LPs Bullish On Private Equity, But Not All Firms Reap Rewards

A new private equity industry report says 90 percent of limited partners are planning to increase their investments over the long term, but fundraising attorneys say that figure obscures a gap between the the biggest names in buyouts — who are sailing past huge fund targets — and those having a harder time hitting their goals.

Two fund managers have missed targets in the past six weeks. Billionaire Wilbur Ross Jr. raised just one-third of the $2 billion he was seeking for a new distressed fund, and middle-market investor RiverRock European Capital Partners LLP fell €80 million ($97.9 million) short of its €250 million goal. Both took heat in the press, but experts say they're just two public examples of what has become an increasingly grueling fundraising process for all but the top few companies.

A report released Wednesday by Preqin Ltd., a London-based private equity intelligence firm, shows that 44 percent of limited partners expect to make new private equity investments by the end of the year. One-third said they are below their ideal exposure, and 90 percent plan to increase their investments long-term.

That's good news for fund sponsors, who have seen fundraising come back slowly since the doldrums of 2009 and 2010. But with nearly 1,900 funds on the road — a level not seen in three years, according to Preqin — competition is fierce. And as LPs push for lower fees, faster payouts and other perks, experts say there's tension between smaller, less established fund managers forced to give in to hit their closing targets, and the elite few that can just say no.

"With this many funds in the market, you're definitely going to have winners and losers," said Bruce Ettelson, head of fund formation at Kirkland & Ellis LLP, which has closed recent pools for GTCR LLC and Thoma Bravo LLC. "LPs are looking closely at historical returns and they're looking closely at terms. For some sponsors, it's a good market. For some, it's a bit more of a struggle."

Fund managers said LPs are looking for more niche strategies, more favorable terms and a track record of better-than-average returns before they'll open their checkbooks.

Hotter Strategies

Energy and infrastructure funds are piquing investor interest, a trend illustrated by recent closes for Global Infrastructure Partners Ltd., at $7.5 billion, and KKR & Co. LP, at $4 billion. Hong Kong-based Kerogen Capital Ltd. closed its first fund, focused on shale plays, at $1 billion last week — nearly unheard-of for a first-time fund manager, even one staffed with JPMorgan Chase & Co. veterans.

Distressed strategies remain popular with certain investors, and for pension funds and insurers looking for more stable returns, a bevy of credit funds have opened their doors. Niche industries like agriculture and shipping are enjoying a surge of interest, too, said Anthony Perricone of Jones Day.

But those with a European growth focus, like RiverRock's fund, are suffering from investor skittishness around the region's teetering economy. Broad-based buyout funds are also slower to close, as investors sense that the golden geese — diamonds in the middle-market rough, with strong cash flows and lots of upside — are harder to come by.

"There's a push for funds to differentiate themselves," Perricone said. "Your bread-and-butter buyout fund will still close for the top brand-name firms, but it's harder to get noticed in the middle of the pack."

Tougher Terms

Attorneys say there has been a palpable shift in the balance of power toward limited partners. Perks that would once have been off the table are back on it. Term sheets circulated by the Institutional Limited Partners Association, an investor trade group, are more often the starting point for negotiations.

"From the pre-2008 era, the pendulum has swung in a meaningful degree toward investors," said Jonathon Soler of Weil Gotshal & Manges LLP. "The capital is still there, but investors believe they are in a position to be far more selective."

Some investors are pressing for discounts to the standard 2 percent management fee. Others want reductions to the transaction fees charged to portfolio companies. Most are walking harder lines on co-invest rights, monthly reporting instead of quarterly, protections against strategy drafts and "key man" clauses, which can require funds to liquidate if a manager leaves the firm.

Another sticking point is the waterfall distribution, which dictates how sponsors take their profits. Most U.S. funds allow private equity firms to take their cut on a deal-by-deal basis. The European model, more popular with investors, makes them wait until the entire fund is liquidated.

"When fund managers say it's a tough climate, that's what they mean," said Marco Masotti of Paul Weiss Rifkind Wharton & Garrison LLP. "It's having to respond to requests for information. It's having ILPA be the starting point for negotiations. The basic economic terms haven't changed that much, but [there is] continuing negotiation around some points."

More established buyout firms with a long waiting list of investors — or at least those than can create that perception — are better able to stand tough with pushy LPs, experts said. Smaller, younger firms may not be able to afford to leave capital on the table.

And the distance between the two classes of fund managers is growing, Soler said. A hunger for outsize returns drives investors toward the elite fund managers and lets them push for more favorable terms with the rest of the field.

"There's a group of fund managers that can say, 'We understand that this is what's common in the market, but at the end of the day, we are ready to move forward on our terms,' and there is [also] a group that can't," Soler said. "The gap between them isn't narrowing in an environment like this. If anything, it's getting wider."

The road is especially tough for first-time managers. Less than a quarter of LPs interviewed by Preqin said they would consider investing in a first fundraise. Even for a management team spun off from a well-regarded firm, that number only inches up to 34 percent.

"With first-time managers, there's a perception of weakness, and that's tough to overcome," Masotti said. "That's where you tend to see the straight ILPA line" on terms.

Better Returns

Preqin's study found investors were looking for average returns of 4 percent above market performance. Just one in 10 investors interviewed said they would be happy with a 2 percent outperformance of the market. Attorneys told Law360 that 6 or 8 percent isn't unheard of.

And while most research — including like a benchmark study published earlier this year by University of Chicago private equity experts — supports the idea that private equity as a whole beats public markets, some recent examples suggest some LPs are souring on the asset class.

A New York Times analysis in April found that the Pennsylvania State Employees' Retirement System, which has nearly half its $26.3 billion portfolio in riskier investments like private equity, reported a five-year annualized return of 3.6 percent, trailing the 4.9 percent median return among public pension systems.

Meanwhile, Georgia's $14.4 billion municipal retirement system, which does not make alternative investments, earned 5.3 percent annually over the same period and paid just $54 million total in fees — 25 times less than Pennsylvania.

That puts pressure on private equity firms, especially those outside the elite upper quartile, from whom better-than-average returns are something of a given. And as the stock market continues to strengthen — the S&P is up 10 percent year to date — it squeezes middle-of-the-pack firms more tightly.

"Top-quartile [general partners] are always oversubscribed," one Malaysian investor told Preqin. "If [you] invest with other GPs and returns are the same as public markets, why invest in [private equity]?"

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