April 15, 2019
Demand for private equity remained sky-high in the first quarter of 2019, with buyout and mezzanine funds raising $80.9 billion. But limited partners, spooked by recent market volatility and other recession indicators, are on the lookout for safer harbors in their PE investments. The start of 2019 didn’t quite match the torrid pace of the previous quarter, which saw $108.8 billion raised, but it kept the tap open, and consultants expect another active year for the asset class.
With all the capital flowing into PE, general partners are raising funds faster than ever, often ramping up their fund sizes or branching out into new strategies. In this environment, LPs are wary of immature track records and of investing in unproven strategies, said Natalie Walker, managing director at Stepstone Group, which provides investment advisory services.
Many private equity firms have raised extra cash by selling stakes in their management companies, using those cash infusions to launch new products outside of their core competencies, Walker said. While some of those strategies are natural extensions of a GP’s business, others — like an infrastructure fund raised alongside a traditional buyout fund — can raise eyebrows.
“This is typical top-of-the-market behavior, in terms of launching ancillary or new products,” Walker said. “In some cases, we have concerns about where general partners’ attention is going to be focused in the long term, and making sure there’s alignment of interest going forward.”
LPs are also uneasy about GPs raising ever-larger pools of capital, which could force them into an area where they have less experience. “I think you saw that in the run up to the great financial crisis in 2006 and 2007, and subsequently there were a lot of fallen stars, funds that didn’t deserve to exist at that fund size,” Walker said. “That’s something that we’re keeping an eye on.”
High-quality spinoffs and first-time funds are one way to retain access to smaller markets as GPs scale up, said Todd Silverman, a principal with Meketa, an investment consulting and advisory firm.
“There continues to be demand for first-time funds, as LPs look to deploy capital with people they know, but not necessarily firms that they know,” Silverman said. “That way, LPs can continue to access certain parts of the market, whether that’s at the smaller end or within a specific strategy.”
Debut funds are not shy about asking for capital: First-time funds are seeking $19.3 billion for 2019, the highest mark of the last four years, according to Buyouts data. One debut fund, Arcline Investment Management, closed on $1.5 billion in March.
Larger GPs, cognizant of the “sticker shock” associated with raising a larger fund, are increasingly using co-investments to bring in additional capital.
“One new strategy we’ve seen gain ground over the last 18 to 24 months has been the concept of overage or co-investment vehicles,” Walker said. “GPs are thinking through how to raise larger pools of capital and punch above their weight, but without the pressure to put capital to work if they don’t see sizable opportunities.”
Battening down the hatches
With the bull market looking increasingly long in the tooth, LPs are trying to position their PE portfolios in case the economy slips into a recession.
LPs are turning to high-quality credit, infrastructure, operational distress and other strategies that can do well in a downturn, said Bart Molloy, a managing director with Monument Group, a placement agency.
“People are enjoying the continued growth they’re seeing, but they know that the record is going to stop at some point, and potentially stop for a while,” Molloy said. “If you can get a net return that’s high single digits that you know is going to be there, you can sleep pretty well with that being part of an overall portfolio.”
Those sentiments also boost real assets, direct lending strategies and distressed debt, according to John Stake, a principal on the fund investment team at Hamilton Lane. Credit-focused GPs are pitching their strategies as valuable in both good times and bad, Stake said.
“The newer trend … has been around groups that are trying to position themselves to be able to target performing credit today, but be well-positioned to target distressed debt if there’s a market cycle or dislocation in the future,” Stake said.Funds focused on industries that can weather a downturn, especially healthcare, are also seeing interest.
“Coming out of the great financial crisis, there’s enough data now to suggest that healthcare funds have performed throughout market cycles,” Walker said.
On the other hand, growth equity may face some headwinds, especially with valuations so high. “People are still interested, but the bar is high,” said Molloy of Monument Group. “Most people have a growth manager at this point, so GPs really need to distinguish themselves.”