End of the line for large cap funds...

Despite the much publicised problems that affected the market throughout 2008, private equity fundraising figures remained surprisingly buoyant. Indeed, according to data published in the unquote" European Fundraising Review 2009, the amount of capital raised over the course of the year was almost 50% up on 2007 at just over €96bn. The vast majority of this sum was raised by large-cap vehicles, with 22 €1bn+ funds holding a close over the twelve months - up more than half on the preceding year.

While this may at first appear counter intuitive considering that this area of the market bore the brunt of the troubles, it is merely a result of the usual lag shown in fundraising figures compared to investment trends. In the final quarter of the year, as the shockwaves from the collapse of Lehman Brothers began to reverberate through the industry, UK-based Permira revealed a glimpse of the future by downsizing its €11.1bn fourth fund, a record-breaker when it closed in 2006.

Liquidity issues
Permira led the way because of its unique relationship with SVG Capital, a semi-captive listed vehicle that emerged from the ashes of Schroder Ventures alongside the buyout house in 1996. SVG, which commits around 80% of its capital to Permira vehicles, publically expressed concerns in November regarding its ability to meet future draw-downs, prompting the latter to announce later that month that all LPs would be given the option of capping their commitments at 60%. Given that the fund was already more than half spent, this equated to a sharp drop in future capital calls (in the case of SVG uncalled commitments dropped by more than two thirds to just under £344m).

But though Permira's situation was ahead of the curve, it is by no means atypical and liquidity issues amongst LPs, especially those that are listed, have become one of the major talking points in the market. Alongside the much discussed 'denominator effect' - when an LP over-shoots its target allocation to illiquid asset classes because of a fall in value in its liquid portfolio - much of this chat is centred on the difficulties caused by the poor exit environment. "Many LPs have employed an over-commitment strategy in recent years, using returns from distributions to finance further commitments. All of a sudden these commitments are looking far more precarious from a funding perspective, especially if the underlying vehicle is geared," explains Jim Strang, director of fund investments at Dunedin Capital Partners.

Within the first three months of 2009 another high-profile casualty had been found in Candover, the trail-blazing UK buyout house that was one of the pioneers of the asset class when it was founded 28 years ago. The firm was raising a €5bn vehicle that had held a €2.8bn first close in August 2008; €1bn of which came from the investor's listed arm, Candover Investments. The latter has since inevitably hit the liquidity wall and announced in March that it would not be able to meet any further draw-downs - putting the future of the firm in doubt as it struggles to restructure the fund.

Moreover, it is not just firms with a liquidity-starved LP base that are suffering; even solvent investors are beginning to apply pressure to large-cap general partners to reduce fund sizes. With debt financing remaining scarce and the ongoing lack of a syndication market making leverage quantum modest when it is available, dealflow at the top end of the value spectrum is likely to remain sparse and the bloated vehicles raised over recent years will struggle to deploy their capital reserves. "It makes sense to downsize at the moment; GPs raised mega-funds to do big deals and now they are just sitting on that management fee," comments Urs Wietlisbach, executive vice chairman of Partners Group.

Changing the (track) record
However, though downsizing does indeed seem to make sense for larger investors in the current climate (and in the cases above there was little other option), it does pose fundamental problems for GPs. Specifically, it increases the exposure of the vehicle in question to boom vintage investments, most of which will be struggling under the weight of too much debt amidst declining trading performance. "Large funds are currently being posed big questions and it almost seems as though they are damned if they do and damned if they don't," opines Strang.

But he is also keen to note that these firms have "some of the smartest and most capable people in the business working on the answers", and indeed anecdotal conversations suggest that there are some creative solutions being worked through. One of the more drastic (and controversial) of these could see GPs writing off an older fund that is almost fully invested and under water; buying the salvageable assets back at attractive prices with a newer vehicle. This tactic - which effectively constitutes a revival of financial engineering - is, however, tricky, as it is unlikely that LPs will be overly enthused with the notion of taking from one hand to give back with the other. Moreover, for those that are invested in the first fund and not the second, they are simply going to lose out altogether.

If this is far fetched, and for those that don't yet have a later fund to fall back on in this way, techniques are apparently being developed to change the perception of the performance in the current vehicle when it comes time to raise the next. The idea centres around the much maligned 'fair value' accounting standards, which have until now been broadly seen as a hindrance to private equity managers. "Though many GPs are under pressure to write down at the moment, some of the reductions are just ridiculous. But if they write down by more than may be required now - when everyone is expecting bad news anyway - they can come back later when they are in fundraising mode with an improvement in NAV and argue that they did well," explains Wietlisbach.

Limited options
Even despite such lateral thinking, though, the problem remains that if LPs believe the large-cap model to be broken raising a new fund will be impossible, whatever PR tricks GPs manage to pull off with their track record. Indeed, sentiment surveys amongst LPs show a movement away from the large buyout space towards smaller value ranges and areas such as special situations and secondaries, as well as away from traditional Western market strongholds and into emerging geographies.

Easily said, but difficult in practice. Taking small- and lower mid-cap buyout value ranges as an example, there is an argument that any opportunity here is limited in terms of scale. "Historically, successful funds have invariably become larger as they have launched subsequent vehicles. However, there is an increasing trend of smaller GPs saying 'this is what I do', and rather than seeking aggressive growth in the size of their funds, they are examining the possibilities of raising vehicles to focus on adjacent strategies" notes Strang. Furthermore, as some of the successful fundraisings at the end of 2008 show, successful GPs in these areas of the market typically have a committed incumbent investor base that provide the majority of the capital in new offerings.

In addition, a small but increasing number of LPs are warning against joining the bandwagon that is currently rolling into areas such as special situations or secondaries with abandon. To some degree this is simply a reaction to the over exuberance of the past, which has seen many investors get their fingers burnt as a result of herd mentality. That is not to say that there will not be opportunities in secondaries/special situations in the coming months, but questions remain over the size of the window in which to exploit them. "It is a bit of a head scratcher at the moment in terms of where to put money - generally if people are saying 'this is the place to be' then it usually isn't," says Strang.

Size is everything
The implications of these limitations could represent a saving grace for larger buyout houses. Major LPs that are looking to maintain their allocation to private equity, particularly in light of the fact that most of the alternatives have suffered as bad if not worse over the last twelve months, may have little choice but to continue to target this space due to the limited options available. Indeed, for institutions with a substantial allocation to private equity, the ticket size of smaller funds is too small to be workable even leaving aside the problems of scale. And fears that investors may ditch Western economies in favour of growing emerging markets could end up being largely unfounded, as leverage, and subsequently dealflow, are perhaps even harder to come by in these areas.

These are, however, long-term arguments and in the short- to medium-term larger houses are going to be fighting to survive. The market is likely to remain closed in terms of new deals for some time yet due to the dearth of debt; incumbent portfolio's are in decline and are eroding potential earnings; and LPs are currently not writing the sort of big tickets needed to close a new fund and move forward. "There will be room in the future for larger funds and transactions again -just not now and probably not on the same scale. Some firms will ride out this storm and get stronger and others will disappear altogether; there are no guarantees which side of this quality names will fall," Wietlisbach comments.

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