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FUNDRAISING FRENZY: NAVIGATING PRIVATE MARKET MANAGER SELECTION

August 12, 2022  |  10 Minute Read


Amy Jupe

Global Co-Head of Private Equity Manager Selection

Amy Jupe


 

Key Takeaways

  • Established GPs are raising new funds at an accelerated pace, with the average time between funds falling below three years for the first time in a decade.
  • With a record number of funds in market and an uncertain macro backdrop, LPs have a multitude of factors to consider as they manage their private market portfolio.
  • Today’s market presents numerous challenges to navigate, but it also creates opportunities for LPs that have in-house expertise, operational capacity, and capital flexibility.

 


It is difficult to overstate the growth of private markets in recent years. Annual fundraising has exceeded $1 trillion every year since 2016, pushing dry powder to an all-time high. As 2021 came to a close, sentiment around private markets was overwhelmingly positive. In addition to strong paper gains amidst rising valuations, funds distributed cash back to investors at record levels, thanks to favorable capital market conditions. Appetite for new strategies remained high, as a prolonged shift in asset allocation away from traditional strategies and towards private markets—driven by strong historical returns—was further supported by record-low interest rates.

 

While distributions reached record levels in 2021, so did the pace of capital deployment. With pent-up demand following the pandemic-induced slowdown, general partners (GPs) have been taking advantage of favorable conditions to deploy more rapidly, leading them to return to market more quickly to raise their next flagship fund. Furthermore, many are expanding into new strategies and/or launching specialized funds focused on specific sectors and segments of the market. Today, established GPs are raising new funds at an accelerated pace, with the average time between funds falling below three years for the first time in a decade.1

 

 

A Record Number of Private Equity Funds Are Seeking Commitments

 

Source: Preqin. As of April 30, 2022

 

 

These compressed fundraising timelines have put pressure on limited partners (LPs). In 2022, a record number of new private market funds are seeking capital.2 Some LPs are finding themselves at the upper end of their allocation limits for the first time in years, or in the position of having exhausted their annual commitment budgets in only the first quarter. Recent drawdowns in public markets are also raising concerns about the denominator effect—where a decline in the total size of a portfolio (i.e. the denominator) causes the private market allocation to grow as a percentage of the portfolio. At the same time, many LPs are facing substantial mark-ups in their private market portfolio, resulting in a numerator effect that has pushed some LPs to the top of—or in some cases over—their allocation targets.

 

 

Investors Continue to Increase Private Market Allocations

 

Source: Preqin investor surveys, conducted in November 2020 and November 2021.

 

 

As private market allocations swell, some LPs are turning to the secondary market to trim their holdings and ensure they can allocate to new funds. Many LPs face resource challenges and time constraints as they attempt to assess all of their re-up commitments—let alone new opportunities. While many LPs find themselves at or near allocation limits, others are still in the process of ramping up their private market programs and striving to hit allocation targets that have been increased in recent years. In today’s crowded market, capital availability can be an advantage for LPs, as can internal resources to efficiently conduct due diligence. Regardless of their current positioning, LPs need to be cognizant of market dynamics as they develop their commitment planning and consider the terms presented by both established and emerging GPs. There is never a single playbook in private markets, but that is particularly the case today.

 

New Dynamics in the Fundraising Market

Funds took longer to reach a final close in 2021 due to the challenges of the pandemic, with the average time to close a private capital fund rising to 19 months, after being 16 months or less each year since 2015. That trend has continued early in 2022. In addition to the pandemic impeding due diligence processes, a prolonged shift towards larger fund sizes is also playing a role. Not only are fund sizes trending larger, but the average fund that closed in 2021 reached 109% of its target. That momentum has also continued in 2022, with the average fund closing at 118% of target.3

 

 

The Average Fund Size Has Hit an All-Time High

 

Source: Preqin. As of May 13, 2022

 

Funds Are Eclipsing Fund Targets but Taking Longer to Close

 

Source: Preqin. As of May 13, 2022

 

 

Even as funds grow larger, the time between fundraises has fallen to less than three years for the first time in a decade. As some GPs raise larger funds and in quicker succession, the pace of capital deployment is top of mind. Capital call rates for post-2017 vintages are faster than for funds raised earlier in the decade, which is perpetuating a cycle of quick fundraises. Combined, these trends underscore the bifurcation that has been increasing in the market for some time: top tier GPs have been able to raise capital seemingly at will, often in short order, while sub-par and average GPs are spending longer in market.

 

Most investors continue to have high expectations for the private markets, with a survey in March 2022 showing that institutional investors expect private equity and real assets to deliver the best risk-adjusted returns over the next 12 months across all asset classes.4 But investors need to be especially diligent in the current environment, as significant markups have been made to private market portfolios in tandem with the post-pandemic run-up in private markets. Given the shorter time in between fundraises, LPs have less progress to evaluate when a GP returns to market, necessitating greater reliance on unrealized returns.

 

Regardless of the market backdrop, research has found that a “current fund’s performance rank is at its peak when the GP is fundraising for a follow-on fund” for two reasons that are pertinent in today’s market. First is that “GPs appear to fundraise on the heels of good exits,” and private market GPs have set records in recent years. The second is that “low reputation GPs appear to upwardly manage valuations at the time of fundraising.”5

 

 

Private Market Funds Have Been Resilient in Market Downturns

Max Drawdowns During Market Downturns

 

Source: Fund strategies are defined and classified by Cambridge Associates. As of December 31, 2021. Max drawdown represents the peak-to-trough aggregate performance for the respective strategy during the designated period. Dot-com era is 2000-2003; GFC is 2008-2009; COVID-19 is Q1 2020.

 

 

Navigating the Market

With a record number of funds in market, shifting valuations in public and private markets, and an uncertain macro backdrop, LPs have a multitude of factors to consider as they manage their private market portfolio. The current environment and market dynamics certainly need to be considered, but private market investing is inherently a long-term endeavor that requires a mindset that looks beyond today’s challenges and considers what decisions can be made today to set a better path for the future.

 

"Top tier GPs are able to raise capital seemingly at will, often in short order, while sub-par and average GPs are spending longer in market."

 

Make a Roadmap

Commitment pacing and cashflow modeling is the foundation of private market investing and needs to be revisited at a regular cadence to ensure investments being made today match the intended trajectory of the allocation for years into the future. Some LPs today are finding that the prior commitment schedule may be too aggressive and that less capital is available than previously thought for new and re-up commitments. In these situations, rather than reducing GP relationships, some LPs have been opting to write smaller checks to maintain exposure to top tier funds and not risk losing access to the next vintage. As these adjustments are made, LPs need to assess vintage year diversification to ensure the portfolio is not overexposed to a particular part of the cycle.

 

With GPs largely dictating when new funds come to market and how much capacity is available, LPs can often feel powerless in controlling the fundraising calendar. While certain aspects will always be out of their control, LPs can be proactive with their existing GPs by discussing expectations for when new funds will come to market. In the current environment, LPs in some situations have been encouraging GPs to delay fundraises given the surfeit of vehicles in market and the desire to maintain vintage year diversification.

 

Go Line by Line

LPs need to take a fundamental approach to underwriting both new and existing GPs. Re-upping with existing GPs tends to be where LPs start, and that is particularly true today; more than half of investors are prioritizing existing relationships in 2022, up from only 10% a year ago. However, a bottoms-up analysis is needed to understand the performance of each fund in the portfolio with new underwriting for each fund, regardless of how well the manager is known. Evidence for performance persistence is lacking in buyouts, with a recent study showing that “for post-2000 buyouts, the conventional wisdom to invest in previously top quartile funds does not hold.”6 While there is evidence of persistence in VC, the people within the organization are the crucial component, with researchers finding that “the partner’s human capital is two to five times more important than the VC firm’s organizational capital in explaining performance.”7 To that end, evaluating the specific people responsible for sourcing, leading, and managing individual investments is essential to understanding how to attribute performance within a firm.

 

Not only does the GP need to be high quality, but so does the specific investment strategy. Today, the market has largely bifurcated between large, multi-strategy GPs with significant scale and smaller boutiques that focus on narrower ranges or even a single area, increasingly defined by both a geographic and sector/industry specialization. For established GPs, investors should evaluate how returns were generated in the past—leverage, multiple expansion, operational improvements, or inorganic growth—and whether the same playbook is viable going forward. Particularly for new GPs or those launching funds in new niches, the manager should be able to demonstrate why they are particularly qualified to source deals and generate differentiated performance around a targeted, well-articulated strategy.

 

For established GPs, recent activity should be compared to both prior funds and the purported strategy for the new fund to identify style drift—whether in terms of deal size, industry, region, or structure. Private equity activity is increasingly moving into technology, for example, which could leave investors with more exposure to the space than they expect. Many funds that purport to be “global” are heavily tilted towards developed markets (or even a single large country like the U.S.), while regional funds are often tilted towards specific countries.

 

"LPs should be cognizant of their competitive advantages as they vie with other capital allocators."

 

Investors should also be aware of changes in capital deployment, as a quicker investment pace can lead to more exposure to certain market environments and lessen the benefits of vintage year diversification. Many GPs are also leveraged at the fund level, which represents an added expense and can change the profile of the fund. Additionally, successful GPs often aggressively increase the target size for subsequent funds, which can not only cause a shift in strategy and position concentration but also alter incentives.

 

Understand the Fine Print

In today’s market, as many GPs are taking longer to close funds and dealing with heightened competition, LPs may be in a relatively better position to negotiate than in recent years. But even if GPs are unwilling to budge on headline terms, LPs need to read the fine print and ensure there is alignment in the mechanics of the fund operations. Additionally, LPs may be able to negotiate additional benefits, such as co-investment opportunities, that may not be codified in legal documents but hold material value.

 

Even when resources are stretched thin and deadlines loom, a thorough review of the legal documentation is required. Headline fees and terms remain little changed from historic levels, but LPs need to look beyond the management fee and hurdle to understand how fees are being calculated and expenses are accounted for. Some GPs may charge administrative fees outside of the management fee, creating additional costs that are difficult for LPs to detect. Some funds implement contractually modified or reduced fiduciary duties into fund documentation, which can lead to implicit costs.

 

Know Thyself

Much of the discussion in private markets centers on the aptitude and resources of the GP, but LPs should also be cognizant of their capabilities as they vie with other capital allocators. One thing that many LPs have in common is a relative lack of internal resources to execute on the ambitions of their private markets program. This can be particularly problematic during co-investments, where detailed diligence is required under an expedited timeframe. LPs should focus their efforts where they have differentiated skill, while forging strategic partnerships or outsourcing certain elements of the portfolio to maximize impact and scale.

 

Today’s market presents numerous challenges to navigate, but it also creates opportunities for LPs that have the in-house expertise, operational capacity, and capital flexibility to execute. LPs faced with allocation limitations need to find creative ways to allow for flexibility in their private market program to ensure decisions made today set the correct path for the future. For LPs that are under-allocated and able to make new commitments, now may be an opportunity to access GPs that otherwise may be capacity-constrained and forge new relations with the leading managers of tomorrow. 

 

 

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1 PitchBook Fund Strategies Report. As of December 31, 2021.

2 Preqin. As of April 30, 2022.

3 Preqin. As of April 20, 2022.

4 Commonfund. "Commonfund Survey Finds Institutional Investors Increasingly Cautious Amid Heightened Economic Risks." As of March 29, 2022.

5 Barber, Brad M. and Yasuda, Ayako, Interim Fund Performance and Fundraising in Private Equity (July 2, 2016). Journal of Financial Economics (JFE), Vol. 124, No. 1, 2017.

6 Robert S. Harris, Tim Jenkinson, Steven N. Kaplan, and Ruediger Stucke, Has Persistence Persisted in Private Equity? Evidence from Buyout and Venture Capital Funds (November 2020).

7 Ewens, Michael and Rhodes-Kropf, Matthew, Is a VC Partnership Greater than the Sum of Its Partners? As of July 1, 2014.

 

Glossary

Growth (growth equity) investing is a style of investment strategy that is focused on capital appreciation.

Venture Capital is capital invested in a project in which there is a substantial element of risk, typically because the project is new or expanding.

Buyouts are an investment transaction by which the ownership equity of a company or a majority share of the stock of the company is acquired.

Private credit refers to non-bank lending that is not issued or traded in public markets.

Distressed securities are financial instruments issued by a company that is near or currently going through bankruptcy.

Senior debt is debt and obligations which are prioritized for repayment in the case of bankruptcy, typically collateralized by assets.

Subordinated debt is unsecured debt that ranks below other, more senior loans or securities with respect to claims on assets or earnings, typically riskier for the bond holder.

Private real estate engages in direct or indirect involvement acquiring and financing real estate properties for current income or long-term capital appreciation.

Public real estate or real estate investment trust (REIT) refers to a publicly traded company that owns, operates, or finances income-producing properties.

Infrastructure assets refer to long-lived structures that support essential services such as utilities, telecommunications, or bridges.

 

Risk Considerations

Alternative Investments such as private equity funds are subject to less regulation than other types of pooled investment vehicles such as mutual funds, may make speculative investments, may be illiquid and can involve a significant use of leverage, making them substantially riskier than the other investments. An Alternative Investment Fund may incur high fees and expenses which would offset trading profits. Alternative Investment Funds are not required to provide periodic pricing or valuation information to investors. The Manager of an Alternative Investment Fund has total investment discretion over the investments of the Fund and the use of a single advisor applying generally similar trading programs could mean a lack of diversification, and consequentially, higher risk. Investors may have limited rights with respect to their investments, including limited voting rights and participation in the management of the Fund.

Alternative Investments by their nature, involve a substantial degree of risk, including the risk of total loss of an investor’s capital. Fund performance can be volatile. There may be conflicts of interest between the Alternative Investment Fund and other service providers, including the investment manager and sponsor of the Alternative Investment. Similarly, interests in an Alternative Investment are highly illiquid and generally are not transferable without the consent of the sponsor, and applicable securities and tax laws will limit transfers. Private Equity investments are speculative, involve a high degree of risk and have high fees and expenses that could reduce returns; they are, therefore, intended for long-term investors who can accept such risks. The ability of the underlying fund to achieve its targets depends upon a variety of factors, not the least of which are political, public market and economic conditions.

 

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Date of First Use: August 12, 2022.  279005-OTU-1614630

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