United States: Private Capital Update: Plenty Of Dry Powder, But Few Targets Of Opportunity

If there were a few overarching themes of the first quarter of 2017 in the private capital community, they would be the following:

  1. The fundraising environment remains robust, but capital continues to flow disproportionately to established sponsors;
  2. While there is plenty of equity available for deals, sky high valuations, both of private companies and their public counterparts, has created a challenging environment in which to get quality deals completed at sponsor-friendly entry points; and
  3. Established markets are receiving a disproportionately high percentage of the attention and asset allocation, as investors shy away from currency and geopolitical risk.

A few general thoughts

So-called "dry powder" for private equity transactions is sitting in the trillions of dollars, not even taking account of co-investment and separate account vehicles. Continued interest in the space is driven, at least in part, by cash-rich but yield-starved institutional investors, as well as historically high valuations of public equities. While the projected rising-interest-rate environment has had the effect of tamping down enthusiasm across particular asset classes (e.g., real estate), in general, the overall low level of interest rates on an historical basis has led certain categories of investors to continue to chase the possibility of higher returns offered through private equity investing. Competition for deals however, both from other sponsors and from strategic investors with highly-valued stock to offer potential targets, are resulting in exceptionally high multiples on closed transactions, and hold out the possibility of longer holding periods and lower returns from the space, moving forward. 

Venture capital

The pace of venture capital investments in Q1 was up in both dollars and deal volume quarter-on- quarter, but remained significantly below the peak levels achieved in 2015. That said, investors continue to shift capital away from seed round investments, and are more focused on mid-to-late stage growth stories. Corporate captive funds continue to be significant players in the space, participating in approximately 25 percent of all transactions. While companies in the internet sector continue to attract the most investment interest in both dollars and deal volume, healthcare continues to grow as an area of focus, commanded a larger average deal size than internet investments, and surpassed mobile & telecom for second place sector by volume of deals. While later-stage investments continue to grow as a percentage of deal volume, median individual deal size in this segment fell during the quarter. San Francisco and Silicon Valley remain the core geographies for this investing activity, and when combined, saw roughly four times the deal value of the New York City area. New England as a whole, as well as Massachusetts individually, surpassed New York in dollars committed, though not in deal volume, in the quarter. While California remains the center for VC investing (with significant activity, not only in the Bay Area, but in Los Angeles and Orange County, as well), the gap between activity there and in New York and Massachusetts has narrowed (among states, Illinois ranked seventh in the nation with $154 million deployed in the quarter).

While there continues to be international investment in venture-backed companies, the bulk of this activity is at the expansion and later stage, with proportional participation by international investors increasing as a company approaches a liquidity event. This may be a product of both risk tolerance, as well as visibility on a company's prospects from a position abroad. North America continues to be the target market of choice for most venture capital, trailed by Asia and Europe. In terms of limited partner commitments to venture funds, less than half of institutional investors committing capital to private equity funds are targeting venture-strategy funds, but this constitutes a significant upswing from the depths of the great financial crisis. The bulk of this investment is from U.S.-based investors, with European investors more reluctant to allocate to the space, given the greater difficulties in performing due diligence with respect to top investment managers. Asian, Middle Eastern, and Latin America-based institutional investors had somewhat greater comfort with the asset class than did their European counterparts. Of the community of private equity investors (primarily sovereigns, endowments, pension funds, foundations, and family offices), endowments and foundations are the most prolific and aggressive investors in the space, committing both a disproportionately large percentage of the capital, as well as investing in earlier-stage (and hence, more risky) investment pools. In some ways, this is unsurprising, as such investors are, in general, the ones with the greatest discretion and the fewest fixed demands with respect to returns on capital, and as a result are more able to target higher-risk / higher-return investment strategies.

A final "X-factor" for the continued evolution of the investment landscape, for both companies and sponsors, is what impact the $100 billion SoftBank Vision Fund will have on the venture capital community. Having assembled an unprecedented amount of private capital, and with a roster of high-powered limited partners that include the Public Investment Fund of Saudi Arabia, the Mubadala Investment Company of the United Arab Emirates, and Apple Inc., how and where the fund will choose to throw around its weight, and what impact this will have on the broader market (in terms of governance, valuations, and otherwise) is an unknown that will have to be monitored as the fund begins to deploy capital.

Other private investment categories

Beyond venture capital, fundraising continues apace through most categories of the private investment space. Within private equity proper, the favorite category of most limited partners continues to be funds focused on middle market leveraged buyouts, and in particular, those sponsors with significant in-house operational expertise, or a track record of executing on buy-and- build strategies. More than 250 private capital funds closed in Q1 2017, raising an aggregate $156 billion and adding significantly to the already stockpiled dry powder for private investment. This trend, worrisome to both the investor and sponsor community, nevertheless shows no sign of slowing, with more than 3,000 funds seeking capital commitments as of the start of Q2. Fundraising by sponsors has become, however, a game of have and have-nots, with established sponsors of mega-funds oversubscribed, and less-established sponsors, particularly those with undifferentiated strategies, facing considerably longer and more difficult paths to closing. Buyout funds more generally, particularly those focused on North America, attracted the bulk of new capital commitments, with private equity secondary funds next in the class, but trailing significantly behind in capital raised.

Some commentators expect 2017 to be a record-breaking year for private equity, with diminished investment in European-focused funds more than made up for by the raising of North American-focused mega funds. The largest buyout fund to close in Q1 was KKR's Americas Fund XII which raised $13.9 billion.

As with private equity, fundraising in the private debt space remains strong, with direct lending vehicles the most popular in the segment. While several mezzanine funds managed to close in Q1, they constituted a relatively small percentage of funds raised. While both venture debt and more traditional debt-based strategies struggled to attract capital, one major distressed debt fund, Carlyle Strategic Partners IV, managed to close on $2.5 billion in capital commitments. While the private debt market continues to maintain significant amounts of dry powder, levels are below peak, and do not generate the same concern among investors with respect to a potentially over-flooded market. The number of funds in the market seeking new capital commitments remains strong, with direct lending funds continuing to predominate.

In real estate private equity, likely in response to perceived interest rate risk, there was a slowdown in fundraising in Q1. Funds raised in the quarter ($15 billion) were down significantly, both from Q4 2016 ($32 billion), and year-over-year ($26 billion). In addition, funds reaching a final close fell sharply from the previous quarter. Of the real estate funds that did manage to close in the quarter, North America continues to be the preferred geography for investment, far outstripping Europe. Value-added funds attracted the most capital, followed by opportunistic funds. The largest fund closing in the quarter was Cerberus Institutional Real Estate Partners IV, a distressed fund that closed on $1.8 billion in capital commitments. Dry powder in the sector reached an all-time high in the first quarter ($245 billion), and the fundraising environment for the rest of the year is expected to remain challenging. While sponsors are continuing to make investments in the space, an uncertain interest rate environment has shifted activity away from development and hospitality, and towards assets with shorter lease terms (e.g., storage and student housing) that give owners more flexibility to tailor rents to then-current market conditions.

Infrastructure investing by private sponsors continues to grow in popularity, particularly among European-based limited partners, who are more familiar with the asset class, and more comfortable with its risk / return profile. Capital commitments in Q1 set a new record for the sector, highlighted by the closing of the largest infrastructure fund raised to date (Global Infrastructure Partners III, whose final close at $15.8 billion surpassed the $14 billion raised by Brookfield Infrastructure Fund III, which had its final close in Q3 of 2016). Although four vehicles with a focus on Asia closed in the quarter, North America, and to a lesser extent, Europe, remain the primary focus of infrastructure funds, given their comparative economic and political stability. Numerous funds in the sector were oversubscribed, as the relative safety of infrastructure gains a more dedicated following among investors. Given macroeconomic and geopolitical factors, as well as the strong appetite for the risk/return profile of infrastructure investments, fundraising for the rest of the year is expected to be strong, but as allocations to the sector rise, valuations are likewise increasing, and high-quality assets are in greater demand. As such, while the risk/return profile in the sector remains favorable, expectations as to overall returns will need to be tempered, and what impact President Trump's proposed public/private infrastructure partnership plans may have on fundraising and capital deployment, remains an unknown. Note that natural resources funds (which sometimes have significant overlap with infrastructure funds) continue to be dominated by energy-focused investments, although the first quarter of 2017 did see the closing of the first ever exclusively water-focused fund, as well as sizable funds focused on timber and agriculture. It is worth noting that natural resources funds are one of the few sectors of the private capital market that has seen a significant reduction in available dry powder.

What it all means

So where does this panoply of data leave us? For sponsors, while the fundraising environment remains positive for the moment, there is increasing concern among their investors that the private equity market may already have crested, and that the combination of historically high levels of dry powder, coupled with exceptionally high comparable values for targeted companies in public markets, means a very competitive environment for quality assets going forward. This has multiple risks, both with respect to potential overpays for exceptional, or even worse, subpar assets (with an associated deterioration in returns), as well as longer holding periods, as sponsors may need more time to create value to assets purchased at higher multiples. Investors in private vehicles should survey their current holdings and asset allocations to the sector in light of current market conditions. For those investors seeking yield, an adjustment to a different risk / return profile (and hence, to potentially different asset classes and geographies) may need to be considered in light of prevailing market trends.

Sponsors may need to continue to think creatively about how to distinguish their firms and their offers from competing bidders (e.g., through calibrating appropriate rollovers, earnouts, and employment / consulting arrangements with insiders, as well as using mechanisms such as representation and warranty insurance to deliver "clean" contracts and certainty to sellers). In their capital raising, sponsors need to think deeply and creatively about appropriate hurdle rates, fee structures, and fund life and associated governance arrangements, given both the competitive landscape and the higher multiple entry points for the bulk of their new investments, along with limiting side letters. For those sponsors who have waited to harvest existing quality assets, the current point in the market cycle likely holds the promise of strong returns on investments held for more than a short period, and the robust fundraising environment and the continued availability of relatively cheap financing, coupled with the strong returns such investments are likely to yield, should keep the momentum going for the raising of their next fund. For new sponsors or those without an established track record, an emphasis on differentiating factors, either through specific sector focus or demonstrated operational experience or expertise, is indicated.

For companies potentially looking to sell to, or receive an investment from a sponsor, all signs indicate that, barring extenuating circumstances (e.g., regulatory restrictions that would limit the universe of potential buyers) that either a robust auction process, run by an experienced professional, including both strategic and financial buyers (if an exit is the goal) or a broad survey of possible sponsor partners, including captive funds (in the event of a minority or partnering transaction) should be the preferred strategy. With valuations as high as they are, and with the amount of dry powder sponsors have accumulated (and now have to deploy), owners of successful businesses seeking an exit are extremely well-positioned to demand favorable terms, both with respect to valuation and risk-shifting, in their negotiations with the potential universe of buyers.

As we look forward, large stockpiles of available capital, exceptionally high valuations, and rising interest rates indicate a potentially challenging investing environment over the next several quarters. While the private equity industry has traditionally ebbed and flowed with the strength of the leveraged finance markets and prevailing interest rates, some of the changes this market cycle has witnessed are likely to be permanent fixtures of the landscape, going forward. As private equity moves well into its fourth decade as an asset class, a part of its maturation has been the continued evolution of acceptable capital structures toward higher equity-to-debt ratios, and an ever-greater emphasis on value-adds beyond simply creative financial engineering. As the private equity industry continues to mature, as more players compete for a dwindling pool of assets, and as returns on fixed-income instruments edge upward, we can expect the trends toward larger general partner commitments, longer holding periods, and greater industry-specific focus and specialization to continue, as the free availability of inexpensive debt financing diminishes, and as limited partners adjust the allocations of their investment portfolios.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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