Buyout News 2008

Cover Stories
7 July, 2008

LPs Embrace Specialized, Mid-Market, International Funds

A mid-sized Russian infrastructure fund¡ªBuyouts isn't sure such a fund exists, but in today's market it would get oversubscribed in a heartbeat.

Specialization took command as a trend to watch in the fundraising market in the second quarter¡ªas did a shift in money toward mid-market funds and international funds. Whether by industry, target size, region or country, limited partners seem to be embracing the narrowly tailored, even as they continue to back more generalist funds.

¡°Specialized funds always made sense, but the world wasn¡¯t ready for them in 1988,¡± said Stephen Moseley, president of pension advisory shop StepStone Group. ¡°Their increasing popularity reflects the maturing of the industry. For GPs and their portfolio companies, there is tremendous efficiency, productivity and deal flow connected with industry immersion.¡±

And then there are the twin holy grails offered by specialized funds¡ªdiversification and returns. ¡°Many investors feel that to achieve proper diversification, they need to find best-of-breed managers in different sectors, such as small buyouts or health care or Poland. And LPs are seeing that focused [general partners] can deliver strong returns in their niche markets,¡± said Greg Jania, a partner with fund-of-funds manager WP Global.

Specialization has gathered force as a movement at a time when the U.S. fundraising market as a whole continues to defy gravity. At the halfway point of 2008, the amount of capital raised by U.S. firms for buyout and mezzanine vehicles totaled $141.4 billion, a hair shy of the $143.8 billion raised at this point in 2007, which hints that we may see another record broken by yearend, if the current pace is maintained. Mezzanine fundraising cooled considerably from its pace in the first quarter. Firms amassed just $1.5 billion for mezzanine limited partnerships in the second quarter, down from $20.5 billion in the first. By contrast, the $74.0 billion that U.S. buyout firms raised in the second quarter marked a sizeable jump from $45.0 billion in Q1.

A recent survey by secondaries specialist Coller Capital suggests that the thrill may be gone for the mezzanine subsector, with LPs ranking it fourth out of six when asked what the bestperforming private equity investments would be over the next 12 months, with lower and midmarket buyouts ranking one and two, respectively. ¡°People have placed their bets on mezzanine and don¡¯t want to see a huge surplus sitting around,¡± an alternative asset adviser told Buyouts.

To be sure, generalist firms with strong track records continue to rake in good money. New Mountain Capital gathered $1.3 billion to complete its $5.0 billion Fund III in 2008. The firm invests in leveraged acquisitions, build-ups, recapitalizations, control restructurings, management buyouts, pre-public offering opportunities and growth equity transactions across a swath of industries. Among its backers: Indiana Public Employees¡¯ Retirement Fund, which committed $50.0 million.

But with LPs disillusioned by the unlofty returns promised by generalist mega-buyout funds from the last couple of vintage years, many are now convinced that fund managers can¡¯t be experts in everything. They see value in smaller, more narrowly focused vehicles, which they believe will provide better returns.

Niche funds taking advantage of that sentiment include Thoma Bravo¡¯s Fund IX, focusing mainly on technology, to which The Massachusetts Pension Reserve Investment Trust recently approved a $50.0 million commitment. Vista Equity Partners is working toward a $1.1 billion for its third technology fund, and received $15.0 million from Pennsylvania State Employees¡¯ Retirement System to help it get there. ABRY Partners, which focuses only on media deals, had no problem achieving its target of $1.35 billion this year for its sixth fund. Catterton Partners raised $300 million for its first fund exclusively dedicated to the lower middle market. The firm takes control investments in high-growth consumer companies
requiring between $10 million and $30 million in equity.

Energy funds remained popular with investors, with the price of oil skyrocketing ever higher. Denham Capital Management, which invests in the energy and commodities sectors, closed its fifth fund with $2.0 billion, all raised during 2Q08. Denham¡¯s LPs include endowments, foundations and high-net-worth individuals. Trust Company of the West closed TCW Energy Fund XIV LP with $2.6 billion. The firm intends to make mezzanine and private equity investments in energy and energy-related infrastructure projects globally. Backers include the Louisiana State Employees¡¯ Retirement System, with a $50.0 million commitment, and the
Treasury Division of the State of Alaska. Cadent Energy Partners closed Cadent Energy Partners II LP at $473.3 million, raising $243 million of the total in 2008. Backers include the Andrew W. Mellon Foundation, the University of Chicago and CommonFund.

Mega-Funds Out, Mid-Market In

In 2006 and 2007, mega-funds of $5 billion or more could do no wrong and attracted the lion¡¯s share of commitments. Even in the first half of this year, mega-fund managers collected their fair share of commitments, gathering $35.6 billion spread out over 16 funds. One of the most impressive accumulations: Warburg Pincus¡¯s Private Equity Fund X LP, which raised $6.0 billion of its $15.0 billion total in 2008.

But with mega-funds out of style due to the credit crunch, LPs are increasingly placing their bets on smaller funds, especially those with targets of between $1.1 billion and $5.0 billion. LPs have always liked the idea that mid-market firms ostensibly wring much of their profits from portfolio companies through operational improvements rather than via debt¡ªand it's an especially cogent
selling point at a time of scarce leverage.

Together, funds with $1.1 billion to $5.0 billion targets garnered 58 percent of the pie in the first half of the year, compared with 33 percent for mega-funds (see table, page TK). What's more, many funds that aimed to raise $1.1 billion to $5 billion exceeded their targets, some by huge margins. Some funds even creep into that category unexpectedly. Technology investor Silver Lake Partners, for example, recently closed Silver Lake Sumeru, the firm¡¯s first middlemarket
fund, with $1.1 billion, well ahead of its $750 million target . The fund enjoyed backing from public and corporate pension funds, endowments, foundations, funds of funds and individuals. Although smaller funds are receiving attention, their popularity seems to be on a downward trajectory, garnering 5 percent of the pie in 2006, 3 percent in 2007 and 2 percent so far this year.

Funds-of-funds managers looking downstream to small buyout funds include Richmond, Va.- based Private Advisors, which has recently committed to sub-$300 million funds raised by Industrial Growth Partners and Stonebridge Partners; Pantheon Ventures, which has committed to sub-$400 million funds raised by AtriA Capital and Pfingsten Partners; and RCP Advisors, which has committed to $300 million funds raised by Arsenal Capital Partners and Sentinel Capital Partners. Topspin Partners LBO just closed one such vehicle, a new
$132 million equity fund which had a target of $100 million. Topspin acquires lower middle market U.S.-based companies in consumer products, retail, restaurants, food and beverage, media and publishing, niche manufacturing, and security.


Outside of the United States, Europe and Asia are attracting the most attention from institutional investors, with Latin America not far behind. But you can¡¯t turn around at an industry event without hearing the words ¡°emerging markets.¡±

¡°LPs are going where the growth is: India, China, Vietnam, Eastern Europe and Brazil, although there are headwinds in Vietnam and India,¡± said Alex Bangash, managing director of Rumson Consulting Group, a New Jersey-based LP adviser.

And, if you listen closely, you¡¯ll hear whispers of even more exotic locales, places like the Philippines, Russia, the Gulf region, Africa and even the ¡°-stans.¡± Regarding the next 12 months, LPs ranked European and Asia-Pacific buyouts numbers one and two out of six top areas for GP investment, according to the Coller survey. One LP looking to increase its European and Asian exposure is the Division of Investment at the New Jersey Department of the Treasury, which is shifting from a primarily U.S. focus to global investments over time. Meantime, the New York City Office of the Comptroller just made its first commitment to an Asian private equity fund.

In Latin America, the emphasis is often on one country, rather than on an entire region, and sometimes on a particular group of sectors within that country. For example, in April, AIG Capital Partners held the final close of AIG Brazil Special Situations Fund II LP, with commitments of about $700 million. The vehicle targets agriculture, natural resources, consumer products and services, retail, financial services, and manufacturing.

As for Asia, TPG recently closed on more than $4.25 billion in commitments for TPG Asia Partners V LP, including $36 million from the Canada Pension Plan Investment Board. Other firms still raising funds for Asian vehicles include The Carlyle Group, for Carlyle Asian Partners III, which has raised $1.3 billion so far this year. The vehicle for general Asian investments will invest across industries in countries outside Japan.

The established economies of Western Europe hold more interest now for general partners than Eastern Europe. In April, Summit Partners closed its first dedicated European fund, reaching a target of €1 billion ($1.5 billion). The fundraising took only a few months, all in 2Q08. The focus will be on the European Union, but the firm will invest selectively in Central and Eastern Europe. The Virginia Retirement System committed €66 million ($104.5 million) to the fund.

.So far the interest in overseas funds is not hurting the domestic fundraising market. ¡°The universe of opportunities has expanded geographically," said StepStone Group's Moseley. "And this has resulted in greater capital inflows, not fewer or smaller U.S.-based funds."

Indeed, the U.S. fundraising market appears to have plenty of life in it this year. For every plan sponsors reaching the top of its private equity allocation, another one seems poised to fill the breach. Some LPs, such as the Los Angeles Fire and Police Pensions, are considering raising their allocations to create more capacity. And several LPs are just now entering the asset class. The Marin County (Calif.) Employees¡¯ Retirement Association recently added a 10 percent allocation to private equity, as did the Alameda County (Calif.) Employees¡¯ Retirement

¡°We have several clients who are in the process of raising their targeted private equity allocations," said Moseley. "And we are in discussion with several U.S. public pension funds and several large sovereign wealth funds regarding the right strategy and structure for new private equity program launches. So there will be fresh commitments looking for a happy home.¡±

By Nancy Gordon

All Rights Reserved © Copyright 2008-2009 Rumson Consulting Group
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