A time to trim?
How are LPs looking to build or shift their private markets exposure?
There is no doubt that LPs have had a busy time over the past few years. As many GPs ramped up their investment pace in the run-up to, and in the aftermath of, the pandemic, fundraising cycles became ever shorter, with fund managers coming back to market less than two years after they raised their predecessor funds in some instances.
This created headaches for some LPs, which found themselves in the difficult position of having to choose between not re-upping with a GP, reducing their commitment amount to a GP, or committing the same amount, but potentially missing out on other opportunities. “We have had to make a lot of tough decisions recently,” says Michael Barzyk, Global Head of Private Equity at Allstate Investments. “At the beginning of this year, we looked at our re-up pipeline to see which high conviction names would be coming out over the next 12 months and we found that our re-ups alone would account for roughly 150% of our annual deployment target.”
The speed at which GPs were coming back to market has also had the potential to reduce LP risk mitigation techniques. “When we make a commitment to a GP,” adds Barzyk, “we are looking for four years of vintage year diversification. When managers come back to us within 18-24 months, it’s difficult for us to maintain that commitment size with those managers.”
It has also meant that many LPs have been pushed into making trimming decisions they might not otherwise have had to make. “We’ve used this period as a forcing function to go through our roster of GPs,” says Ryan Karaian, Investment Director of Children's Healthcare of Atlanta. “We’ve been asking who really makes the cut and what role each GP plays in our portfolio. We’ve been looking at whether each GP solves a problem for us – it can’t just be that the GPs is good; it has to be good for us as a programme.”
Yet there are signs that the fundraising frenzy the market has witnessed through to the start of 2022 is now coming to an end. Indeed, private markets fundraising totals have declined so far this year versus – an albeit strong - 2021. Private capital funds raised US$645 billion in H1 2022, down from US$789 billion in the first half of 2021, according to Preqin. Buyouts saw an even larger decline, falling to US$138 billion from US$284 billion in the same periods.
LP experience backs up this trend, although with a delay. “We saw funds that had deployed most of their capital in 2020 and 2021 come back to us through the first half of 2022,” says Sean Olesen, Investment Officer, Cornell University – Office of University Investments. “They could see cracks emerging in the market and so our first half of the year was incredibly busy. However, as the year progresses, we are starting to see signs of an incremental slowdown of fundraising pace.”
Sejal Patel, Director at AT&T Investment Management, agrees, pointing to the denominator effect as a major cause of this. “The fundraising market is now challenged,” she says. “The first half was busy, but the public markets correction has left many LPs overallocated to private equity and so we are now seeing fundraising slow.”
This is helping buy some time for LPs, many of whom are now able to make more measured decisions about how they allocate their capital. “The pace is slowing a little,” says Karaian. “In some cases, we are now more comfortable pushing back on GPs because we know other LPs are in the same boat.” And this, in turn, will slow down fundraising further.
The continued development of the secondaries market may provide some welcome good news for those seeking to raise funds in the current market. “We are seeing the return of tender offers in GP-led transactions,” says Matthew Sparks, Managing Director, Northleaf Capital Partners. “Tender offers provide LPs with liquidity across an entire fund. They can provide liquidity to those over-allocated to private equity. In a challenged fundraising market, we are seeing more of these deals with a staple for the GP’s next fund.”
However, GPs hoping that a steady stream of over-allocated LPs will reach for the secondaries market to free up capital may be disappointed. While there’s no doubt this will happen, some LPs don’t necessarily see this as a solution. “We have looked at secondaries,” says Olesen. “But you can only sell older exposure to free up capacity for newer funds so many times. It poses the question: Does that actually solve a problem? It can help if you’re over-exposed to a single manager, but otherwise, it comes back to the fundamental issue of what managers are doing for you in the context of an overall portfolio.”
He adds that pricing in the secondary market is also not attractive enough currently. “Selling older positions in the secondary market doesn’t necessarily solve an overweight issue because these tend to be small positions, but the valuations we’ve seen haven’t been worth it in any case,” says Olesen. “Why would you sell a good asset that may just take a little while longer to crystallise?”
For established GPs, the slowdown in fundraising may present some issues, but the fact that private equity deal volumes and values have been trending down this year should mean their capital will last longer and cycles will revert to more normal timescales.
Yet for emerging managers, this development will prove more challenging. As one endowment investment professional says: “We have nothing against first-time funds, but the hurdle has to be what they bring to the table that other funds don’t. We are currently overweight in private markets and so there’s not a lot of room for anything in our portfolio. The issue with first-time funds in the market today is also that their track records tend to be very short and gained in a one-direction market, so it’s hard to tease out the alpha value add from the beta of just riding the market – that will take another three to four quarters to determine.”
There are some LPs that see this as an opportunity, however. “If we rewind to the last challenging fundraising market in 2014-15,” says Barzyk, “we found a lot of opportunities to co-invest alongside emerging managers that found they couldn’t raise blind pool capital and so sought to gain traction with LPs through deal-by-deal arrangements. This isn’t ideal for the GP, but for us, it was attractive – it was effectively a try before you buy situation and led to some really interesting co-investments.”
There seems little doubt that we are heading into a more difficult fundraising environment than we have seen for several years and that GPs will need stores of patience and determination in addition to strong track records to get funds across the line. Yet for LPs, this is largely a more positive development as they have more time to conduct due diligence and select managers to back. “Fundraising will take longer,” concludes Karaian. “Achieving target is a victory as not all GPs will hit their hard cap. And there is pressure on LPs to get their allocations right.”
In a challenged fundraising market, we are seeing more of these deals with a staple for the GP’s next fund
