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By Michael Mueller
CFA, CPA, Deputy Chief Investment Officer, Oregon State Treasury


Private Equity Fundraising in the Current Economy

"It was the best of times; it was the worst of times." This classic line from A Tale of Two Cities describes the dramatic shift from "the golden age" of private equity investing, in recent years, to the dire situation facing general and limited partners today. To put the drop off in some perspective, the most recent data from Preqin shows that total fund raising for private equity in the first quarter of 2009 totaled just $49 billion. This compares to $161 billion raised during the first quarter of 2008, a year-over-year decline of nearly 70 percent. Of course, the figures are subject to the usual vagaries of private equity markets, most notably, the number of funds in the market and the types of funds being raised (e.g., large buyouts versus venture capital). However, by almost every measure, the general decline has been significant. While most public pension funds and endowments remain committed to the asset class for the long-term, the near term environment will prove to be challenging on several fronts.

The causes of the decline are several fold. The most often cited reason is the denominator effect, whereby valuations of private equity investments are "sticky" downward, due in part to less frequent marks, in contrast to public investment values which can fall instantaneously and are marked daily. Thus in down markets, the denominator (total fund value driven largely by its public investment holdings) falls faster than the numerator (private equity valuations). For the Oregon Public Employees Retirement Fund (OPERF), private equity has a target allocation of 16 percent of the total fund, with a range of 12 to 20 percent, based on fair market value. To demonstrate the impact of the denominator effect on OPERF, private equity represented approximately 15 percent of OPERF at the end of January 2008. One year later, the actual allocation was just under 23 percent, or three percent over the target allocation range. To a large extent, as general partners complete their year-end audits and update their portfolio market values in accordance with FASB 157, this situation will be self-correcting. Nevertheless, boards faced with the prospect of exceeding their pre-established ranges for the asset class are likely to proceed with an abundance of caution before making new private equity commitments. In fact, many have reportedly turned to the secondary market to sell existing investments in an effort to offload current private equity exposure and rebalance their portfolios in-line with their target asset allocation ranges. Buyouts reported in their April 27, 2009 issue that "private equity commitments will be down significantly in 2009 at the Ohio Public Employees Retirement compared to prior years." Funds across the United States, with generally more mature private equity programs, will be revisiting their investment pipeline and will likely prune the pace of commitment; how much, remains to be seen.

A second factor likely to reduce the size of the private equity investment landscape is the expected decline of the mega-buyout fund. It is not that these funds will no longer be sought after, but rather because during the "the golden age," these funds were able to attract capital in excess of $10 billion per fund, with a few exceeding $15 billion. Several of these funds still have "dry powder," or existing capital commitments, on which to draw, which will enable them to avoid fundraising over the next 12 to 18 months (although Blackstone Capital and KKR are reportedly back in the market). The pace of investment for these funds may slow as well, unless the credit markets thaw sufficiently for buyout funds to attract the debt that they have traditionally used to make deals happen. Even historically successful groups, while being able to raise capital, may find they are comfortable with lower fundraising targets, given the time and energy that would be necessary to achieve a higher close. One recent example is the twelfth fund being raised by First Reserve Corp., a general partner to which Oregon recently committed $300 million. While First Reserve Corp. was reportedly seeking $12 billion in total commitments, they just closed on $9 billion in total commitments.

The most likely casualty of reduced commitments will be general partners raising first-time funds. Funds with a roman numeral "I" after their name will find the current environment exceedingly unfriendly to their efforts. The rare exception may be general partners that have departed from successful partnerships from which they can take direct credit for some of the historical success (think Vinod Khosla who left Kleiner Perkins to start Khosla Ventures). According to the formerly cited Preqin report, 1,673 private equity funds are presently in the market raising capital. This represents an increase of 65 percent from the first quarter of 2007. More funds with fewer dollars in the market, along with more discerning investors, will likely lead to a shake out, with general partners having to either dramatically reduce their fund target size (which may jeopardize their investment strategy), or alternatively, find something else to do.

A byproduct of the recent market downturn has been a renewed emphasis by some large institutional limited partner investors to seek improved investment terms. These investors are generally seeking more "LP friendly" terms ranging from lower base management fees and higher fee offsets to improved governance, primarily through the advisory board, and increased transparency. In the event that enough limited partners are serious about demanding certain terms, as a condition of their capital commitments, this may have an impact on future fundraising success for general partners. Alternatively, if the pendulum swings too far, sought after general partners may find that pent up demand for the more premier names in the industry will offset those limited partners willing to withhold their capital over certain terms not being met.

The most recent cloud over private equity investing, which may have an impact on fundraising, is the scandal surrounding certain "pay-to-play" allegations between a consulting firm, a middleman, and a large public pension fund. The investigation is ongoing, including the involvement of the Securities and Exchange Commission. The New York Attorney General has issued subpoenas to "more than 100 investment managers and their placement agents," which indicates that this scandal is not likely to be concluded soon. As this investigation lingers, with others likely to follow, it is conceivable that limited partners will take a wait-and-see attitude before committing new capital in light of the pall over these allegations of serious and criminal improprieties.

While I have painted a somewhat gloomy outlook for private equity fundraising, based on several key factors from the denominator effect to limited partner pressure on terms to industry scandals, the longer-term prospects for the asset class should be quite positive. Given the decline in funding ratios, as a result of the recent stock and bond market declines, private equity will still offer one of the better risk-return options for institutional investors, although there will certainly be some wounds to lick for funds that were raised and invested from 2005-2008. It is also likely that there will be a flight to quality, with the premier private equity firms forcing out less established or new general partners as limited partners become more discriminating in their allocation of reduced dollars available for private equity investing.

1 Attributed to KKR founding partner Henry Kravis in April 1997.
2 Buyouts, April 27, 2009, page 19.
3 Pensions & Investments Online, May 1, 2009.

About the Author

Michael Mueller

MICHAEL MUELLER
CFA, CPA, Deputy Chief Investment Officer, Oregon State Treasury

Mr. Mueller has served as the Deputy Chief Investment Officer for the Office of the State Treasurer for nearly ten years, prior to that, he served as the agency's Audit & Risk Manager for five years. In that position, his responsibilities included monitoring Treasury compliance with internal policies and Oregon State law, and managing Treasury's overall risk exposure. He served as Interim Chief Investment Officer for the State Treasury during 2002.

As the Deputy CIO, his duties span all asset classes as well as managing the Treasury's custody, performance, consulting and lending relationships. In addition, he helps the CIO to plan, organize, and direct the day-to-day activities of the Investment Division staff for the Oregon Public Employees Retirement Fund (OPERF) ($42 billion in assets; $8.7 billion in private equity). He also has primary responsibility for Treasury's relationship with the State Accident Insurance Fund ($3.3 billion in assets), the Department of State Land's Common School Fund ($720 million in assets; 10% private equity target), and the Higher Education Pooled Endowment Fund ($48 million; $6 million in private equity). Mr. Mueller is also the OST staff to the Oregon Growth Account Board, an in-state fund using a portion of lottery revenues to investment in venture capital in Oregon ($91 million committed).

Prior to his employment at Treasury, Mr. Mueller worked for five years at the international accounting firm of KPMG Peat Marwick in their San Francisco and Portland, Oregon offices as a certified public accountant. His client responsibilities included firms in high-tech, government, banking, and investment management, including many with SEC reporting requirements. Mr. Mueller earned his Chartered Financial Analyst designation in 2002. Mr. Mueller is a graduate of Stanford University where he earned degrees in quantitative economics and history.