Fundraising for private equity firms (PE) has certainly been challenging, given the recent market turbulence and increasing scarcity of capital worldwide. At the annual Wharton Private Equity Partners dinner, members of a panel discussed fundraising trends and offered insight into what may lie ahead.
Fund-level transparency was a key concern voiced by Andrea Kramer, managing director at Hamilton Lane, and it became a key panel theme. Other notable concerns included issues ranging from the effects of increasing acquisition-price efficiency for portfolio companies in developed countries to the fragile economic environment in the U.S. and Europe. These concerns were highlighted by Brad Atkins, CEO and founder of Franklin Park, an investment advisory firm in Philadelphia, and Tom Dorn, CIO of the Private Equity Fund of Funds for Morgan Stanley Alternative Investment Partners.
Moderator Antoine Dréan, who also is the founder, chairman and CEO of Triago, a PE firm based in Europe, pointed out that close to half of the $4 trillion raised in PE funds since 1970 went to equity buyout funds. While most of the panelists conceded that a fair proportion of their capital at present also is committed to buyout funds — both in the traditional and turnaround spaces — all agreed that they now prefer a bottom-up selection process.
As Dorn noted, "what's becoming more and more prominent is specialization. In the U.S. and Europe — highly developed markets — we look for competitive advantage…. We find that the most compelling funds have a pretty carefully defined scope of investment activity, a well thought-out set of skills, and team members to attack that kind of strategy and to demonstrate competitive advantage." Noting that those requirements trump any macro theme, Dorn added, "We're looking for lots of individual bricks, each one individually advantaged to build a diversified portfolio."
For Dorn, the process starts with finding talented managers. "Assessment doesn't start with a track record — it starts with the strategy…. The track record is a validation, not a leading indicator."
Atkins pointed out that "it really starts with picking the right strategy and then finding someone that has an edge … or that is able to source deals on the table to add value, to propel cash flow." Kramer said that at her firm, "performance does matter…. The manager trumps all. When we're doing our bottom-up analysis, we look at what the strategies are, diversifying across the portfolio, making sure that we're finding the top performers. We have very concentrated portfolios, with sufficient diversification, but concentrated in the sense that we're willing to back the best performers, best-of-breed in a big way."
Given that both Kramer and Atkins emphasized the importance of a portfolio company's track record and management team, Dréan asked whether they invest in first-time funds. Atkins' firm does, and he noted that "the challenge with them is that they're not always institutional quality…. Secondly, we don't always know the teams. You're investing with a 10-year-life private equity fund in a blind pool. You have to therefore trust the managers…. It takes years to get to know and trust a manager. Typically, when we invest in [first-time funds], we know them from a prior organization." Kramer added that "you actually have to work with [first-time funds] very carefully on setting up their own infrastructure. Without that, we don't have a great chance of making sure we can track with … transparency."
The panelists each resisted the notion of top-down manager selection when questioned about regional portfolio themes. While conceding they had a bearish view on some regions — like Europe — they all said they focus on the quality of the manager, and that opportunities can be found in nearly any market.
Emerging Markets: 'A Lot of Talk'
That said, Atkins' firm is increasingly looking to emerging markets, given the mounting efficiency in developed markets that makes favorable deals harder to uncover. Regarding emerging markets, Dorn noted that "capital flows a lot more quickly than the private equity talent pool develops, so emerging markets are where you get the wildest step-ups in fund size relative to capability." According to Kramer, "There's a lot of talk in the LP (limited partner) market about emerging markets — around chasing growth to be willing to derive yields from investments. The challenge is, when push comes to shove, nobody wants to invest in those regions…. It's good cocktail party discussion, but [LPs] don't really put a whole lot of capital to work [there]…. You need to actually be local to evaluate any of these managers and find the opportunities."
Another hot-button issue: fee structure. PE fees have generated a fair amount of bad press, with the most visible case involving Republican nominee Mitt Romney's run for the U.S. presidency, which has created an uneasy, high profile for the traditionally discreet industry. As Kramer noted, "private equity has always preferred flying below the radar, but obviously some PE deals have become so large that they can't do that." Atkins added that "there's bad press around taxation, excessive use of financial leverage and lack of transparency. There's obviously a need for good PR. Private equity does create wealth, economic development and jobs. Remember, the goal of the managers is to increase profits, and all of that is good for the economy."
With private equity payouts under intense scrutiny in recent months, particularly in terms of transparency, the discussion inevitably turned to fee terms. As Atkins noted, "In a perfect world, GPs [general partners] would be paid well and entirely out of carry [carried interest]. The market dictates fees and carry and waterfall [the order of the distribution to various investors], and we are big supporters of a fee schedule that would better align interests between GPs and LPs. But there hasn't been a very big movement in fees." That said, however, "we would rather invest with an 'A' manager that had 'B' quality terms than vice versa," Atkins stated, echoing the night's theme that quality and talent are paramount.
As tough as the fundraising environment has been, none of the panelists' firms engaged in "early bird discounts," an evolving trend of offering conciliatory fees for early investors in funds. Dorn said that the "early bird discount addresses something that's always been a problem." The most difficult thing about raising funds is making the first close, because "the first close is in no individual investor's interest. It's like a prisoner's dilemma…. An interest rate charged on the fund that accrues from the time of the first to last close has never been sufficient to compensate investors to incent them to a first close…. Maybe it doesn't have to be an early bird discount — it could also be a dramatic increase in the interest rate on the fund that's charged to late closers for the benefit of first closers. You have got to treat first closers better."
A continuing belief in PE as an enduring asset class will ultimately determine fundraising capacity, and the best way to convince capital providers is through performance, Dorn said. The prevailing industry themes going forward will likely continue to be quality managers with idiosyncratic advantages, incentive-alignment through mechanisms such as fee structure, and an ability to find opportunities in both up and down markets.