Pepper Hamilton annually commissions a survey to keep clients abreast of middle-market private equity trends. This year, with Mergermarket, we surveyed 50 middle-market PE firms regarding fund life cycles. Our findings were no surprise. Compared to five years ago, fundraising is taking more time, investments are being held longer and overall fund life cycles are lengthening. To succeed in this marketplace, sponsors must understand these trends and respond accordingly.
On the fundraising side, 58 percent of funds reported longer fundraising time frames than for their most recent funds, with an additional 16 percent reporting significant increases. This is not due to a lack of available capital, as the amount of capital being raised has been stable. Instead, the trend appears to be driven by investors trying to concentrate capital with fewer managers. Data from Preqin supports this: The more than $550 billion raised last year was invested in only 1,061 funds—a drop of 24 percent from the prior year. Investors are more closely investigating funds before committing capital (and using third-party advisers hired specifically to do so), determining which have the best track record and are most likely to obtain high returns. Respondents indicate investors are more aggressively negotiating their rights with these top-performing funds than in prior investments, and funds are equally aggressive in negotiating due to their “top performer” status.
Sponsors have had to rethink their approach because of longer fundraising cycles. Increasingly, sponsors aim to distinguish themselves from competitor funds. Partly this may be due to specialization for specialization’s sake, but sponsors must examine their track records to identify strategies that have worked. What particular industries or asset types have outperformed? If areas of specialization are not obvious, funds examine general industry trends to identify higher-performing asset classes. We expect this specialization trend to continue.
Sponsors noted that deal life cycles are extending due to increased competition for quality targets. Further, “A+” assets are commanding premiums, which could lead other sellers to have unrealistically high expectations for their assets. This increases price pressure on sponsors and contributes to more broken deals. Sponsors are ensuring that assets are worth these premium prices through measures such as enhanced diligence, additional (often protracted) negotiations, and earn-out and/or price renegotiations. These all take time to implement. Thus, the period between signing and closing has lengthened.
Furthering this trend is the fact that expensive assets require that either add-ons be completed at discounts to “average in” to the target return or that sponsors organically increase an asset’s value to achieve that return. Both processes contribute to longer deal life cycles. Indeed, 56 percent of sponsors said the time between initial platform investment and final disposition has increased, with an additional 12 percent saying it has increased significantly.