Institutions gain the whip hand; after several years of record breaking fundraising, private equity firms face tougher times to come. (Supply of finance).

The institutional message from the recent EVCA International Investors Conference in Geneva was very clear: "The balance of power has shifted and we are now calling the shots".

After several years of extremely clement fundraising conditions, the climate has begun to look decidedly gloomy for those fund managers whose coffers are beginning to run dry. According to both delegates and speakers at the conference, there is more pain to come, as the full effects of the economic slowdown become manifest on private equity portfolios.

At the core of the problem is the fact that both deals and exits have dried up over the past six months, after several years of record-breaking fundraising, leaving the private equity market awash with cash. Given the circumstances, why should institutional investors want to carry on pumping new money into the asset class?

According to figures provided by Venture Economics, there is currently a US$100bn cash pool waiting to be spent in the global private equity market. The same figures, compiled by Venture Economics and the National Venture Capital Association, show that the amount of new capital being raised is beginning to reflect this overcapacity.

US institutions shut the gate

As is usually the case, the fallout has manifested itself in the US first. In 2000, US buyout and venture firms brought in a record-breaking haul of US$184.4bn: in 2001 this figure had fallen by more than 50% to US$80.1bn.

Predictably, US venture firms have been especially badly hit by this change in investor sentiment. In the fourth quarter of 2001, they raised a paltry US$4.6bn, against the US$50bn-plus garnered in the record-breaking second quarter of the previous year.

Venture firms contemplating raising a follow-on fund will find the post-boom environment very different. As Austin Long, managing director of US-based Alignment Capital put it: "When the music stops there are going to be very many fewer chairs than there are participants."

However, the conditions are different in the US. According to Paul Myners in his keynote address to the Geneva Conference, US institutions invest an average of 2% of their total allocation in private equity, while their European counterparts commit around 0.2%.

David Swenson, another keynote speaker, who holds the purse strings to the US$10bn Yale University Endowment, was discussing whether Yale's allocation to private equity should fall from 25% to 20% in the current climate, a discussion that would never trouble a European institution. Most people agree that there is an imbalance of capital relative to the available deal opportunities in the US market.

US institutions also have important internal dynamics to deal with in the current climate. Most of the larger investors in private equity pursued a deliberate policy of over-allocation in the asset class, assuming that distributions would start rolling in before the full allocation had been drawn down.

As distributions dried up, investors quickly began to see their private equity allocations rise, a problem that was compounded by rapidly falling stock markets. Because adjustments to private equity valuations take longer to filter through than drops in the public markets, institutions found their asset allocation models to be unbalanced.

According to Willie Schmidt, managing director of Advent International, which raised around 68% of its latest US$2bn vehicle in the US, last year represented the "perfect storm".

"The effects of a large overhang of capital, the slump in the economic cycle, the well documented problems associated with specific sectors such as telecoms, and a falling stock market all had an adverse effect on US institutions," he says.

Schmidt adds that domestic problems made them even wearier about investing abroad. "In 1998, 1999 and 2000, Europe was a very easy sell to institutions that wanted greater diversification and saw Europe as the next logical step," he says.

"In 2001, when institutional investors began to realise how much trouble they were in at home, they assumed that the same problems would soon spread to Europe. The euro also brought with it an aspect of insecurity, especially after it started falling against the dollar, and US institutions displayed the natural reaction of retreating to their home market."

Another problem, which although not specific to the US is magnified there, is the increasing pace of the fundraising cycle.

"During the 1990s there was a three to four-year fundraising pattern, which most people adhered to. When the boom happened this all changed and funds were coming to market every one or two years," says Schmidt.

With more fund managers raising faster funds, the limited resources of investors became increasingly stretched, Schmidt says.

"For limited partners this became a problem because PPMs [private placement memoranda] were coming in at such a fast rate that investment committees became overstretched. Because of this increased competition, it became very difficult to even get past the door of institutional investors in the US."

The recent aggressive moves by the State of Connecticut against Forstmann Little, the fourth largest buyout firm in the US, are an indication that the patience of limited partners is wearing thin.

The State, which has filed a lawsuit in the Superior Court, claims that Forstmann mismanaged its US$100m commitment by investing rashly in two ailing telecoms companies. The action, whether successful or not, has already made headline news and may encourage other disgruntled institutions to take a long hard look at the investment behaviour of their general partners during the last two years.

A lot of institutional capital has gone up in smoke, and there is a lot more pain still to be felt. After the heightened expectation of recent years, US institutions may not be so willing to be burnt again.

European institutions look to the future

On this side of the Atlantic, the fundraising slowdown has not been quite so dramatic and the outlook for the future not so bleak. Indeed, the 17.7bn [euro] amassed in the fourth quarter of 2001 represented by far the largest single quarterly total since records began, according to Initiative Europe data.

Admittedly, the figures were distorted by the fact that the two largest European funds ever, the 4.7bn [euro] CVC European Equity Partners II vehicle, and the 4.2bn [euro] BC European Capital VII, both held final closings in the same quarter. Since then, fundraising in Europe has taken a predictable hit, but the climate does not appear to be nearly so bleak as that in the US.

For several years, the supply of capital flooding into the European private equity market looked unstoppable. Each quarter appeared to trump the last, as the size of funds became ever larger.

During much of this period, the relationship between the amount of capital raised and the amount invested remained fairly constant and many feel that the current imbalance will be quickly soaked up as soon as the deal-doing market recovers.

As Paul Myners says: "The outlook for Europe is positive but there is a temporary imbalance of too much money chasing too few deals."

This confidence is reflected in a recent study jointly conducted by consultants Watson Wyatt and Indocam, a French alternative asset manager, which showed that European institutions could be investing nearly 5 % in alternative asset classes by 2003.

The institutional dynamic in Europe is very different to that of the United States. In the US, private equity has been an accepted part of diversified asset allocation for many years. In most parts of Europe, institutions had just begun dipping a toe in the water when the dotcom boom exploded. In contrast to the US, where many institutions are over-weight in the asset class, many European investors are still trying to initiate investment strategies.

Colin Buffin, managing director of Candover Investments, explains this difference: "The US is a very flat market because it is more mature and there is far greater competition for deals. The European market, especially on the Continent, is still at an embryonic stage in terms of private equity completions relative to GDP. Compared with the US, it is difficult to say that there is an oversupply of capital, especially in markets such as Germany, France and Italy as they mature."

Buffin adds: "Since we were last in the fundraising market we have noticed a marked difference in the attitudes of Continental European institutions in their willingness to invest in private equity deals. Institutions have become more sophisticated. There is a far larger community of advisors and fund-of-funds, which help to consolidate institutional capital."

The proliferation of professional advisers is a topic that Schmidt also picks up on. "We have reached a situation in Europe, where institutional investors are saying `we want to get into private equity and we know what we don't know'," he says.

"In the past, if institutions had a private equity allocation, it would often be carried out on an ad hoc basis by someone with very little prior knowledge. This is a mistake, because the difference between upper and lower quartile in private equity performance is far greater than with publicly managed funds."

The European advisory network has evolved over the last few years to compensate for this skill shortage among the institutional community

European differences

Despite the proliferation of advisers and facilitators now operating in Europe, the market remains diverse. Ongoing consolidation in the financial services industry coupled with changes to legislation governing investment allocations should ensure that these large discrepancies are ironed out over time.

In the case of pension funds, which have traditionally been the largest investor in European private equity, the underlying driver for change across Europe is one of demographics.

As the population ages, governments are having to re-adjust their cradle-to-grave provision of state services and open their markets to private pension provision. The countries that have traditionally provided the most fertile hunting ground for private equity fundraising, namely the UK and the Netherlands, are also the most advanced in this deregulation process.

Since the publication of the Myners report last year, and the subsequent abolition of the Minimum Funding Requirement, a number of new institutions, especially county council pension funds, have initiated investment plans, often starting with an investment in a fund-of-funds such as Pantheon Venture or Westport Private Equity.

It is also notable, and perhaps regrettable, that UK institutions that had their fingers burnt in the private equity market during the 1980s and early 1990s were tempted to re-enter the market by reports of the massive returns being generated by venture funds during the past two years.

Despite the increased awareness of private equity in the UK, the market is still characterised by a plethora of smaller players, which makes fund-of-funds investing an attractive option. By contrast, the Netherlands is dominated by several very large institutions, which are more likely to adopt a diversified private equity strategy.

Schmidt explains: "Dutch pension funds have tended to consolidate around industrial sectors, creating huge pools of capital with very advanced investment capabilities."

The two very largest, ABP and PGGM, took the consolidation one step further when they acquired NIB, and created their own investment bank. Another example of this rationale is the BPMT pension fund, which established MN Services as an external fund management business to service its own, as well as third-party money.

In the Nordic market, which also has a more liberalised legislative framework for pension fund investing, commitments have tended to be channelled toward indigenous players until recently. Changes to legislation, as well as increasing asset allocations, have seen them look further afield.

Across much of German speaking Europe, where pension fund regulations are far more prohibitive to investing in alternative assets, fund managers have been more advanced in offering investors alternatives to the traditional 10-year limited partnership.

Part of the rationale behind these moves is to tap into non-institutional sources of capital, such as the high net worth and mass affluent cash pools. In Switzerland and Germany, private banks have been used as a distribution channel to consolidate capital from this client base. Listed investment trusts and innovative structures, such as the "bond wrap" adopted by Partners Group, have also sought to offer institutions, as well as individuals, an alternative route into the asset class.

The other major European economies -- France, Spain and Italy -- all have relatively embryonic pension fund markets and have tended to rely heavily on bancassurance companies for institutional capital. Changes are, however, afoot.

The Spanish and Italian governments have introduced new funding structures designed to attract indigenous capital, while at the same time cutting red-tape and introducing pro-investment tax regimes. In France, tax reforms should also encourage the reticent investment community to commit more capital to the asset class.

Despite continued EU integration, the pension fund market -- the main source of private equity capital -- is fluid and varied. While the demographic logic suggests that major changes will occur in years to come, private equity fundraisers are faced with the important challenge of maximising their investor base in the interim. Expect to see more by way of alternatives to the traditional 10-year LP in the years to come.

Investor expectations

The institutional climate for private equity fundraising has changed dramatically over the last few years. Caught by the frenzied high-tech investment boom, investors have become more reticent about their alternative asset allocations and more careful in their choice of partners.

As Patrick Cook, a director of 3i, says: "The balance of power is shifting toward the institutions in these more difficult times." Gone are the days when tech funds, with little or no experience, can raise multi-million pound funds in a matter of months.

The proliferation of private equity advisers, funds of funds and gatekeepers, as well as consolidation in the financial services industry, is concentrating capital in the hands of those that can point to an established track record throughout the economic cycle (see "Sources of new European private equity funds raised during 2000"). In the current climate, investors also carry more weight when they air concerns over reporting and valuation mechanisms and the fees that fund managers have begun to take for granted.

Nigel McConnell, managing director of Electra Partners Europe says: "During the boom years, investor expectations became very high as the whole investment cycle speeded up and distributions flowed back to investors at record levels."

The dramatic fall in the value of high-tech portfolios has changed all this but, as McConnell adds, institutions that steered clear of the tech boom are rubbing their hands in the current climate.

"Investors in mid-market buyout firms such as ourselves, that stuck to their original investment remit, have very high expectations because they expect to be insulated against the filling valuations elsewhere in the market," he says. "They are rubbing their hands in glee, but in a falling market it is sometimes necessary to manage these expectations downwards."

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