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By Bronwyn Dylla Bailey, Ph.D.
Private Equity Consultant


Swinging the Private Equity Pendulum

The private equity asset class took a sharp hit from the financial crisis and subsequent economic recession. In particular, it has become more difficult for fund managers to raise private equity funds. The difficult fundraising environment may have started to swing the pendulum toward limited partner (LP) investors as they begin to wield more influence in their relationships with fund managers. This article explores how extensively the balance of power between LPs and private equity fund managers has shifted and what this change means to LPs.

While fewer firms were in the market raising funds last year, LPs’ financial position had perhaps the biggest impact on levels of private equity fundraising. The economic downturn reduced the amount of capital available to invest in private equity. Falling values across many asset classes, from public equity to real estate, sharply curbed the amount of capital available for new private equity funds. In some instances, the value of some asset classes declined disproportionally to other areas of a portfolio and created an over-allocation to private equity (the so-called “denominator effect”). Amidst the financial crisis, many LPs devoted more time monitoring their current portfolios, which took time and effort away from reviewing potential new investments.(1) Even today few LPs are in the market with fresh capital, but instead, most are focused on secondary opportunities.

The result is the lowest level of fundraising since 2004. According to Preqin, private equity funds worldwide raised only $246 billion in 2009, a 61 percent decline from 2008.(2) The funds that held final closes last year also took much longer to do so–18 months in 2009 compared to 12 months in 2007.

 

Recent surveys of LPs suggest that fundraising will not rebound quickly. One survey from Coller Capital found that fewer respondents, 20 percent in 2009 compared to 40 percent in 2008, expect to increase their private equity allocation targets over the next 12 months.(3) The same report found that some investors’ attitudes toward private equity have soured. One half of respondents from Europe and the Asia-Pacific and more than one quarter of respondents from North America noted that they view private equity “less favorably” due to the economic downturn. These changing attitudes towards private equity may reflect dampened expectations about its performance. Less than one third of this survey’s respondents, down from one half last year, expected annual net returns from private equity to exceed 16 percent.

More critical attitudes and lower performance expectations translate into less demand for private equity investments, at least compared to the boom years of 2005-2007. Given these factors, some in the industry expect that private equity is becoming a buyer’s market. In a July 2009 survey, Preqin found that 55 percent of investors believed that the “balance of power had shifted towards the LP.”(4) If it is so, does this shift translate into better economic terms for LPs?

The evidence of better economic terms post-recession is limited. Yet, a number of venture capital firms with a history of premium fees have offered lower carried interest in their latest funds. Redpoint Ventures reduced carry from 30 percent to 25 percent until the fund returns two times investor capital.(5) Joining Redpoint is Battery Ventures, which will take 20 percent of profits on its current fund until it returns three times capital, at which point carry increases to 30 percent. Draper Fisher Jurvetson also reduced carry for its latest fund to 20 percent until distributions equal 2.5 times equity, and then carry increases to 25 percent. These funds will charge lower carry only under specific performance targets, and thereafter the firm will collect its more typical premium fee. Rather than reducing carry below 20 percent, these reductions simply converge the carry rates for these funds to the industry standard.

Like carry, there is little evidence that management fees are showing a significant downward trend. The annual survey of fund terms by the European law firm SJ Berwin found that the range of management fees of private equity funds were similar to prior years.(6) However, the survey suggested that larger mid-market funds were facing more pressure by LPs to reduce fees below 2 percent.

While certain funds or types of funds may furnish discrete examples of reduced management fees or carry, this trend is not taking place across the entire industry. Indeed, many LPs doubt that they are successfully influencing fee terms. Instead, they believe LPs are having more success with setting parameters around economic terms, such as defining fund investment periods and the types of costs that management fees will cover.

More widespread is the impact of negotiating more downside protections on non-financial terms, such as tightened key-man and end-of-life terms, greater transparency in fund reporting and a stronger role for the Advisory Committee. LP requests around these terms may have some teeth. When asked in the Coller Capital survey how their portfolio management has changed since summer 2007, almost one half of LP respondents reported that they are demanding better reporting from general partners (GP), and 75 percent of respondents answered that unsatisfactory transparency of reporting is a factor that would deter reinvesting in a firm’s subsequent fund.(7) In some instances, funds are proactively providing more frequent communications than before the financial crisis, including presentations with detailed information about new deals and portfolio performance as well as e-mail updates on the market trends and investment climate.

Many LPs, however, doubt that the pendulum has shifted significantly towards LPs. They believe that a GP whose fund is over-subscribed will feel little pressure to alter fund terms or practices. In contrast, funds that have trouble raising capital may begin to implement more LP-friendly terms to secure certain investors. As more firms come back to market to raise new funds in 2010, more favorable terms may give certain private equity funds an advantage over competitors.

In conclusion, LP capital constraints have changed the dynamics between LPs and fund managers. LPs have become more cautious than in years past about where they will invest their sparse capital and are asking for more LP-friendly terms and best practices. Most concessions are seen in non-financial terms, such as key-man provisions and great transparency in fund reporting. While LPs may have more bargaining power around non-financial terms and practices, this shift is hard to quantify and it is not completely widespread. Many limited partners believe that, regardless of the fund terms, “good firms will always be able to raise the next fund.”

1 - See Michael Mueller's “Private Equity Fundraising in the Current Economy,” Thunderbird Global Private Equity Center Quarterly Newsletter, Summer 2009.
2 - Preqin Research Report. Q4 2009 Fundraising Update.
3 - Coller Capital. “Global Private Equity Barometer,” Winter 2009-10. This survey was conducted during September and October 2009.
4 - Preqin Research Report: Private Equity Investor Survey, August 2009. 
5 - “Redpoint Joins Shift to LP-Friendly Carry,” Private Equity Insider, January 20, 2010.
6 - See discussion in “Private equity fund terms in 2009, according to SJ Berwin’s annual survey,” AltAssets, June 19, 2009. 
7 - Coller Capital. “Global Private Equity Barometer,” Winter 2009-10.

About the Author

Bronwyn Dylla Bailey

BRONWYN DYLLA BAILEY
Private Equity Consultant

Bronwyn Dylla Bailey has been conducting research and providing analytics for business engagements and academic studies for more than 13 years. She is currently a consultant in the private equity industry and is contracted by the Institutional Limited Partners Association to analyze private equity benchmarks. She was formerly the research director for the private equity division of SVB Financial Group where she identified strategic market opportunities, spoke on private equity trends and developed knowledge leadership.

Prior to SVB, Bronwyn conducted financial and economic analysis in support of intellectual property, antitrust and other commercial litigation as a manager at PricewaterhouseCoopers in Los Angeles. Bailey also directed economic consulting engagements at InteCap in Los Angeles and advised telecommunications and media clients as a strategy consultant for Capgemini in London. She has authored numerous publications, such as SVB’s quarterly Venture Capital Update, a chapter on entertainment industry finance for a leading financial reference book and academic papers. Bailey graduated magna cum laude from Cornell University with a bachelor's degree in government and international relations. She earned a master's degree and a doctorate in political science from the University of California, Los Angeles, where her research examined the economic outcomes of European policy.