Michael Rebagliati October 07, 2013
Last week, we took a look at the rise of small funds evident in PitchBook’s preliminary 3Q 2013 PE fundraising numbers. While this emphasis on small funds (less than $500 million raised) should be viewed in the context of broader fundraising trends—large PE funds are still a force to be reckoned with and will likely continue to account for significant portions of capital raised—the growing prominence of small funds in the fundraising landscape points to a strong improvement in LP confidence.
As highlighted in last week’s article, many of the sub-$500 million funds raised in 3Q 2013 were either debut funds, second funds, or funds that represented a significant shift in GP strategy. Why do LPs appear to be on board with these new fundraising strategies, breaking with tradition and committing capital to more new firms and firms with new fund focuses?
Strong public markets and an uptick in exits, which subsequently mean greater distributions to LPs, have a dual influence on this phenomenon. First, LPs receiving liquidity from previous fund commitments will be more likely to have capital available for new commitments in the next fundraising cycle. Second, as shown in a Forbes fundraising analysis written by Bain & Company, high public-market valuations increase the overall value of an LP’s portfolio, allowing it to essentially exploit a “reverse denominator effect” and increase its allocation to PE in absolute terms, in order to maintain relative allocation balance compared to public equities and bonds.
Additionally, a 2011 survey indicated that 85% of LPs would be willing to move beyond their existing GP relationships and form new partnerships under the right circumstances. This post-crisis willingness to branch out, in conjunction with improved market conditions and enhanced allocation flexibility, could provide insight into this growing confidence in smaller PE funds.
In particular, LPs may feel more comfortable building fresh GP relationships with newer firms that do not have legacies tarnished by the financial crisis and that have a strong niche focus. Aquillian Investments illustrates this possibility. Aquillian, which closed its debut Ecosystem Integrity Fund I at just less than $20 million in the third quarter this year, focuses almost exclusively on growth investments in companies that help develop solutions to environmental threats. Furthermore, Aquillian restructured itself in 2008, spinning off its original incarnation as a broker dealer, in order to set itself up to manage pooled capital following the financial crisis.
One counter to these arguments is that rather than deliberately raising capital for small funds, less experienced firms are simply missing their fundraising targets and are therefore forced to settle for smaller funds. However, data from PitchBook show that 89% of PE funds raised in 3Q 2013 met their target, supporting the theory that this is a deliberate fundraising strategy.
Forging ahead and committing to unproven firms on the fundraising trail will certainly remain risky for LPs, and market conditions and GP performance will ultimately determine whether this trend strengthens and endures. But for now, heightened investment in newer, sometimes narrowly focused funds, should be taken as a positive sign. As an asset class, private equity has not only survived the financial crisis, but is also acting as a dynamic economic force, rewarding innovation and allocating capital to new frontiers.