Advancing to final close

Raising a private equity fund in 2010 is not a task for the fainthearted – long gone are the days when GPs could easily double fund sizes and rely on re-ups. With colour-coded references to the Capital Pursuit! board game in April’s issue, PEI examines a selection of the complex issues one must navigate in today’s global fundraising market.

Any fund manager will tell you the fundraising business hasn’t exactly been all fun and games lately.
The volatility and uncertainty that characterised global financial markets last year is reflected in private equity fundraising totals, which were down roughly 65 percent over 2008 totals. In Europe, for example, the €13 billion raised last year by 184 funds managed by members of the European Private Equity and Venture Capital Association amounted to less capital than the two largest funds raised in 2008.

Last year there was obviously a big jolt to confidence, where everybody just pulled their horns in and decided to wait and see what happens

Ed Gander

“Last year there was obviously a big jolt to confidence, where everybody just pulled their horns in and decided to wait and see what happens,” recalls Ed Gander, partner in the private funds group at Clifford Chance. Amid the “wait and see” environment, some GPs postponed fundraising and revised or missed targets. Gander notes that in addition to the “usual” impediments to fundraising like poor track records and management instability, the scarcity of capital will continue to be a key issue for fundraising during 2010. 

Many limited partners – plagued by their own portfolio and liquidity problems, including sinking assets under management and drastically reduced private equity distributions – have re-examined their approach to the asset class over the past year. In some cases, that has meant retooling their allocation models or reducing manager relationships and/or commitment sizes.


Adding to the madness and mayhem in the fundraising world has been massive upheaval among placement agents.

A dramatically slowing fundraising environment, increased scrutiny from US regulators, and in some cases the merger of investment banks, caused some institutions to shake up their private placement divisions. Bear Stearns’ fundraising group was essentially dispersed when the bank was purchased by JPMorgan. Citi, Merrill Lynch (purchased by Bank of America) and Deloitte were also among the groups last year to halt or reduce fundraising activities.

Meanwhile, proposed Securities and Exchange Commission regulations barring placement agents’ interaction with US public pensions – and the bans already instituted by some US public pensions – are the product of a kick-back scandal that erupted in New York last year. The ongoing investigation has centred on political fixers that secure commitments from state pensions for side payments, but the proposed bans and regulations have caused industry-wide outcry as they fail to distinguish between legitimate placement agents and “finders” or “fixers”.  The SEC received hundreds of letters from industry figures warning that cutting off access to bona fide placement agents would be detrimental to both public pensions and small- to medium-sized private equity firms.


Less capital up for grabs, coupled with lacklustre GP performance amid an industry-wide slowdown, has further pushed the LP-GP power pendulum toward LPs. Today, GPs find themselves travelling farther and

Right now LPs hold all the cards.

Loren Boston

wider to compete for capital that is doled out more selectively and often contingent upon more friendly terms.

“Right now LPs have all the cards,” says Loren Boston, partner at Connecticut-based placement firm CP Eaton. Firm founder Charles Eaton adds: “LPs are much, much, more selective. There is a lot less money being committed and the selectivity is extremely intense.”

That heightened level of selection is expected to lead to a reduction in the number of fund managers and make first-time fundraisings extremely difficult; however, fund formation lawyers report a steady stream of GPs meeting with them in advance of fundraisings expected to launch soon. “What we’re seeing at the moment is a lot of structuring work going on, a lot of planning behind the scenes, a lot of people getting revved up, but the actual launches are yet to come,” Clifford Chance’s Gander says.

Josyane Gold, a partner in SJ Berwin’s private equity team, agrees. “We’re really beginning to see people coming in and talking about funds, a number who last year had already postponed their timetable to 2010,” says Gold. Many of those groups have opted to begin marketing in the latter half of the year or have decided to wait to 2011, she adds. “I don’t think we’re going to see a rush, but we are seeing some people coming back to market now and there will be some more activity. But people will be cautious.”

Part of that cautiousness has to do with market participants’ feelings that economic recovery remains fragile. “There’s renewed fears that we could be in for a double dip recession in the US and Europe,” warns one European placement agent.

“There are still a number of dark clouds on the horizon with significant increases in governmental deficits, which means that there are going to be more uncertain times ahead on a country level in many jurisdictions,” agrees Gander. “But things are definitely better than they were.”
With that sense of cautious optimism as a backdrop, PEI spoke with these and other global industry insiders to learn how a firm in pursuit of capital can best avoid the pitfalls and advance to a final close. The following themes link back to individual events on the Capital Pursuit! board game as identified by coloured dots. 

Performance and strategy

GPs with average track records, teams and strategies will find fundraising tough.

“Given that we are in the final phase of a deep crisis, selectivity is more important than usual – all that glitters is not gold,” Swedish Investment Bank SEB recently said in a statement accompanying a research note on private equity investment and fundraising prospects. The bank projected that smaller funds whose deals are less reliant on leverage will have greater fundraising success, while mega-funds are “probably a phenomenon consigned to history”.

Given that we are in the final phase of a deep crisis, selectivity is more important than usual – all that glitters is not gold


Prime among the reasons LPs back a fund manager are its performance and strategy, which also encompass how GPs have confronted recent portfolio crisis situations and volatile market conditions. While arguably all fund managers have faced some challenges in their portfolio in the past two years, the gravity of the problems has varied greatly from firm to firm, as has the way in which they have been addressed.

This latter point is now a critical due diligence matter for LPs, who generally frown upon GPs that chalk up their 2009 portfolio company troubles to “the market”. LPs expect to hear GPs explain how they dealt with difficult situations and what measures they have taken to ensure the same issues don’t occur again, to the extent they can be controlled.

“It was a tough time for everybody in 2009,” explains one heavyweight European LP. “Hardly anybody went through it unscathed. But at the same time you shouldn’t hold that out as an excuse [for poor performance] because it’s been the same [conditions] for everybody else.”

Despite the challenging deal and exit environment, caused in part by a near total lack of leverage for much of the year, there was still a respectable stream of 3x and 4x exits, says one European placement agent. He pointed to BC Partners as an example of a firm that had indeed lost an investment or two during 2009, but at the same time had done some interesting deals and scored one of 2009’s most eye-catching exits in November with the €3.5 billion sale of German cable TV provider Unitymedia.

There were two examples of firms that marked down their portfolios quite significantly at the outset of the crisis – EQT and BC Partners – and those have started to come back, quite strongly over the last 12 months

European placement agent

“There were two examples of firms that marked down their portfolios quite significantly at the outset of the crisis – EQT and BC Partners – and those have started to come back, quite strongly over the last 12 months,” the fundraiser said. “So that has made LPs believe that the top quartile of GPs ought to be continuing to produce the performance that they’ve always produced in the past.” 

Firm management

Institutionalisation is the name of the game.

Limited partners have become much more sensitive to quality of a GP's business, “how it is managed, its governance and disciplines”, says Mounir Guen, chief executive of global placement firm MVision Private Equity Advisers. “2009 showed inefficiencies and character weakness as well as character strength [among private equity fund managers], so investors want to now have better visibility and transparency, better alignment. They will be more selective – you can't just be top quartile, you have to be top decile – and they will take their time to make sure they are making the right decision.”

Part of making that decision is contingent upon a flood of documents and materials from GPs – requests for which have become more frequent and more detailed from both existing and potentially new LPs. As a result, many firms are further “institutionalising” their processes, often spending significant resources on in-house investor relations and communications to better serve LPs.

“We believe the current economic environment provides us with attractive new opportunities to build stronger relationships with our investment partners,” Kohlberg Kravis Roberts co-founders Henry Kravis and George Roberts said in a statement early last year when the firm hired Suzanne Donohoe as global head of its client and partner group. In late September, it added Jonathan Levin as its first ever head of investor relations for its public shareholders.

KKR has also been among the frontrunners on another LP-pleasing item linked to firm management: it is a signatory to the UN’s Principles for Responsible Investment. Since their establishment in 2006, there have been nearly 700 signatories, a good indicator that institutional investors, investment fund managers and service providers believe a consistent, structured approach is necessary to address environmental, social and governance issues. The PRI does not limit what can or cannot be invested in, nor does it single out particular ESG issues that the GP should address. Rather, it asks GPs to create a process-based approach to ESG that is followed throughout the life of the investment, document it and share the information with LPs.

PRI compliance is most important to European LPs, particularly public pension plans, but will continue to gain ground globally, say market participants. “What has happened in the last 18 months or so is that in the face of the financial crisis, people have put these issues to one side but they’re going to come back,” says a large US fund of funds manager. 

Team alignment

Classic alignment of interest issues – from carry to key man clauses – remain at the core of GP-LP relationships.

New York-based Quadrangle Group, Paris-headquartered PAI Partners and UK-focused Alchemy Partners were among the firms in 2009 that were challenged by key-man issues – all due to events that weren’t anticipated, some happy and some less so. Alchemy’s co-founder, Jon Moulton, quit in a public strategy spat with his partners; Dominique Mégret, a 35-year veteran of PAI and chief executive since 2006, was ousted by Lionel Zinsou; and Quadrangle co-founder Steve Rattner resigned to take over the Obama administration’s auto task force (a role he has since quit).

Alchemy’s capital structure relied on revolving annual commitments from LPs, while both Quandrangle and PAI raised traditional private equity funds, but all three groups suffered the same initial key-man setback: they had to halt investments and renegotiate the fundamentals behind their firms and funds with LPs. For Alchemy, it may mean the emergence of a new capital structure to fund deals, while for PAI it meant slashing its current fund in half to €2.7 billion. Quadrangle LPs, meanwhile, voted to maintain their commitments to the $2 billion fund the firm closed in 2005.

At least five years before a firm’s key investment professionals plan to retire or pursue other interests, “a PE firm’s principals had better think hard about what the key-man provision in their next fund is going to say”, Michael Harrell, co-chair of the global private funds group of Debevoise & Plimpton, previously told sister

You do not want to invest in a fund where the economic interest of the entire firm and the entire fund is owned by one or two individuals.

Réal Desrochers

publication “You don’t want to include Paul Smith, for example, as a key man in the fund you are raising next year if you think he is going to retire in three years. PE firms need to think carefully about succession planning, and that plays into the partnership agreement and LP relationships.”

Key-man clauses are in place to encourage team stability, a tenet that also encompasses the sharing of power and carry among investment team members. “You do not want to invest in a fund where the economic interest of the entire firm and the entire fund is owned by one or two individuals,” Réal Desrochers, the former head of alternatives for the California State Teachers’ Retirement System, warns in PEI’s new book, Risk Management in Private Equity.

Similar red flags go up for LPs if GPs commit little or no capital to their own funds, an issue that becomes more intense in negotiations as funds increase in size and collect more fees.

Terms & conditions

How LPs are using the fundraising downcycle to secure more favourable terms.

In late 2009, the Institutional Limited Partners Association, whose 220 members control the vast majority of commitments to private equity funds across the world, established a set of LP-centric terms and conditions, the ILPA Principles. The guidelines call on GPs to adopt a number of practices including a European-style waterfall for profit distribution, reducing management fees and offsetting them with transaction fees.  They also call for limited partners to be given stronger rights to suspend, terminate or dissolve a fund.

“There is a question right now about what being ‘ILPA compliant’ really means,” says Jen Tedesko, a partner with placement agent Atlantic-Pacific Capital. “Does this mean a general partner agrees with the spirit of the principles, or literally has checked every box?”

There is a question right now about what being ‘ILPA compliant’ really means.

Jen Tedesko

SJ Berwin’s Gold says the ILPA guidelines are being broadly used to frame GP-LP negotiations on terms. “Many of them are using [the ILPA Principles] as a starting point, it’s not necessarily a finishing point but it’s a back drop for the discussions. The themes that come through there are very much alignment of interests, good corporate governance, much stronger investor downside protections.”

The ILPA-related discussions tend to centre on the same sort of GP-LP alignment issues that have always been at the crux of fundraising, particularly for first time or newer fund managers, says Marco Masotti, deputy chair of the corporate department and co-head of the private equity group at Paul, Weiss, Rifkind, Wharton & Garrison. 

Both Masotti and Gold noted that recent discussions on terms have not focused on the classic economics underpinning a fund, like the 2-and-20 management fee and carry structure. Transaction fees, however, are a source of consternation for LPs.

“GPs are under a lot of pressure now to give ground on transaction fees,” says Gold, noting it’s not a new phenomenon but one that has gained traction. “There’s been quite an aggressive move by investors on fees because they sense it deviates from the alignment of interest.” 


Increased regulation threatens to make fundraising even harder.

Failing to negotiate on terms with LPs may mean failure on the fundraising trail, which is also going to be impacted by various regulatory issues being debated by legislators.

The pending SEC rules that could prevent firms from using placement agents to secure public pension commitments would significantly impact fundraising costs and marketing abilities for smaller firms, market participants say.  As will the uncertainty surrounding the EU’s Directive on Alternative Investment Fund Managers, which will dictate how and where GPs can market their funds. “It’s very difficult to predict which structures will and will not be acceptable to the regulators,” says Gander. “They are unwanted uncertainties for the market which need to be resolved as soon as possible. But good managers will still raise capital, there’s no doubt about that.”

Among the most keenly watched issues as the AIFM goes through various drafts, is the “third country” or “passport” rules, which would prohibit non-EU fund managers from marketing within the EU unless they can demonstrate that they are subject to a regulatory regime of equivalent rigor in their home country. Currently, many major EU trading partners, including the US, Russia, China, India and Brazil, do not meet this standard, and therefore would be denied a “passport” to market within the EU. EVCA has been speaking out against the third country rules for months, but at press time, the rhetoric against this part of the directive was reaching a critical mass, with politicians, legislators, and trade associations around the world raising an alarm against what are being perceived as protectionist measures. 

Asset class

Many veteran LPs are re-examining their approach to the asset class, while new entrants are mulling non-traditional models.

The Pennsylvania State Employees’ Retirement System is one of several pensions and endowments that experienced turbulent liquidity issues in the market downturn and subsequently changed its private equity approach.

The $26 billion US public pension saw the value of its overall portfolio drop, ramping up its exposure to private equity as a percentage of total assets. It became grossly over-allocated to the asset class, stuck with an actual allocation of 23 percent compared to its 12 percent target. As a result, the long-time private equity investor is culling its portfolio and not looking for any new relationships. The pension’s situation is mirrored by other institutional investors, especially in the US, that have to hang back from the asset class while portfolios come back into balance. 

Meanwhile, other veteran LPs may be feeling over-diversified and want to pare down the number of relationships with GPs employing the same broad strategy, while still others – including the Alberta Investment Management Corporation and the Ontario Municipal Employees’ Retirement System – are looking to increasingly cut out fund managers and move towards direct investing.

GPs, as a result, face a tougher time gaining commitments from such institutions, especially if they have no existing relationships. Unfortunately, they might face just as many difficulties garnering commitments from cash-flush LPs that are just starting to move into private equity. “LPs that are new to the asset class completely [like some pensions or sovereign wealth funds], aren’t all following the model of the traditional LP – they will look at models like managed accounts, pledge funds, deal-by-deal funds, part-ownership structures of GPs and other concepts or different types of relationships,” says MVision’s Guen. “They’re looking at spending significant amounts of time identifying the right partner and then spending substantial sums of capital with that partner.”