The Pilot's Log Q&A

Katherine Steiner-Dicks speaks to Andrew Marchant, former executive chairman of Unigestion’s private equity division and a former founding director of Cinven, on how private equity funds can prepare themselves for the next onslaught of fundraising while keeping their brand’s reputation intact.

The drying up of the leveraged debt market has caused severe delays in investment realisations/exits in many GP portfolios. This could mean that some firms will not be able to trade on their pre-existing brand strength come fundraising time.

What would you advise GPs to make as their number one priority before they start to raise another fund in the current economic climate so to better their chances to hit target or even become over subscribed?

The surviving GP’s will be the ones with the best track records and importantly, the best LP profiles. Those lucky enough to have been oversubscribed in previous fundraising should have taken the chance to favour the most durable investors who are the ones most likely to come through this down cycle.

With the exception of those GP’s who still have very little called on their present funds; all will be focused on how to raise their next fund. Everyone within the firm will be deciding which of three categories they fall into.

Firstly, there are the firms who look set to raise their next fund with reasonable ease and who look secure. They will continue to focus on their strengths and might well take advantage of a good recruitment climate to improve the team further.

Secondly, there are the firms which have had difficulties and which are unlikely to raise any more money. Some consultancy firms have estimated that this could be as much as 40% of the population, although I think that this might be a bit on the high side. I would not be surprised to see teams splintering and junior talent leaving to find more valuable carry elsewhere.

Thirdly, there are the firms where it could go either way. They will have to have a long hard look at themselves and define what it takes to convince their investor base that they should re-up. I would say that their number one priority is to very honestly evaluate what they have got right and where they have gone wrong. They should show evidence that they have addressed the latter and that the future will bring better returns.

One of the most significant changes that has taken place is that the velocity of funds flowing back to LP’s has almost ground to a halt. This velocity is closely aligned to the cycle, but many LP’s have misjudged this and got caught in a liquidity trap. It will take time to unwind this and those with funds will allocate in a highly judicious way. They probably won’t support the same number of GP relationships, which they have in the past, and there will inevitably be some ruthless rationing.

Do you think that the 10 year framework for private equity funds still works?

Overall, I think that the basic model will remain because the majority of private equity funding comes from institutions with long term profiles and the present structure is quite easy for them to accommodate. However, there are many others, such as retail investors looking to get exposure to private equity who are unlikely to accept such terms.

However, the standard model has been severely tested during this downturn, throwing up some interesting innovations to address some of the difficulties.

Firstly, the working assumption that all investors will be able to meet their drawdown commitments has shown to be flawed leaving some GP’s with difficulty making new investments. We are beginning to see some innovations arising from this in the form of permanent capital vehicles many of which are quoted. These should offer greater opportunities for wider participation in PE.

Secondly, I doubt that terms for fees and carry will be so easily accepted. The expansion of fund sizes over the last decade have improved the economics for medium and large firms, but I hope that investors will allow reasonable economics to some of the smaller firms who have not benefitted from this in the same way.

How do you retain LP confidence when distributions are far and few between?

You have to convince your LP’s that you still have the right investment strategy and that you can continue to generate good returns for them. Liquidity events give the chance to show the integrity of GP’s valuations as well as delivering cash returns.

LP’s will also be watching to see how managers are actively managing their portfolio and what steps they are taking to preserve value. The information memoranda of the last few years have been littered with claims about how teams add value through enhancing enterprise value as well as clever debt structures. Now is a particularly important time to prove it.

Another vital component is the quality of information, which gets sent out to investors. With fewer commitments being made, they have more time to focus on the existing portfolio. The better they understand what is going on, the more likely they are to make rational decisions.

Where do you see the most opportunities coming from out of Europe?

There are still many distressed situations, which need to be unlocked. Some are private equity related and some are not. Either way, there is still a lot of uncalled capital available to the PE community, which can be skillfully deployed.

Development capital opportunities are an obvious territory – particularly for those sectors which continue to show growth.

How can funds harness these opportunities with limited financing capabilities?

I cannot see debt returning to levels seen at the height of the last cycle, but the start of this year shows that there is debt available to those GP’s in whom the lenders have confidence. Deals will therefore get done.

Historically, PE firms have been able to match or outbid competing trade buyers through skillful usage of debt. In today’s market, that will be more difficult and so there will be fewer opportunities.

Overall, I think that there will be huge tension between two opposing objectives. On the one hand, there will be the desire to invest cautiously and reflect the scarcity of remaining funds. On the other hand, there is the chance to make some great investments and it is arguably dangerous to miss out.

Andrew Marchant has held senior positions at Cinven, Permira and Unigestion in a private equity career covering 26 years. He now advises private equity firms and investors on strategy and optimizing their portfolios.