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Prepare for a soft landing

Private equity fundraising can only go in one direction – down – but don’t expect it to drop off a cliff.

Look down the list of the Private Equity International Awards 2016 winners – announced this week – and you will see firms with a lot of dry powder at their disposal.
 
Among them are names associated with banner fundraising efforts on flagship funds – Advent International, Cinven and Permira – and others that have successfully diversified beyond their core strategies and geographies, such as EQT, Ardian and Blackstone.
 
The market for raising private equity capital, to paraphrase a report published this week by consulting firm Bain & Co, has been “as good as it gets.” Two factors cited in the report summarise neatly why there has been abundant LP demand for private equity in the last few years.
 
First of these is the six successive years of net distributions to LPs. Every year since 2011 – even in the face of rampant fundraising activity – net cashflows have been positive to LPs. On average for this six-year period, for every dollar that an LP has put into the asset class, it has received around $1.90 back, according to Cambridge Associates' data cited in the report.
 
Second is the strength of public markets, which after a volatile start to 2016 rebounded to perform surprisingly well.
 
Between them, these two factors have conspired to make it very difficult for many investors to maintain their private equity exposure at anything like their target allocation. Bain points to US pension fund Washington State Investment Board, as an example of a long-time private equity investor that has felt this “reverse denominator” effect keenly, seeing its private equity exposure (the “numerator”) shrink in relation to the rest of its assets (the “denominator”). According to PEI data, the pension has a target allocation to private equity of 25 percent. As of the end of the year its actual allocation was down to 16 percent.
 
Private equity firms have met excess demand by raising larger funds. A look back at the 20 largest funds closed in the last four months shows that, on average, firms have raised vehicles that are 40 percent larger than their predecessors. Most dramatic among these “growers” were the $3.5 billion Dyal Capital Partners III, which is nearly 2.5 times larger than Fund II, and the $3.5 billion Veritas Capital Fund VI, which is nearly twice the size of Fund V.
 
You could argue they are wise to do so, as conditions will not remain benign forever. As the Bain report notes, a recession coupled with falling stock markets could soon erode the “denominator effect” that has recently worked so emphatically in the GPs' favour.
 
Meanwhile, the giant wave of distributions – which peaked by volume in 2014 – is abating. It was driven by the glut of investment that occurred in 2006 and 2007. In these two years alone, total global buyout value was nearly $1.4 trillion, according to Dealogic. In the nine years since, the pace of private equity investment slowed to less than one-third of this: just $217 billion per year on average.
 
Very little capital that was invested in that '06-'07 glut remains in completely unrealised deals – less than 10 percent, says Cambridge Associates – although around 40 percent of these deals are only partially realised. “The proverbial elephant has now largely passed through the snake,” in the words of the Bain report author, and as a result the pace of distributions will normalise. The pressure on LPs to put capital back to work should become less intense.
 
With dry powder reaching a record $1.47 trillion globally by the end of 2017, perhaps this is no bad thing.