Winners and losers

The private equity picture becomes clearer. Selwyn Parker speaks to Kirk Radke


Private equity is turning into a sellers’ market – sellers of capital, that is.

Burned by the financial recession, as some were, the usual investors in private equity are taking longer than they once did before allocating capital to firms, because they want to know more about the houses that are taking responsibility for their money.

The good news is they’re still investing.

That’s the view of Kirk Radke, private equity specialist at 101 year-old global law firm Kirkland & Ellis. “Limited partners are making more disciplined analytics of houses, both external and internal,” he says, as the funding market begins to free up in the post-crisis era and the winners start to emerge.

As Mr Radke explains, potential investors who are investigating factors like the stability of buy-out firms’ management teams are wary of those with high staff turnovers. “It gives them reason to pause because it raises succession issues,” says the private equity legal specialist.

A firm’s external performance, judged by its success with portfolio companies, is also coming under much closer scrutiny. The big question is whether a firm is doing better or worse than the economy at large as well as in relation to its peers. “Investors are looking for value added to the real economy more than they once did,” he adds.

In the meantime, the pecking order for the rest of the decade is slowly emerging as investors work through their analytics and make their decisions. Mr Radke sees the process as a re-run of the years 2003-8, when a number of firms emerged from a very large pack simply through their superior performance. “We’ll see that process repeated in this coming cycle,” he says.

It’s the more thorough scrutiny by potential investors of private equity’s shop window that has contributed to the slower flow of funds into the sector, even if temporarily. Clearly, it’s harder to raise capital than it was three years ago. According to Prequin’s latest quarterly survey of the first three months of 2011, funding is still scarce. In fact the $46.1bn raised in the period is down by $1.4bn on the corresponding quarter in 2010 and, of course, wildly down on the record second quarter of 2007, when nearly $212bn was collected.

Caution, not fear
However things aren’t as bad as they may seem. Although last year did not conform to the trend, first quarters are often slower than later ones as investors take stock of the opportunities and plan strategies before plunging into the market in later months.

Geography also makes a big difference in the wider funding picture. At this stage most of the winners are found in an increasingly confident America. About four times more capital ($28.5bn) flowed into the private equity pot in America than it did in Europe ($7.7bn) and nearly three times more than in Asia and the rest of the world ($9.9bn). The three largest funds in the global market are all American – Blackstone (real estate), KKR and Providence Equity (both buy-outs).

A deeper look at the funding picture suggests that the crisis, while leaving its mark on investors’ appetite for private equity, has not scarred them. Of the 4,300 investors tracked by Preqin, only 1,500 are definitely out of the market and the majority of these will be absent temporarily. Many have frozen private equity funding for six months but intend to reinvest in due course. Dai-Ichi Life Insurance placed its investments in alternatives, including private equity, on hold in 2008 – but expects to start making new commitments this year to the tune of $50m.

“A third of the 1,500 missing investors are therefore set to return to the asset class within the next couple of years,” Prequin points out.

Perhaps more importantly because of the greater mass of capital at their disposal, only 28 percent of pension funds – both public and private – intend to sit out the market this year. In many cases that’s not because of a general disenchantment with the sector but because they are required to get their investment percentages back on track. One such fund is Teachers Retirement System of Louisiana, which has earmarked $245m for private equity in 2011 (rather than the more than $1bn it set aside in 2010) because it has exceeded its mandates.

Secondary clues
Meanwhile, a busier secondary market tells us something about who’s winning and losing, and Mr Radke believes the secondary market may become much bigger in the future. Current activity is prompted partly because liquidity has become a prime concern of investors as they unload under-performing assets or because they’re sticking to ratios in a more disciplined way. Indeed, more than half of all investors trading private equity stakes gave liquidity as the main reason for doing so.

And although about a quarter of investors traded on the secondary market because their private equity stakes had gone south, that hardly implies widespread dissatisfaction with the sector so much as a sensible desire to divest unproductive assets. Just 17 percent of the 4,300 investors surveyed by Prequin said they were “no longer investing in private equity.” The rest will rejoin the sector in due course.

“Limited partners [LPs] are managing their own liquidity profiles better than they once did,” Mr Radke says. “But most LPs will remain in private equity. They will be perfectly willing to take what is an illiquid position in the sector because the ultimate return more than justifies them doing so.”

Identifying trends
Another factor in the always complex liquidity equation is the more onerous capital rules that will be progressively imposed on banks under Basel III, especially the bigger institutions that have provided big chunks of private equity funding. “The big question is where does private equity funding fall in banks’ priorities now,” says Mr Radke. “Everybody is watching without knowing exactly what will happen. It’s very important to monitor, but too early to tell.”

Another burning issue in private equity is in which industries will the winners operate. So far this year some sectors – healthcare in particular, which accounts for three of the biggest funding deals in the first quarter – appear to be more popular than others. A healthcare fund run by Chicago-based Waud Capital collected $463m, a whole $113m more than it was looking for, possibly because of the success of healthcare flotations such as that of hospital group HCA Holdings for $2.8bn in mid-March.

However, warns Mr Radke, it could be misleading to suggest that investors are looking for buy-out houses with specialist sector expertise: “I don’t see that there’s one favoured industry. It depends on the nature of the limited partners. Some classes of LPs are sector-focused while others are region or globe-focused. The excellence of the firm will be the main determinant in who attracts the funds.”

Underlining this point, Bessemer’s latest venture fund, which invests across numerous sectors and geographies, also ended up with a bigger pot than it was seeking – $1.6bn instead of $1.5bn. Similarly, the top 10 funds that closed in the first three months of 2011 defy easy classification. The biggest pot was collected by Encap’s natural resources fund with $3.5bn, followed by GTCR Golder Rauner’s buy-out fund ($3.25bn) and Baring Asia’s balanced fund ($2.46bn). The remaining seven included early stage funds (Yungfeng Capital), real estate (Blackstone) and general venture (Insight).

And although the healthcare sector saw three of the biggest 10 private equity-backed deals in the first quarter, the rest were in media (America’s Citadel Broadcasting sold by JP Morgan), energy (Australia’s Alinta Energy bought by TPG) and power, materials, IT and telecommunications.

It is, however, possible to say that some sectors leave investors cold. The least-supported areas, according to surveys, are distressed debt and infrastructure – probably because there’s little left in the former category that’s not been thoroughly picked over, and even less in the latter that’s not overburdened by expensive debt.

In the meantime, the roadshows say a lot about investors’ appetites for private equity. More specifically, it’s the time it takes to fill the pot, and the latest figures augur well. Some 40 percent of the funds closed so far this year filled up within 12 months of the partners going on the road, while 62 percent were full inside 18 months. Only 17 percent took longer than two years.

However, as Mr Radke explains, time spent wooing investors is only half the story in private equity’s fast-changing world. “There’s the official time [the road show] and I believe it will become shorter than it was over the last couple of years because the climate is improving,” he says. “But there’s also the unofficial one of investor relations, because LPs want more transparency, more discussion.”

The winning firms in the next few years will be those that set out not only to fill the pot but also engage investors in a continuing dialogue about financial performance and other matters of concern to people with $500m or more in the game. “The information flow will be much akin to the way publicly listed companies report,” says Mr Radke. “It’s a logical progression.”

Having witnessed several private equity cycles, Mr Radke is in no doubt that for the stand-out performers at least, the intense debate over the last few years about private equity’s charges will die down. Typically one or two percent fees plus 20 percent of profits (but no share of losses), charges have been criticised as excessive. It may well be that the less well-respected firms will be forced to meet the market and reduce fees, but that won’t apply to the winners.

“There will be specific negotiations on fees as part of the fund-raising process but good firms will attract the same economic terms as before,” Mr Radke suggests. “We’ll see a flight to quality: ten years ago there wasn’t a lot of differentiation between firms but you’ll see that process of differentiation happening all over again.”


For more on Basel III please see here.