private equity real deals

Over the next year, 15 big European funds will go out to the market looking to raise 40 billion euro, according to placement house Almeida Capital. It’s a tall order. Last year, there was only 18 billion euro in the whole market and while there will be some growth, a leap of that size is considered highly unlikely.

Richard Sachar, chief executive of placement firm Almeida Capital, says: “There is increased demand in private equity but because so many pan-Europeans are going out to market at the same time, they won’t all be able to get their allocations. If so, some of the brand names are going to have a hard time.”

Roger Wilkins, senior fund manager at Morley Fund Management, says: “There are a large number of funds going back to the market in the next six to nine months because they are reaching the fully invested status of their current funds. We have had cycles in the past where a number of funds have come at the same time and there has been demand. Whether it will be this time, I don’t know but some funds might not reach their aspirations.”

So who is going to the markets? Apax Partners is fundraising at the moment and is thought to be looking to raise between 4.5 and 6 billion euro for its Apax Europe VI fund. CVC is aiming for a similar figure. Hicks, Muse, Tate and Furst is seeking 1.5 billion euro. Exponent, set up by four former 3i directors, recently raised £400 million – ahead of expectation - in just five months for UK buyouts.

Both Carlyle Group and Doughty Hanson have been raising funds since last year and both are thought to be looking for 2 to 3 billion euro. Doughty Hanson’s first close came in at US$800 million in September.

San Francisco-based private equity firm Hellman & Friedman announced the final closing in July of its HCFP V fund at US$3.5 billion. Although the fund is primarily intended for investments in the United States, there are signs of an increasing focus on Europe with the opening of a London office headed up by Patrick Healy. The HFCP IV fund made four significant investments in Europe and tends to make investments in the US$100 to US$750 million range.

With so much competition for institutional funds in the market, it is unlikely that general partners (GPs) will be able to raise significantly more in this cycle than they did in the last cycle. Apax’s Europe V raised four billion euro in its last round in 2001, for example.

Finding 40 billion euro from institutional investors for an alternative asset class is always going to be tough but particularly now.
The tone was set earlier this year with the closing of Standard Life’s latest private equity fund of funds, European Strategic Partners II, which closed with a touch over 1 billion euro in January. Jonny Maxwell, chief executive of Standard Life’s private equity arm, said at the time: “We have successfully closed our fund and exceeded our target. This has been achieved during an extremely difficult environment when a number of our competitors have closed down or been acquired having failed or struggled badly in their fundraising.”

Despite the inclusion of a specific recommendation in Paul Myners 2001 report on institutional investment that decision-makers should consider the full range of asset classes, specifically naming private equity, it is still not a priority for many.

Research released in May by consultants MercerHR of pension fund asset allocation showed that just 3 per cent of pension schemes currently invest in private equity, although this is expected to increase to 4 per cent by next year.

Appetite among pension funds for private equity varies dramatically across Europe. The UK, although it is well behind the US in terms of allocations to private equity, has one of the most developed markets.

Part of the dilemma for pension funds is that FRS17 accounting standard and the soon-to-be-introduced IAS19 international standard have caused trustees to look closely at the market value of assets, something that can be problematic where the asset is unquoted. The only reliable valuation comes when the asset is sold.

However, tax and other legislation in countries such as Germany, Denmark and particularly Austria means that pension fund investment in private equity remains limited.

Other European funds are very keen however. In January, AlpInvest Partners of Holland announced one of the largest private equity mandates ever awarded –six billion euros from ABP and PGGM, two of the largest pension funds in the world. The new mandate added to 16 billion euro already managed for the two funds. The combined mandate represents just under ten per cent of the total assets under management of the two pension schemes.

Will the increased demand come from increasing allocations to private equity? Richard Sachar says: “Where we have asked limited partners (LPs) what they are planning to do in terms of allocation of private equity, European LPs 42 per cent were planning to increase their allocation, and of North American LPs 24 per cent,” says Yet for those schemes that do invest in private equity, the allocation is still relatively small – perhaps two to two and a half per cent among the most committed investors. By comparison, in the US where private equity has become much more commonplace thanks to its longer track record, you might find between six and eight per cent.

If Europe follows the US, as it does in many things, there is obviously potential for considerable growth.
Mounir Guen, chief executive officer at Mvision, says: “More and more institutions will get involved with private equity and those that have allocations will increase theirs. Certain large pools of assets still have relatively low allocations to private equity compared to those that have been in the asset class for a longer period of time. However, we don't have the pattern we had a couple of years back when cash was pouring from whichever window you were opening - the public markets, asset growth, capital returned, and allocation increases.”

Consistently high returns is what will attract institutions. Almeida Capital figures for expected returns show why the asset class has prompted interest from enlightened institutional investors. Expected returns among North American LPs for buy-outs was 17.1 per cent, while for European LPs this was 14.4 per cent. For venture, North American LPs expected 15.4 per cent while European LPs expected 13.5 per cent. “What is interesting,” says Richard Sachar, “is that what people expect from venture is not far off what they expect from buy-outs. That is likely to have changed this year - expectations for venture will have gone down.”
The British Venture Capital Association’s 2003 Report on Investment showed that net returns from UK private equity funds measured 14.2% over a ten year period, 10.2% over five years, 2.6% over three years and 12.3% during 2003. The strongest performance was from generalist and large funds.

But, says Richard Sachar: “Most people will realise that if you going to invest in private equity because you believe in the returns, you are going to have to have a significant amount in your portfolio.”

The diversification provided by private equity is important for institutional investors too. Roger Wilkins, senior fund manager for private equity investing at Morley Fund Management, says: “Portfolio diversification is the main reason for schemes investing in private equity and it is an opportunity to enhance their returns at the margin."

Mid-market buy-outs are proving to be the most popular sector of the market – attracting twice as much interest as the large buy-out sector.

Pan-European buy-out strategies have been the most common focus, particularly since much of the money was coming from the US, but there is a trend towards market-specific funds.

MVision’s Mounir Guen says: “This allows more depth to markets, especially continental European markets where in the past, they didn't have the support of international investor, they just had the support of local investors. In areas such as Spanish micro-cap, Italian small cap, French small cap, historically these were funded by local investors and were in the region of 50 to 150 million euro size fund. With international scope, a GP is able to move up to 300 million euro and better execute a local market strategy.”
For its maiden fund, Clessidra Capital Partners – the company of former Fininvest chief exec Claudio Sposito – achieved 560 million euro by its first close, with a final target of 1 billion euro for its fund targeted at Italian medium to large companies. Institituions that have invested include Assicurazioni Generali, Aviva and CGU.

Smaller funds are also attracting interest because of an increas in interest from the trade for exits. “A number of the realizations that we will be seeing in the short term are recaps and sales to other general partners,” says MVision’s Guen. “There's probably more trade sale activity at the smaller end of the spectrum and that is probably one of the reasons that investors are keen to get exposure to some of the smaller funds.”

The multi-billion euro size of some of the proposed new funds raises questions about the ability of the houses to find the deal flow to invest all the money within the specified investment period. Morley’s Roger Wilkins says: “In recent years, they haven’t proved to be too large to get the money invested. Whether they have been invested in the best things to achieve the best returns, it is too early to tell. The risk of raising too large a fund is that you have to do any large deal that comes up and end up paying top dollar for it since you need to invest the money.”

General partners (GPs) such as Permira, Blackstone and Texas Pacific Group have little difficulty in raising huge funds, usually on the back of repeat business from their US investors. ”The most popular groups can still raise absolutely huge funds,” says Richard Sachar. “On average, however, fund sizes are actually reducing because there are a lot more smaller funds. If you’re not a top name, it is more challenging to raise a big fund. One of the biggest risks is that GPs shouldn’t be looking to raising a bigger fund this time than last time. Most of the big names are looking to raise about the same size fund. I don’t think we will see any major fund step-ups from last time.”

If these firms do succeed in raising the money, there is the question of what happens next since there will be intense competition to do similar deals.

One increasingly common scenario is that several private equity firms form a syndicate to fund deals. Morley’s Roger Wilkins says: “If they compete aginst each other, they just drive the price up. So rather than these deals being done by auction, why not collaborate? From our point of view, we do monitor this quite closely because we don’t want to be in a situation where we end up getting the same underlying portfolio but paying twice the fees. Whenever we invest in these funds we look at how this matches our own portfolio so that there is very little overlap.”

Most investors will want to have exposure to a group of two or three general partners but this can be a problem when another GP provides the exit route.

“LPs are a little sensitive when the deal travels from one to the other. They want to make sure that there is some form of value that can be added to the equation. It does get harder if a deal tours over three times from one GP to another,” says MVision’s Mounir Guen.

So will the private equity houses achieve their aims and reach this 40 billion euro target? Those firms which have been clever with marketing have lodged themselves in the minds of LPs and enjoy a halo effect, although track record, consistency and the extent of their regional coverage.

Almeida’s Richard Sachar says: “Some of the big names are going to sweep up – they are already over-allocated and won’t need to go to new investors. There are a couple of brand names that will struggle. They are taking comfort from the fact that the fund-raising wasn’t too difficult last time round because it was done at a particular time but they are competing with many more players this time round. Even if the strategy is different from another firm, they are now competitors because they are trying to ask for the same allocation of money.”

Mounir Guen believes that the figure is attainable. “If Apax is coming back and they want to between five and six billion, CVC wants to come back and be around five and six billion then BC also. It doesn't take much more to achieve that,” he says.
However, apart from these challenges, there are other forces in play. Europe’s banks have been exiting private equity investment, in part because of concerns over the Basel II capital adequacy proposals. Mvision’s Guen says: “On average when fund comes to the market it can expect an natural attrition of about 20 to 25 per cent, for example a lot of the banks have let the market. In some funds, the large and mid-market buyout funds, they would have had a significant allocation of bank money. One fund had 40 per cent bank money so it had 35 per cent attrition.”

What is certain is that the market for private equity firms has changed dramatically since a three or four years ago when cash was pouring from whichever door or window they opened. The clout of the bigger houses will mean that they will continue to attract institutional investors, particularly those who have had substantial cash returns from the previous cycle. US institutions already have an appetite for European private equity and this is likely to increase, particularly for those that can see beyond the pan-European focus and into market-specific funds.

The recovery of equity markets and the reopening of the IPO exit route will also help to convince institutions that returns can be sustained in the months to come.

So while 40 billion euro may be something of a pipe-dream, institutions’ appetite for something other than quoted equities and bonds and with a reasonable risk-return profile means that we may see at least half that figure being realised.

Are the edges blurring between private equity and hedge funds?

Private equity and hedge funds are often conveniently lumped together into the category of alternative assets, along with property.
However, there has tended to be a blurring of the distinctions since some private equity firms have started looking at branching into hedge funds as part of a wider asset management brief for their clients. The appeal for private equity firms is that hedge funds can provide them with a much more stable income stream.

Some hedge funds also look at private equity as a way of getting arbitrage in the unquoted markets, through innovative structures.
Texas Pacific Group, one of the largest US houses, is thought to be involved in a new hedge fund venture.

Yet the two approaches could hardly be more different. Hedge funds are based on a trading mentality while private equity favours ownership.  “For example, a private equity GP will judge that to buy a company in a sector they have experience in, it makes more sense to acquire the bank debt and to turn that to equity and then take control of the company,” says MVision’s Mounir Guen. “If he then starts to buy the bank debt, the hedge fund are going to be all over him, as they are looking to buy at 40 and sell at 70.”
 

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