Unlocking LP Capital – New World, New Approach

“Difficult fundraising market” is a phrase that has been expressed far too often this year. The private equity fundraising market is going through one of the toughest moments since private equity became a more mainstream component of LP portfolios in the final years leading up to the global financial crisis. Both GPs and LPs alike are questioning whether this is a short-term correction or a more long-term structural change. A look at the factors that have led to the current state of the market can reveal why this may be more of a medium-term correction and also provide some clues as to how to navigate the current market and unlock LP capital.

The events of 2022 have certainly changed the jargon we use to speak about the markets and brought back into our lexicon some old favourites, namely, “numerator effect” and “denominator effect”. But whilst the cycle-tested amongst us can reference working through these in the past, the difference this time around is that the industry is experiencing both effects simultaneously, with the results being quite severe. For the denominator effect, public market valuations are falling with the S&P 500, down 17% since the start of 2022, which has the unfortunate result of automatically pushing LP allocations overweight in other areas of their portfolio, such as alternatives. To compound this further, there have been limited to no falls in valuations on the private equity side (as evidenced through most industry-leading benchmarks).

Figure 1: European Buyout Fund Performance[1] 

Overlaying this is a near-decade-long fundraising boom, meaning we have a record number of managers in the market targeting their largest ever funds, record step-ups in fund sizes, and returns to market quicker than before, with higher valuations—the so-called “numerator effect”. It will not come as a surprise, then, to note that funds are taking much longer to raise with fundraising timelines being extended by 6 months on average compared to pre-pandemic levels (2019). In the first half of 2022, 48% of GPs were taking 18 months or longer to reach a final close and there are also a number of established GPs who are struggling to achieve their target fund size with paused fundraises. This has been compounded with more funds in market than ever before. Between 2020 and 2022, there has been a 71% increase in the number of funds in market but during the first half of 2022, the number of funds closing compared to the same period a year before had fallen by 44%. One does not require a degree in economics to see that a record demand for capital combined with the falling supply of capital from LPs is not conducive to a happy fundraising environment.

Figure 2: Private Equity Funds in Market[2]

Until recently, differentiation was enough to see a manager through a tough market successfully. A sector specialist would be one such example. It would at least secure sufficient interest from LPs to pick up the pen for due diligence. Beyond that, there was always the option to pull different fundraising levers to accelerate momentum, such as offering co-investments and fee discounts. Unfortunately, with 40% of capital raised over the past six months being allocated to just five funds, it is clear that these levers are no longer sufficient. With such limited restrictions on capital allocation in the alternatives, LPs are required to aggressively prioritise where funds can be best deployed and inevitably decide to back the largest and most blue-chip managers. This may explain why there has been an increasing interest in the services of placement agents by GPs, even among those who have historically had no issues raising capital.

Figure 3: Proportion of Capital Raised by Fund Size [3]

So what has worked? Whilst the institutional capital route has been difficult, managers have had increasing levels of success with investors who are newer to private equity and have a relatively less mature fund portfolio. Certain family offices and ultra-high-net-worth investors have provided much-needed capital. Beyond this, retail money has been a significant contributor to the industry over the past 12 months. We have seen managers access this market quite successfully, often with the help of an aggregating wealth manager or bank, which has led to much-needed capital. Retail money has been trying to access private equity for some time now with limited success, but the change in fundraising dynamics has helped to accelerate this process and move retail money further up the food chain. It will be interesting to see if this remains the case once the institutional market normalises in, dare I say it, more stable times.  

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Alex Odysseos is a Director in Houlihan Lokey’s Private Funds Group in London

Footnotes:

[1] Burgiss benchmarks; includes all European buyout funds by quarter. Vintages: 2015, 2016 and 2017.

[2] Source: Preqin. Data includes global buyout funds. All data as of January 2022.

[3] Source: Preqin as of July 2022. Includes global buyout funds, latest available.