When ECI set out to raise its 12th fund in February 2022, little did the team know how much of a mountain it would need to climb. “The fundraising environment was tough this time around,” says Chris Watt, ECI managing partner. “For the past few funds, we’ve reached first and final close within three to five months, with significant oversubscription. This time, it took more than a year.”

He adds that it was a chastening experience, despite ECI having a good story to tell: “We didn’t have problems in our portfolio, we had strong returns and good exits coming through – there was consistently good news to present to the market. That shows how tough the environment has been.”

In a rare success story for today’s private equity fundraising market, ECI announced that it had hit its £1bn hard cap for ECI 12 last September. It was oversubscribed by £250m and the amount raised was a 40% increase on its previous £700m ECI 11 fund. 

As Watt describes, not that long ago private equity fundraising wasn’t so arduous. Boosted by a low interest rate environment, the asset class had quite a run over the past decade, with dealmaking and fundraising totals regularly breaking records. The pandemic may have led to a slight pause, but the flood of capital continued to flow towards private equity and venture capital strategies in 2021, which globally attracted more than $1trn through almost 5,000 funds, according to Preqin. That was up from the $900bn raised by 3,498 funds in 2019.

Fast forward to today and the situation has significantly changed, as geopolitical shocks and high interest rates work their way through the system. By the end of November, according to Preqin, the total raised by private equity and venture funds had dropped to $743bn.

Global buy-out activity has stalled – values were down by 58% year on year to $202bn in the first half of 2023, according to Dealogic. And the number of buy-out funds reaching final close in 2023 also dropped. By the end of November 2022, some 291 pure buy-out funds had closed, according to Preqin, compared with 443 in the full year 2022 and 610 in 2021.

Investor pressure

It’s clearly a tough market in which to raise capital today. Bain & Co estimates that, for every $3 of capital that funds are seeking, there is just $1 of limited partner (LP or institutional investor) allocations available. This is partly down to the denominator effect – institutional investors’ investments in public markets have reduced in value since the peak, while private equity portfolio values have declined less, so private equity exposures have increased as a percentage of investor allocations.

Confronted by a frenzied fundraising market in 2021, some investors also front-loaded their commitments to private equity, in effect borrowing from future years’ allocations to the asset class. And finally, a lack of exits is causing further liquidity issues. “Today, fund investors are finding it challenging to commit to funds because distributions have been slow to materialise – their cash budgets are out of kilter,” says Janet Brooks, partner at placement agent Monument Group.

Yet, according to some, the industry has been through worse. “I don’t think the market is as tough today as it was during the global financial crisis,” says Gabrielle Joseph, head of due diligence and client development at placement agent Rede Partners. “During that period, fundraising was at a total standstill because there was a very difficult backdrop for limited partnerships specifically. They had serious liquidity problems and some were even defaulting on their commitments. We are not seeing this today.”

We are, however, seeing some funds dusting off the kinds of inducement used after the global financial crisis to attract LP capital. “Some are offering discounts, such as early-bird discounts and fee reductions for large ticket sizes,” says Joseph. It’s not a tactic individual funds are likely to shout from the rooftops, but a report in the Financial Times suggested that big names such as CVC Capital Partners, Ardian, TPG and Cinven were offering some kind of sweetener to LPs, including improved co-investment rights. 

Some firms are also reducing their next fund’s size to reflect an environment in which valuations have – or will – come down (and, perhaps, to save the embarrassment of not reaching a higher target). Others are taking a pragmatic decision to delay fundraising where possible, or to postpone final close. Bridgepoint, for example, said in its 2023 Interim Report that its seventh fund “will remain open for commitments until early 2024 to allow investors… to participate in the fund using both 2023 and 2024 capital allocations”.

Fortunate few

Yet, as ECI illustrates, some firms have secured the capital they were seeking – a few even exceeding their targets and/or previous fund sizes. PAI Partners, for example, recently announced it has reached a final close on its seventh flagship fund at €7.1bn – 40% more than the €5.1bn it raised in 2018, while Verdane’s 11th fund was oversubscribed, reaching a €1.1bn hard cap in September.

For ECI, the fundraising was a story of two halves. The fund had strong momentum to begin with, says Watt. “This is our 12th fund, so we have the benefit of a long-standing, loyal and high-quality investor base,” he says. “That was a good start and it meant we were able to reach first close relatively quickly at around half our target. It really helped that we’d been talking to our existing investors for a while and so they were expecting to see a new fund from us.”

Yet events soon took a turn for the worse, with external factors adding to the mix. “The second half was more challenging,” explains Watt. “This wasn’t helped by the political situation in the UK, with the Liz Truss government and the mini budget. We were promoting the UK as a place to deploy capital and it was a tough sell to investors at that point.

The differentiators

Despite this the firm got the fund over the line, in no small part because of the exits it completed, even during a particularly tough market for vendors in Q1 2023. It also sold vehicle management and leasing business Tusker – at a 6.2x return. This, say advisers, is one of the factors that really distinguish firms in today’s fundraising environment. “Those getting raised quickly in today’s market tend to have top-quartile performance with continued realisations in a difficult market,” says Brooks.

“There has been some reluctance to exit in the current environment as some general partnerships are opting to wait for a more buoyant market,” adds Joseph. “However, that is feeding into the LP liquidity squeeze. Exits really make a fund stand out because DPI [distributions to paid in capital] is so important to LPs at any time, but especially now.”

Strong relationships with LPs are also vital. “There has been a shift in LP sentiment over recent times,” explains Joseph. “Through COVID-19 and until recently, there was more of a bias towards re-upping, because of the risks involved in backing teams where they couldn’t spend time building relationships, and because it was a booming market and so there was no need to go elsewhere.”

However, this trend for re-upping, or increasing their investment with managers they had already backed, has now reversed. “LPs are now expecting to deploy more with GPs they haven’t previous invested with,” she warns. “That means no fund can take their existing LPs for granted. GPs need high-quality relationships if a fund is to get momentum with their existing investor base.”

Yet sometimes, even the strongest relationships can be challenged by outside circumstances. This is what Panoramic found when it went out to raise its third SME fund. Stephen Campbell, investment partner at the firm, describes the experience: “Fund 2 took three months to raise; our third fund took 18 months – and that’s despite having a longer and better track record than before. It was very difficult this time around.”

Pension providers

Factors affecting other funds played a part, but smaller UK funds are facing a particular challenge. “One of the biggest factors was the consolidation of the UK local authority pension funds under the LGPS [Local Government Pension Scheme],” says Campbell. “This has led to unforeseen consequences, including much larger minimum ticket sizes. That creates issues for funds targeting the smaller end of the market because there are very few sources of capital for them – the local authority pension funds have historically been important here.” 

Last year, the government’s Mansion House agreement saw nine of the UK’s largest pension funds commit to allocate at least 5% of their default funds to unlisted equities by 2030 – time will tell whether they meet that commitment and if they do, how much of it is allocated to buy-out funds.

Panoramic and other regionally focused funds in the UK are also feeling the effects of Brexit – the European Investment Fund has not been replaced as a major source of capital.

Panoramic ultimately raised £100m and was oversubscribed, helped by a commitment from British Business Investments and a slew of successful exits. Another aspect that helped push investors over the line was the fund’s regional focus on the North of England, Scotland and Northern Ireland. “There’s less competition in these areas than in the South of England and we are providing much-needed capital to established, but smaller, businesses here,” says Campbell. 

What’s on the horizon?

Panoramic’s experience illustrates one of the big trends of recent years – concentration of capital at the top end of the market and consolidation as private equity operations become more complex to manage. The difficult fundraising market may well play into this, as most observers predict that some players will not raise another fund, while others may opt instead to raise capital using deal-by-deal structures, which has obvious challenges around timetables. 

“There is a question mark around the long-term viability of smaller funds – those below the £250m mark,” says Campbell. “Many of the UK’s capital sources have consolidated and so, without any large policy changes, we may well see consolidation among smaller funds. It may be, for example, that some groups will become SME arms of larger investment businesses.”

We have clearly seen the mega buy-out houses sweep up other private capital firms over the past decade to build multi-asset managers that can offer LPs a range of alternative strategies. Many are also seeking to tap retail investors, from wealthy individuals right through to those on the street (usually via financial advisers).

“There are a number of managers looking at launching evergreen funds,” says Meiping Yap, director in the private capital team at Stonehage Fleming. “In part, they are targeted at wealthy individuals that need semi-liquidity – this channel has grown faster than institutional capital.”

Diversification strategy

Yet there are other, smaller players looking at similar strategies. Foresight Group is one example. Having listed on the London Stock Exchange in 2021, the firm has capital to invest in buying other firms. In its private equity strategies, it manages both VCTs on behalf of retail investors and via regional funds for institutional investors. It has also grown its assets under management significantly through its infrastructure strategy, so that today its AUM (assets under management) stands at over £12bn. Recent acquisitions include Australia’s Infrastructure Capital Group and the technology ventures division of Downing.

Having diversified sources of capital is clearly attractive and can help firms weather the times when liquidity is constrained among institutional LPs. Yet accessing the retail market, in particular, can add complexity to operations. “There is a high level of responsibility in managing capital on behalf of both investor types – retail and institutional,” says Matt McLoughlin, director in Foresight’s private equity team. “Clearly, there is a very stringent regulatory regime for managing retail capital, and the fact that we are a listed business adds to the transparency requirements.”

He also cautions: “It would be challenging to raise capital from retail investors without a track record, and if you’re also managing institutional capital, you need to have the right structures in place for the different investor types. That requires high levels of administration.”

Institutional capital, however, is likely to remain the predominant source of capital for private equity. And the fundraising market will improve at some point as LPs work through their indigestion. As Campbell says: “We may have reached the trough – things may start getting better over the next year or so. The positive aspect is that investors are more interested today in private markets – albeit often at the top end of the food chain – so things will improve over the long term.”