Fundraising: Heavy traffic ahead

Even though macroeconomic indicators and the level of private equity activity have notably improved throughout 2010, there are still a number of issues that could affect the fundraising environment going forward. Firstly, calls to LPs have been on the rise as private equity firms began completing deals on a regular basis once again - including significantly large ones - after an extended period of subdued activity. This should be good news for the industry, but distributions have failed to catch up as Antoine Dréan, founder and CEO of placement firm Triago, notes: "One of the main drivers in fundraising is the level of distributions. Until there is a substantial flow of distributions from funds to their LPs, it is unlikely that we will see large commitments coming from investors."

Dréan highlights some of the factors which are hampering distributions: "Many investments made during the boom years of 2005-2008 are not yet mature and a disturbing percentage is underwater. So many are not yet ready for sale. Besides, exit markets in general are still tough, except for very high quality assets with relatively modest levels of debt." Coupled with the large amount of dry powder still waiting to be deployed by GPs, this could further delay fundraising for a significant number of players.

If GPs manage to overcome both the capital overhang and the challenge of returning money to their investors, some fear that a sudden influx of firms raising could exceed LP appetite for the asset class. Concerns about regulation and a cautious outlook on the macroeconomic environment going forward have taken their toll, as a large number of investors are either fully allocated already, with some even looking to reduce their exposure to private equity.

Even large funds managed by established GPs are expected to work harder to meet their targets - LPs might still be drawn to big name brands, but Dréan observes that ticket sizes are tending to shrink: "Some big funds have managed to raise large amounts recently, but they often have very broad LP bases and/or exceptional track records. Even then, it is not easy to meet a fund's target; raising $5bn or $10bn today requires many more LPs than was previously the case."

That said, the general consensus seems to be that the asset class is still an attractive one and there are pools of available LP money to be tapped into - notably in Asia, Australia and, to a certain extent, the Middle East. But, given the substantial amount of funds to choose from, investors will understandably get picky. Track record is vital here, as the downturn acted as a litmus test for outstanding teams able to create value in tough times.

However, LPs are also likely to see past the raw numbers and really look under the bonnet. "Investors today are increasingly selective," notes Dréan. "They will tend to analyse performance in-depth. They will study where the value is coming from, whether it is from operational improvements and sound management or through pure financial engineering. The latter might not attract many commitments."

Differentiation is also expected to play a major role going forward. "The market risks getting crowded with too many "me-too" generalist mid-market funds, failing to offer a distinct strategy to LPs" warns Dréan. Investors are increasingly attracted to emerging markets opportunities and looking for less mainstream strategies in Europe and the US. Turnaround players could have a chance to stand out from the crowd, as would teams with proven operational know-how in a particular sector.

What will happen to funds failing to attract LP interest remains to be seen. There has been much talk among market observers regarding an upcoming "private equity shakeout" which could see up to 50% of active players disappearing over the next few years. "It is hard to be so definitive. The private equity cycle is very slow paced, and most GPs can delay their fundraising while still getting management fees - unlike hedge funds, they will not fold overnight. Besides, that figure does not take into account the number of new teams that will emerge to better meet the LP appetite for differentiation" says Dréan.

While substantial changes to the private equity landscape will take a long time to materialize, it is likely that only the most successful and singular GPs will emerge unscathed from the heavy traffic ahead. As Dréan concludes: "2011 should be a pivotal year; we will progressively see who really has what it takes to stay in the game in the long run."

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• Fundraising