The bursting of the various financial bubbles that inflated during the late 1990s will be a long time in the unwinding, even if the noisiest moment of the process – the precipitous crash in public equity markets – is beginning to recede in the collective memory. The private equity industry provides an immaculate example of this phenomenon. Last year saw the steepest fall in fund raising since the peak of 2000 and although 2004 looks certain to show an improvement in general conditions, the outlook remains grey at best for a large proportion of firms. The simple fact is that the size of the present private equity population, even allowing for some winnowing over the last few years, is still predicated on a fund raising environment that is unlikely to be repeated in the foreseeable future. The late 1990s were highly atypical and there are still too many firms to be sustained by the available capital. Last year provided the most brutal portent of this imbalance but the full impact will take several more years to unfold.
Only 37 European private equity firms announced a final close on their funds in 2003. Together they were worth E17.6bn, some 40% less than the E29.3bn that was raised by 72 funds in 2002. The year’s total was only just over a third of the record amount raised in 2000 of E48bn. The blame for the drop lay with familiar culprits; lack of institutional liquidity, a weak exit environment, and general economic and financial uncertainty. The drop in the value of public equity portfolios meant a lot of institutions were over-allocated to private equity and unable to make new commitments. This was compounded by the lack of distributions from existing fund investments. And all of this simply crystallised a feeling of nervousness about the prospects for the global economy, especially in the first half of the year when geo-politics cast a dark shadow over all sorts of investment decisions.
The resulting theme for 2003 was an even more pronounced risk aversion and hesitant investing pattern among institutions than in the previous two years. This was reflected not just in the overall fall in fund raising but in the composition of the handful of funds that did manage to reach a final close. Buy-out funds accounted for about 77% of total funds raised, compared with about 70% in 2002. Venture capital firms, by contrast, accounted for just 8%, a massive collapse from their share of nearly half at the peak of 2000. But even greater proof of the distaste for risk last year was the surge in popularity for mezzanine, a hybrid debt and equity product that marks the very low risk end of the private equity spectrum. It doubled its share of total fund raising to 7% from 3.5% in 2002 and was the only sector to experience a nominal increase over the period.
The realities of this sort of fund raising environment produced some striking contrasts and unexpected results. Permira, for example, managed to break all European records by announcing a final close of E5.1bn within six months of launching. And Altor, a new fund set up by former Industri Kapital (IK) professional Harald Mix, raised E650m in a similar time frame. Some other big names, however, found the going unexpectedly tough. IK itself, for example, could only manage a first close of E500m on its way towards a target of E2.5bn after 18 months in the market. Similarly, Doughty Hanson, another pan-European brand name, had to settle for a first close of E800m as it made slow progress towards an E3bn target. A rash of humbling marketing campaigns quickly proved a disincentive to entering the market, with the effect that many institutions ended the year complaining that there were very few top quality firms to explore. There are now only 90 private equity funds in the market with targets of more than E100m trying to raise a combined total of E33.6bn. At the same point in 2003 there were approximately 140 funds in the market with a combined target of E51.6bn.
The abruptness of the slowdown in institutional investment activity last year had the effect of almost paralysing potential new entrants. Firms postponed fund raising plans, stepped up their efforts to push some exits out of their portfolios, and held tight for an improvement in conditions. And to an extent their patience has been rewarded: public markets have obliged by staging a strong a steady recovery in recent months. This has already produced a handful of encouraging IPOs; the flotation of Yell by its backers Apax and Hicks Muse Tate & Furst in the buy-out sector and the launch of Wolfson Microelectronics have both served as beachheads in the market’s creeping advance. Large-scale trade sales have also begun to pick-up, such as Air Liquide’s acquisition of industrial gas business Messer Greisham that will provide a partial exit for Goldman Sachs’ and Allianz’s private equity groups. The environment is unrecognisable from the first half of 2003 and will improve further with every realisation and distribution that makes its way back to investors.
But the legacy of last year’s fund raising inactivity means there remains a serious imbalance between supply and demand for institutional capital. Indeed, this looks set to be one of the defining themes of 2004 and further evidence of just how long it can take for an epic bubble to work its way out of the financial system. Institutional investors and private equity firms alike are all predicting a crush of funds in the market in the second half of 2004 and first half of 2005. It will be composed of the firms that delayed fund raising from last year and those on an unaltered cycle. We estimate that there could be as many as ten large pan-European buy-out groups launching in the second half of the year with an aggregate target of E20bn, based on the conservative assumption that they will be trying to raise the same amount they raised last time. BC Partners and Nordic group EQT look set to be the first out of the blocks, possibly in the first half of the year, with a combined target of more than E6bn between the two of them. All this is in addition to the E30bn that is being targeted by funds presently in the market or the money being chased by smaller, country-specific or venture capital groups that might enter the market over the next 12 months. The result will be an unprecedented scramble for a share of a pool of capital that, while larger than the amount raised last year, is certain to be insufficient to meet their collective appetite.
The consequences of squeezes such as this are hard to predict with any accuracy in private equity. The length of the fund raising cycle, typically three to five years, means that it can be a very long time before firms yield to these pressures. And the novelty of this particular experience, given the relative immaturity of the asset class, means there is little in the way of historical precedent to illuminate the outlook. Mega funds, for example, were unheard of in Europe before the late 1990s and the hyperbolic growth in the number of firms largely a function of the explosion of enthusiasm among institutions for the asset class in the context of the equities bubble. The present difficulties of the venture capital sector, more immediately affected when the bubble burst, makes clear how protracted the whole process can be. Fund raising has collapsed since the peak and there have been signs of a major shake-out in some regions, notably Germany. But the determination of many groups to try to raise another fund suggests the fall-out is far from over.
A similar moment of truth, albeit one that is unlikely to be anything like as dramatic, can be expected for the buy-out sector. The next 18 months will be crucial for Europe’s buy-out firms. Many of them will be forced to test their mettle in the fund raising crucible and the result will be a stark separation of the groups that institutions rate most highly from the rest of sizeable pack. There will be casualties, if not fatalities. There is simply not enough capital available to sustain all the groups that consider themselves capable of playing in the large end of the market, let alone the myriad of smaller groups that harbour ambitions of establishing a franchise in their locality. In other words, the feeling among many institutions is that the ground is thawing and that conditions are set to improve dramatically through the course of the year is unlikely to translate directly through to the private equity firms themselves. They have yet to undergo the entirety of the post-bubble adjustment. And as befits a long-term asset class, it will take a long time for that to happen.
Chris Davison is head of research at Alt Assets in London

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