and died after aborting fundraising following years on the road. Theoretically, this process could now be accelerated.

While few are prepared to accept such an apocalyptic scenario, still fewer believe that all private equity houses will survive this downturn intact. "The industry will be smaller and there will be fewer firms in the market," says Granoff.

"I am sure that in the large cap segment, at least one or two firms will disappear in the US and the same in Europe, over the next couple of years," adds Gombault. "When some of the biggest names in the asset class are targeting $20bn but only reaching $5bn or $6bn, there are going to be some problems ahead."