PE and the debt crisis: Coping with chaos

The Dow Jones Industrial Average Index reached 12,724 points on July 21, close to its 12-month high. It lost 10% over the next two weeks as political negotiations about increasing the US debt ceiling floundered and then plunged another 6% in the three days after Standard & Poor’s stripped America of its triple-A credit rating and left a “negative” outlook rating in its place. The pain was felt in major markets across the globe, adding to uncertainty over potential debt defaults in the euro zone.

Although the markets have since stabilized somewhat – the Dow has recovered to 11,400-point territory – concerns remain about the state of the global economy. As Jon Parker, a partner at KPMG, points out, valuations are low and so it is potentially a good time to invest money: “Private equity firms are expected to execute more deals this time around as they have a significant amount of un-invested capital.”

Wider impact

But the impact on the industry varies according to geography – Asia is clearly going to outperform developed markets – and industry segment. Any private equity firm looking to exit an investment, issue debt or raise money in the next few months will have to reassess its position. LPs may have to do the same concerning the funds they invest in.

Public listings by portfolio companies have inevitably been hit and the downgrade has impacted the amount of leverage private equity firms can secure for buyout transactions. According to Bob Partridge, Greater China leader for transaction advisory services at Ernst & Young, before the downgrade banks in the West were becoming sufficiently light-handed in financing, comparisons were drawn with the covenant-light days before the global financial crisis.

“I was discussing it with some colleagues and we all thought it was quite a scary environment,” Partridge says. “Now I am hearing that the banks have started to tighten up.”

Fundraising is particularly interesting given how much is likely to be raised this year and by whom. Prequin estimates that global fundraising could reach $300 billion in 2011, with 341 vehicles having secured $160.7 billion as of mid-August. A total of 1,721 funds are believed to be in the process of fundraising, with a collective target of $692 billion. According to AVCJ Research, 114 Asian funds are currently in the market for at least $60 billion. Fundraising for the year so far stands at $27.8 billion for 99 vehicles, most of them China-focused.

Market participants – both LPs and GPs – agree that competition for capital is intense. “Recent events will impact fundraising to a degree,” says Markus Ableitinger, a director at CapitalDynamics. “Only the GPs with very stable LP bases and who can show a few good results will do well.”

Even in buoyant Asia, a few private equity firms have extended their fundraising windows. One fund-of-funds LP says he was visited by a GP last week who announced that the final close deadline had been shifted from the current quarter to the second quarter of 2012. A partner at a Hong Kong law firm adds that one of his clients – another Asian fund targeting $2 billion – has applied the brake to fundraising because of the uncertain global outlook.

“They have no overall qualms about raising the money but they want to figure out what the situation is,” the lawyer says. “They are taking more of a wait-and-see approach.”

Notably, a host of leading US and European buyout firms are expected to launch their latest round of mega-funds in the second half of 2011 – the first time many have tapped the market for large sums of money since before the global financial crisis. The Carlyle Group, Bain Capital, KKR, Warburg Pincus, Vestar Capital, Thomas H. Lee Partners, Apax Partners, Permira, EQT Partners and BC Partners are among those tipped to seek investment alongside a host of leading venture capital players.

Market sources tell AVCJ that the buyout firms could target well in excess of $100 billion – Warburg Pincus alone is said to be preparing a $12 billion fund now that the $15 billion it raised for its last buyout vehicle in 2008 is nearly exhausted.

“The world has changed in many regards since the last run of fundraising by these large firms and this will affect how they operate,” Partridge says. “We may see more scrutiny by LPs and tougher due diligence processes given what has happened in the last few years.”

Globally, and in Asia specifically, industry participants talk of a flight to quality. Investors who would typically back a number of funds are now doubling down their bets and supporting certain players they believe have become leaders. This wouldn’t appear to bode well for first-time funds.

Responses to a crisis

A deterioration in market conditions can also force an LP’s hand through the denominator effect. Large institutional investors such as pension funds have specific allocations for different asset classes. CalPERs breaks down its portfolio into public stocks, global fixed income, commodities, infrastructure, forestland and inflation-linked bonds, real estate, and private equity. If there is a sizeable drop off in any of the first three due to volatility in the public markets, then the private equity share becomes comparatively larger. If it passes a certain threshold there is an obligation to cut back, which means less money for new investments.

The internal analysis doesn’t stop there. Although US and European pension funds – as well as the likes of endowments and foundations – remain among the most significant investors in private equity globally, it comprises a relatively small amount of their total portfolios. Strategic decisions are made by chief investment officers and trustee boards, and the smaller the allocation, the lower the priority.

“A lot of US and European investors are busy re-upping with existing managers,” says David Pierce, CEO of Squadron Capital. “At the same time, a large number of funds are being raised right now and investors are constrained in terms human resources available to do due diligence – so funds have to compete for time as much as for money.”

Another LP describes the typical US institutional investor response as following one of two threads: They become enlightened about the possibilities of growth in Asia and devise plans to leverage it more thoroughly; or they conclude that the problems in existing portfolios must be addressed and, in the circumstances, it is better to stick to markets with which they are familiar than become overexposed to markets they don’t know.

It is also suggested that capital originally earmarked for general funds might be channeled into more specialist mid-market vehicles such as distressed or secondary funds in order to take advantage market conditions.

The implications for Asia are considerable – as a source of capital as well as an investment destination. First, Asia-focused vehicles launched by the big buyout firms should not struggle to raise capital. The so-called “Asia-enlightened” LPs in US are generally seen to outweigh those who shy away from exposure to the region, but they would still rather go with a familiar name than a local fund that has no wish or no resources to engage in marketing overseas.

Second, the mega-funds launched by buyout firms shouldn’t want for subscriptions either. Any shortfall created by traditional LPs reducing allocation amounts or capital being shifted to the small and mid-market offset by the continued growth of private equity investments from international investors – particularly sovereign wealth funds and other emerging market investors, says Monte Brem, CEO of StepStone.

“These investors are typically very large so they need to commit large amounts per fund, making it difficult to invest in smaller funds. They also tend to have an affinity for the well recognized brands due to their perception that they are lower risk,” he adds.

Others note that an investment professional at China Investment Corp. (CIC) who works with a mid-market fund is unlikely to receive credit commensurate to the risk involved. Dealing with the likes of KKR attracts the attention of superiors as well as being a safety play.

The irresistible rise

The rise of the Asian sovereign wealth fund as an LP would have continued regardless of the recent market turmoil, but it is conceivable that it might now accelerate, especially if global conditions deteriorate. The perception is that sovereign funds don’t face the liquidity pressures of their institutional counterparts in the US. This certainly appeared to be the case when several took advantage of the distress created by the global financial crisis and made large investments.

Opinion is divided on the extent to which sovereign wealth funds are interventionist and pose a threat to the traditional model of the passive LP. To some market participants, these funds are only becoming more aggressive in their requests for information; they don’t seek to tell GPs how to run operations or where to place the capital. At the same time, certain sovereign wealth funds stand accused of demanding special conditions and more of say in investment strategy, which can make standard LPs quite uncomfortable.

“Sovereign wealth funds are a different animal to the traditional pension funds,” says Michael Chin, a partner at Hogan Lovells. “There are a lot of conspiracy theories about how they are reflective of their countries’ political ambitions, but the more likely reality is that it’s simply about financial return.”

It is not unusual for an Asian sovereign wealth fund to contribute 25% or more of the capital required by a regional or single-country fund and in return pay a knocked down management fee or take part ownership of the GP, earning a share of all fees and carry. For Temasek and Government of Singapore Investment Corp. (GIC), this is often part of a strategy to pursue co-investments.

Committing $500 million to a US buyout fund would command a smaller overall stake and fewer special conditions. However, one of the largest global funds raised recently – Lexington Partners’ seventh secondary fund, worth $7 billion – includes separate accounts for two investors who each committed $500 million. One of them is CIC. The sovereign wealth fund previously entered into a similar arrangement with J.C. Flowers.

According to a person familiar with the situation, the rationale was that CIC can bring value that will benefit the wider fund. “CIC is being shown large portfolios or commitments to big GPs and Lexington is going to get access to it,” the source tells AVCJ. “CIC is number one on the list of institutions people are targeting so they see some unique things.”

In this respect, it appears that momentum is gathering behind the sovereign wealth funds. Alongside a growing influence on fundraising by virtue of the large checks they are able to cut, these funds are increasingly seen as a strategic asset in themselves. And that gives them greater license to dictate terms.

“The market cannot survive without them – there is just too much money and most people regard them as prestige investors,” says Andrew Ostrognai, a partner at Debevoise & Plimpton.

The role of these funds might be weighing more heavily on the market due to their reputation for consistency in uncertain environments, but the impact will be felt well beyond a 5-7 year horizon. 

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Restructuring
• GPs
• LPs
• GIC Private
• Warburg Pincus Asia
• Permira Advisers
• EQT Partners
• Apax Partners Hong Kong