Fundraising evolves for a difficult climate

SJ Berwin's James Bromley
26 October 2011

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While public financial markets remain punch drunk from the latest series of downgrades, debt crises and bailouts, private equity has, by necessity, been slowly emerging from one of its most difficult periods.

The end of investment periods for vintage 2006/7 funds has forced many firms back into a turbulent marketplace. Several well established firms are already raising new funds and a number of managers have achieved closings in recent months.

While the fundraising climate remains challenging, there is an up-tick in investor appetite from the low point of investor allocations to the sector back in 2009 - there are high hopes that this will result in increased commitment levels in H1 2012.

Traditionally, investors in private equity have had less publicly available information than their counterparts in the public markets on which to base their allocations to particular managers. Investors have fewer industry comparables and are required to take a more active role in deciding on allocations to individual managers.

Pre-Lehman and at the height of the last fundraising cycle, figures for European fundraisings hovered around the €110bn mark in 2006 - in such a GP-friendly atmosphere, investors were frequently left with little time to research new funds and their management teams before they closed.

The market now is very different. Closings are taking longer - in some cases 18 months to two years -allowing investors more time to demand detailed information and concessions from general partners. Investor scrutiny has deepened - past performance, team make-up, deal pipeline and track record have now been joined by due diligence on environmental and social responsibility, corporate governance, exit strategies for existing investments and succession planning.

Managers need to anticipate these demands ahead of time to ensure that they are properly prepared to answer the searching questions that investors will raise.

Perhaps the most tangible evidence of this shift in power away from managers to investors can be seen in changing fund terms and the growth in new and alternative strategies.

A number of managers are coming to the market with bespoke structures that differ from the traditional fund model. These structures draw from other areas of the alternative asset space and corporate finance sphere - co-investment structures, pledge funds, managed accounts, direct investment into investee companies and the syndication of assets.

Often these structures are being employed by new managers who lack the track record or detailed financial information from previous deals that are so sought after by investors. Where managers are previously untested, these alternatives provide an opportunity for investors to participate on a short-term or limited basis, without necessarily committing to a manger for a full ten-year term.

The traditional alignment of interests between managers and investors is also coming under increased scrutiny. Even amongst the well established managers, investors are demanding that new funds include a higher level of participation from the general partner, either by way of direct commitment or co-investment. . In so doing, they aim to ensure that the manager has more ‘skin in the game' and will share proportionately in any downside of the fund's performance.

Management fee levels have come into sharp focus, with large funds including a reduction in the management fee as a 'first close incentive'. Reductions can be structured either as a rebate on a proportion of an investor's total commitment or as a rebate on a percentage of the management fee itself. These incentives are not without difficulties, but several of the large funds currently in the market are placing heavy emphasis on them in their fundraising activities.

At both a macro and micro level, the fundraising market is changing - fund terms are being negotiated in minute detail over longer periods; investors are reviewing their private equity allocations against a backdrop of global economic difficulties; first time managers are attempting to gain traction for their funds in whatever way they can; and regulators are looming large over the industry in both the US and Europe.

Yet in the best spirit of private equity, managers and advisors are finding innovative solutions to adapt to, and make the most of, this changing landscape.

James Bromley is an Associate in the Corporate Finance team at SJ Berwin.