Capital overhang and the potential for growth in the private equity market

22 April 2003

Tweet
Facebook
LinkedIn
Google plus
Send to

There has been much discussion surrounding the issue of capital overhang in the European buyout market, says the working paper The Private Equity Forecast: An Assessment of Capital Availability and the Potential for Growth in the Buyout Market by IE Consulting, an affiliated company of Initiative Europe. In essence, the ever increasing pools of capital raised have led to the supposition that there must be a substantial pool of excess capital developing in the market, exacerbated by the falling investment rates of the past two years.

Historic development

The much-mooted belief that there is too much capital chasing too few deals, has many negative implications, not least that increased competition will push up entry multiples, negatively impacting returns, and that this additional pressure on investors may lead to questionable investment decisions. From the institutional investor perspective, the supposed existence of a capital overhang suggests that there is a large pool of institutional money lying un-deployed in the market and that GPs are experiencing difficulty in putting this capital to work. The fear amongst institutions that further investment into the asset class will simply swell the reservoir of un-invested capital that already exists, together with the fact that existing committed capital is failing to distribute a return on investment, has led to reluctance amongst institutions when it comes to signing off new investment decisions.

Numbers show that the rolling two-year compound annual growth rates for fundraising, investment and the pool of available capital have consistently marched in step since 1998, showing the balance between supply and demand that has underpinned the market over the past five years. Further results indicate that the pool of un-invested capital in the European buyout market has represented a consistent proportion of investment activity since 1997 while it has actually declined as a proportion of fundraising activity. This would suggest that aggressive rates of investment activity have kept the growth of the pool of available capital in check. Although the actual pool of available capital appears to have been expanding fairly aggressively, its growth has remained commensurate with the actual development of the European buyout market. Therefore, despite speculation regarding the excessive pool of capital within the European market, it would actually appear that the level of available capital is very much in line with the size and maturity of the buyout market as it currently stands.

In addition, the pool of available capital in the European buyout market and its annual percentage growth. In 1997 it experienced its largest ever growth spurt, as the European market saw fundraising activity levels almost double, boosted by the first of the EUR 1bn+ fund launches. The pool of available capital continued to register positive growth, although at a much slower rate, right up until 2001. The consistent period of growth between 1994 and 2001 is not surprising given the year-on-year increases in fundraising activity during this period. However, growing levels of investment activity in the bullish European market in the 1997-2001 period smoothed out any further dramatic peaks in the growth of the pool of available capital.

Drivers of European fundraising capital

In order to establish whether or not the pool of available capital is likely to grow or decline in the future, it is essential to understand the drivers behind the historic development of the European buyout market, both in terms of investment and fundraising activity. Two drivers behind market growth over the past decade have been escalating fund sizes and geographic patterns of fundraising. Starting with a historic overview of the market, the following section will examine each of these trends and how they have impacted the growth of the pool of available capital.

The European buyout market has evolved considerably during the past decade, with fundraising reaching its record-breaking peak in 2001, when EUR 34.5bn of capital was raised. The statistics clearly display the main periods of growth over the past decade, with 1994 and 1997 producing significant peaks in fundraising activity. The rolling compound annual growth rate shows that, although fundraising has undergone year-on-year increases since 1995, the actual growth in European fundraising has slowed considerably since the height of 1997, with 2002 showing the first actual decline in funds raised by vintage year since 1994.

A key driver behind the growth in the amount of capital raised for investment in the European buyout market, and the associated pool of available capital, has been the ability of groups to take advantage of growing institutional appetite for private equity by launching ever larger fund vehicles. The acceptance of financial buyers at the higher end of the European M&A market has created deal flow opportunities for buyout houses, which have sought to raise fund pools sufficient to supply them with the fire power required to take advantage of investment opportunities at the upper end of the deal value spectrum.

Growth potential 2003-2004

Levels of fundraising and investment activity fundamentally drive the development of the pool of un-invested capital in the European market. The fact that high levels of fundraising have been matched by a strong growth trend in investment activity has meant that the European buyout market has maintained equilibrium in terms of the pool of un-invested capital. The European buyout market has continued to grow steadily in value since the mid 1990s, when the recessionary conditions began to ease.

The current pool of available capital could sustain investment activity levels in 2003 at a reasonable level, even if the amount of new funding raised during the year remains modest. However, significant erosion of the pool of available capital together with a low level of new fundraising activity would have serious implications for investment activity levels in 2004 and beyond. Should fundraising activity remain low in 2003, the amount of capital that would be required to maintain investment activity levels in 2004 could be un-achievable high, as the pool of available capital becomes dangerously eroded

Potential equity investment value ranges were be predicted as follows for the years 2003 and 2004:

Best Case Scenario:

A 19-29% increase on 2002 levels of investment to EUR 23.9bn-26.1bn in 2003 and a 31-35% increase on 2003 levels of investment to EUR 30.2bn-35.3bn in 2004

Worst Case Scenario:

A decline on 2002 levels of between 4-15% to EUR 7.1bn-19.3bn to 2003 and a modest increase of between 7-17 % on 2003 levels to EUR 8.4bn-22.6bn in 2004.

Mid-Range Scenario:

A representing a possible decline of up to 4% on 2002 levels or an increase of up to 18.2% to EUR 19.3bn-23.9bn in 2003 and an increase of between 17-30% on 2003 levels to EUR 22.6bn-31.1bn in 2004.

This is an excerpt of the recently published qualitative and quantitative 111 pages strong working paper The Private Equity Forecast: An Assessment of Capital Availability and the Potential for Growth in the Buyout Market produced by IE Consulting. The paper considers whether capitals overhang exists and how, if it does, it might affect levels of activity and competition in the market going forward. If you wish to learn more about this report or other services provided by IE Consulting please contact:

Hazel Clapham, Private Equity Consultant, Email: hazel.clapham@ieconsulting.co.uk, Tel: +44 1737 784 207.