This month, MJ Hudson celebrated its 10th birthday. So, for this latest Alternative Insight, we thought we’d enter into the spirit of the occasion by spotlighting the 10 biggest changes we have observed in the private equity funds market, over the last 10 years:
With interest rates pushed to (and staying at) historic lows ever since the global financial crisis (GFC), investors have had to search harder for yield, with many expanding allocations to buyout, venture capital, infrastructure and real estate funds. The result, over the last decade, has been dramatic growth across private funds. The 2020 McKinsey Global Private Markets Review found that there are now nearly 7,000 PE firms (up 40% since 2010). By the end of 2019, according to Preqin, the industry marshalled $1.45bn of dry powder, more than twice the level reported in 2009.
We also saw a concomitant concentration of power in the hands of big, established management firms. Mega-funds ($5bn-plus) now account for roughly half of all the money raised in the buyout sector, a share that has inclined with time. The sheer size of these funds has allowed some managers to reduce their fees, from the traditional 2% of committed capital to around 1.5%, while maintaining (or even increasing) total fee receipts. At the same time, many big firms have expanded and diversified their own businesses, beyond their buyout strongholds, to become multi-strategy managers, with private credit strategies very popular (see below). The concentration trend shows no sign of reversing; three-quarters of LPs surveyed in Coller Capital’s Global Private Equity Barometer Summer 2020 expect private equity AUM to become even more concentrated over the next five years.
Private credit (essentially, non-bank lending, away from public markets) has developed at such a clip that it’s now big enough to constitute its own asset class. Particularly in Europe, it was an opportunity born of crisis. In the wake of the GFC, regulators tightened capital buffer requirements and newly cautious banks cut back on lending to de-risk balance sheets. This opened up a funding gap as the economy recovered, which attracted not just credit specialists but also big PE and hedge fund management groups, looking to diversify their businesses.
Credit funds now run the gamut of the risk spectrum, from senior to distressed debt. According to Preqin, there are now over 1,750 managers active in the private credit space (more than twice the number just five years earlier) and over 4,100 investors. The Alternative Credit Council, a trade group, puts global AUM at $767.5bn in 2018, compared to $237.9bn a decade earlier. Private credit is much more lightly regulated (and, as the term ‘private’ implies, less transparent) than bank lending. How it performs in the COVID crisis will be an important signal of its underlying resilience and potential for further growth.
After severely contracting during the height of the GFC, the secondaries market recovered strongly in the 2010s, smashing records for fundraising and deals almost every year. Near-term available capital (including leverage) now stands at around $170 billion – a more than fourfold rise over 10 years, according to Greenhill. Even in the present tumult of the pandemic, Secondaries Investor reported that PE secondaries funds raised $48.3 billion in the first six months of 2020. That exceeds all previous full-year totals (apart from 2017); it is more than double the money raised in 2009. The secondaries market is now a standard portfolio management tool for all LPs, and increasingly for GPs, too – secondaries funds have branched out to cover a wide array of GP-led transactions.
The Institutional Limited Partners Association was founded almost 20 years ago, to advance the interests of private equity LPs, but it was the 2010s which saw it transform its public profile and begin to have a real impact on policy. At the start of the last decade, it had only recently launched the Private Equity Principles, aiming to promote good practice and common standards at fund level. By the end of the decade, it had released an expanded, modernised third edition of the Principles. That capped years of intensive work on multiple fronts, developing fee and expense reporting templates, model fund agreements, and guidance on topical issues like GP-leds.
ILPA now counts 550+ members, more than double its roster, 10 years back. Those members account for around $2 trillion of capital managed by private funds, an estimated 40% of total AUM. MJ Hudson’s lawyers are proud to have worked closely with ILPA for many years, including providing two members of the international task force responsible for designing ILPA’s whole-fund model LPA.
Subscription lines – loans made to a private fund, secured against investors’ committed capital, generally without recourse to the fund’s underlying investments – were traditionally only a short-term filler for capital calls. However, in the last five years, sub lines have swollen in popularity, magnitude and term duration. Aberdeen Standard Investments estimates the global fund finance market at over $575 billion.
A sub line enhances a fund’s short-term liquidity, allows the GP to defer capital calls (which lifts the fund’s IRR), and lowers the administrative burden by reducing the frequency of capital calls. Not all LPs find credit-enhanced IRRs problematic; indeed, many strive to maximise IRR in their own portfolios. But concerns remain. ILPA has published special guidance on sub lines, mainly aimed at making their usage, terms and IRR effects more transparent. GPs need to take care when negotiating sub line terms.
Historically, alternative investments were fairly unregulated as an asset class. But the GFC ushered in a new era of regulation, spearheaded by Europe’s AIFMD and the U.S. Dodd-Frank Act. Many market participants were unhappy or at least sceptical about these developments, but, given the industry’s continued growth, there is no evidence that the new laws inhibit fundraising or investing, in aggregate, as some had initially feared. They may even have served as a sort of kitemark, encouraging more LPs into the market.
The COVID crisis also highlights genuine improvements in GP attitudes to transparency over the past decade, spurred on by new regulations, investor pressure and, particularly in America, regulatory enforcement. According to Coller Capital’s Global Private Equity Barometer Summer 2020, only around 40% of LPs reported being satisfied with their GPs’ transparency in the aftermath of the GFC, but that’s now risen to 80%.
Ten years ago, only a handful of GPs had signed the UN Principles of Responsible Investing (PRI). Outside of DFI-backed funds, it was rare to see significant attention paid to environmental, social and governance issues (ESG) in a fund PPM or LPA. A decade later, it’s rare to not see that. The PRI now has more than 400 GP signatories. GPs have moved from treating ESG predominantly as a compliance exercise to acknowledging its importance, as well as the potential for corporate value creation through strong, effective ESG policies – indeed, impact investing was enjoying its own mini-boom before the pandemic struck. There are now even ESG-linked sub lines, with EQT, Quadria Capital and Investindustrial among those leading the way.
This was the decade when direct investing and co-investments established itself prominently in the private assets sphere. Triago estimated “shadow capital” (co-investments, separate accounts and direct investments) at $189 billion in 2018. In our experience as lawyers representing GPs and LPs, it is rare to encounter seasoned institutional investors who do not request co-investment preferences when investing in a new fund. Co-investments are viewed as a good way to gain exposure and build stronger GP relationships, albeit more cheaply, because the fees on co-investments are low (sometimes, zero). Similarly, direct investments don’t incur external management fees and allow the LP in question to actively shape its portfolio.
The inequalities in the private equity model mirror those that have encrusted the wider economy since the go-go 1980s: managers and providers of capital have enjoyed a long period of good returns, while the industry, through its portfolio companies, oversees the earnings and working conditions of millions of workers around the world, many on quite low pay. With power and success came scrutiny – from the press, lawmakers and regulators.
Writing in Invest Europe’s 2019/20 Annual Report, the organisation’s chairman, Thierry Baudon, issued a clarion call to the industry: “[I]n the post-pandemic world, we will have the opportunity to demonstrate that we outperform other forms of ownership when it comes to economic and social impact. For many years, we have been better at generating jobs, driving change and fuelling innovation than we have at making these achievements known to decision-makers and society at large. We must show that we are good corporate citizens, making a positive impact on European society in order to validate our license to operate for years to come.”
Copyright © 2021. All rights reserved.