In the first half of 2011 there was a growing sense of optimism in the private equity fundraising marketplace. Private equity M&A activity was robust, financing was readily available and fund managers were able to generate a high level of exits. Returns for private equity were viewed by investors as generally having beaten other competing asset classes during the post-Lehman period. In addition, the low-yield environment was pushing investors into risk-oriented asset classes such as private equity. As a result, private equity fundraising was trending up over the industry’s (admittedly depressed) 2010 levels. Many market participants thought that a degree of normality was being re-established following the financial crisis. It might not be an immediate return to the “golden years” of private equity before the crash, but at least the historic trend of industry growth would resume.
During the third quarter of 2011, however, the improved tone in the fundraising market gave way to increased anxiety in the face of the threat of a double-dip recession, the European sovereign debt and bank crises and the resulting global market turmoil. This anxiety has resulted in investors seeking greater liquidity and lower risk over the short to medium term, with a consequential adverse impact on fundraising. According to Preqin, while US$82.8 billion was raised by the 175 funds that closed in the second quarter of 2011, a mere 97 funds closed in the third quarter of 2011, raising only US$44.8 billion. The figures themselves do not reflect another important phenomenon, namely a greater “lumpiness” of commitments, reflecting the outsized influence of a relatively small number of sovereign wealth funds and large pension funds to the success of fundraisings. At the same time, the number of private equity firms seeking to raise capital has reached an all-time high, with Preqin reporting that as of October 2011, there were a record 1,728 funds on the road seeking a combined US$706 billion (only a modest fraction of which is likely to be ultimately raised). The above trends have created an enormous supply/demand imbalance which has the potential to create a strong adverse effect on fund terms from the manager’s perspective in the case of all but the very strongest fund managers. In a number of cases, it is resulting in failed fundraisings, leading to firms going into a de facto wind-down mode.
In our view, the current fundraising climate is likely to persist for some time and reflects a fundamental change in the prospects for the industry as a whole. In particular, while some firms continue to thrive, most firms are facing declining profit margins due to trends on both the revenue and cost sides of their businesses. On the revenue side, management fee streams are under increasing pressure due to a combination of lower capital under management, lower gross management fee percentages and increasing fee offsets. In addition, a slower pace of realisations and muted returns are producing less carried interest. In addition, the very largest investors are increasingly focused on obtaining preferential access to “no fee, no carry” co-investment opportunities as part of any fund commitment as a way of investing capital with lower effective fees. On the cost side, increased regulatory and reporting demands are driving managers’ costs disproportionately higher for all but the largest private equity managers. There has been a fundamental change in both the detail and frequency of investor reporting and the recently released ILPA guidelines for investor reporting will place further pressure on the already overworked administrative functions within many private equity firms. In the US, Dodd-Frank registration and systemic risk reporting adds a significant layer of expense onto managers, and the AIFM Directive will lead to a similarly increased reporting burden on both European and, eventually, non-European private equity managers. The combined effect of the above is that many private equity firms are facing substantially compressed profit margins.
A typical pattern in a maturing industry facing declining profit margins, stagnating growth prospects and an excess number of industry participants is consolidation in an effort to exploit economies of scale and tap into the advantage of being able to cross-sell complementary products. In our view, the private equity industry is likely to follow this pattern.
Another driving factor for change within the private equity industry is that the industry is becoming a capital-intensive business, both for working capital to fund product line and geographic expansion (particularly in emerging market economies that offer the potential for significant growth but require significant initial setup costs) but also to fund the firm’s capital commitments to new funds, particularly as investors seek to create an even greater alignment of interest between themselves and their managers. With so much firm capital tied up in unrealised investments in existing funds, many firms are seeking to bolster their capital base by taking in strategic investors, going public or being bought out by a larger firm.
Equally, as private equity firms mature, succession issues will drive a need for exit opportunities for founder partners. In such circumstances it is difficult to see how founders can maximise the value of their interests through some sort of transition to the next generation of professionals as compared to the alternative exit routes of either selling their interest to an outside party or seeking an IPO.
In addition, we expect that the increased demands of diligencing and monitoring manager relationships will lead investors to have fewer relationships and place bigger bets with those relationships so as to reduce internal costs per fund and maximise negotiating leverage to reduce fees. We would argue that examples of the latter can already be seen through the increased number of “managed account” relationships that a number of the world’s largest investors are seeking. In addition, the move towards fewer relationships has already started to arise. For example, New York City Employees’ Retirement System (NYCERS) recently announced that it expects to cut the number of managers with which it invests by around one-third. The California Public Employees’ Retirement System (CalPERS) has also announced a similar review that is expected to result in a substantial reduction in the number of its private equity manager relationships.
In our view, each of the above factors will drive consolidation of assets under management toward those firms that have “institutionalised” themselves by developing a professionalised marketing and investor relations function, maintaining a strong balance sheet, undergoing some form of succession planning themselves and establishing a broad-based product platform that will appeal to the largest investors who are seeking to consolidate their own manager relationships. Likely beneficiaries of the above will include large diversified institutions such as Apollo, Blackstone, Carlyle, KKR, Oaktree and TPG.
Furthermore, each of the above firms either has gone, or is seeking to go, public and therefore gain what are arguably key competitive advantages in terms of having permanent capital to build up their businesses, the ability to make acquisitions of complementary managers using stock as an acquisition currency, an additional form of compensation to attract and retain the best professionals and an exit route for founders that does not shackle the business. Of course, the appeal of these businesses to the public equity market is enhanced through the diversification of their base of assets under management and revenue streams. Hence, these firms have a desire to consolidate with other alternative asset firms in a “win-win” transaction.
Inevitably, the above changes are likely to have a significant impact on law firms serving the industry. In our view, the success of law firms will to a large extent depend upon their relationships with those firms that are the survivors in the industry consolidation process (the “consolidators”). Inevitably, consolidators will look to engage their “house” firm on both the acquisition of other alternative asset businesses and (as the consolidators look to integrate the acquired businesses) the fundraisings by those acquired alternative asset businesses. However, even those law firms that currently act for the consolidators will face challenges. In particular, the ability of a law firm to retain consolidators will be dependent on the diversity of the law firm’s fund product offering (which may potentially need to cover private equity, hedge, real estate, and debt products as well as provide tax and regulatory coverage) and its geographic platform, particularly in the key financial centres (Hong Kong, London, New York). In short, the fund product complexity and geographic diversity of private equity consolidators will need to be matched by their law firm providers. In this regard, we believe it is no coincidence that the recent lateral hirings in London by US firms of a number of leading private equity fund formation specialists has taken place at a time when the changes in the private equity industry described above are occurring.
Of course, the skills that law firms will need to possess extend beyond the fund formation skill set to include a strong capital markets platform (eg, to handle IPOs of fund managers) coupled with a public company and M&A capability well versed in the unique issues of the private equity industry. Also, the sheer number and array of fund product offerings of a private equity consolidator will result in a need for significantly greater resources from its preferred law firm. In particular, law firms will need to embrace multi-partner client management as well as a culture and business model that facilitate effective collaboration within practice groups and across multiple practice disciplines. Additionally, as market conditions remain tough, managers will seek out the best legal negotiators with the best market knowledge as managers strive to find an “edge” versus their peer group in investor negotiations.
All of the above dynamics are going to result in a continued demand from law firms for the very best private funds lawyers. In our view, the recent mobility in the UK market will be replicated elsewhere. That will mean that the lawyers featured in this edition of The International Who’s Who of Private Fund Lawyers will not only be sought after by the private equity community but they will also have great appeal to those law firms who are seeking to attract and retain private equity industry consolidators as clients.