This article was written by Guo Sun (Goz) Lee, Jingjing Jiang, Alex Lam, Alexander Cheng and Andrew Watson.
The COVID-19 pandemic continues to adversely impact fundraising activity of private equity funds.
In this report, we summarize the current fundraising environment, our experience from the 2007-2009 global financial crisis (“GFC”), our experience from the COVID-19 outbreak, innovations for fundraising during the COVID-19 outbreak that we have devised for fund managers based on our experience from the GFC and silver linings.
Investors in private funds (“Investors”) report an impact on their investing activities or plans and personal business activities.
Placement firm Eaton Partners’ (“Eaton”) March 2020 LP Pulse Survey shows:
- 70% of 69 leading Investors surveyed between 5 March 2020 and 13 March 2020 said that their investing activities or plans have been affected by COVID-19.
- 75% said that their personal business activities have been affected by COVID-19.
As travel restrictions are enacted across the world, in an effort to contain the spread of COVID-19, contact between fund managers and Investors is being postponed.
Many Investors have also restricted travel and are only taking video or phone meetings.
The lack of face-to-face meetings may stall fundraising on funds that were about to launch, according to Peter Martenson, a partner at Eaton. Martenson said “[t]his business is about personal interactions.”
Fundraising – Private Real Estate Funds
On the private real estate funds side, our experience has been that funds with no actual solid pipeline (in particular those focussing on opportunistic assets) may have issues fundraising as there are no tangible assets to conduct due diligence on and Investors are in risk-off mode. In contrast, managed accounts with targeted actual assets in the waiting are likely to perform better in this regard as there are tangible assets to assess and these assets are therefore more likely to appeal to the current risk-off mindset of Investors. Having said that, for targeted actual assets, some Investors in private real estate funds are concerned about the ability and willingness of current tenants to pay rents during COVID-19 and may wish to delay closing until there is greater certainty on this point. In the first quarter of 2020, private real estate funds only raised US$18 billion, as compred with US$51 billion in the first quarter of 2019.
The silver lining for private real estate funds is that those funds focused on opportunistic and distressed-asset investment had US$142 billion in dry powder as of the end of 2019, leaving them potentially in a strong position to pick up bargains during COVID-19. COVID-19 has led to rating downgrades in many industries and should inevitably lead to an increase in the availability of distressed assets. Although hotels and the retail sector are the obvious candidates to experience distress, the longer COVID-19 goes on, the more assets in other real estate sectors will become distressed.
Fundraising – First-Time Funds
Few Investors look to sponsor first-time funds and the spread of the COVID-19 will only make it harder for first-time fund managers. This is especially true for first-time fund managers who have not had in-person meetings with Investors.
Private Equity International’s (“PEI”) LP Perspectives Survey 2020 shows:
- Nearly half of respondents said they only invest opportunistically in first-time funds.
- 37% said they do not plan to invest in first-time funds.
But there could be an opportunity for first-time fund managers shifting from establishing blind-pool funds to funding pipelines on a deal-by-deal basis. According to PEI, market participants agree that deal-by-deal fundraising will be commonplace for first-time fund managers, at least until travel restrictions are lifted.
Fundraising – Geographic Region
Eaton’s March 2020 LP Pulse Survey shows:
- 78% said they would not reduce or pull capital out of certain geographic regions.
- 10% said they would reduce or pull capital out of Asia.
- 3% said they would reduce or pull capital out of Asia and Europe.
The 2007-2009 GFC and comparisons with COVID-19 Outbreak
During the 2007-2009 GFC, we saw Investors in existing funds either default on capital calls, in an effort to cut their losses and run, or try to sell their stake at a highly discounted rate (sometimes at a 100% discount) in order to relieve them of future capital call obligations.
But contrary to doomsday predictions, most private equity funds, unlike some other asset classes (e.g. mortgage-backed securities), generally emerged from the GFC with limited long-term damage.
Bain & Company highlighted in its Asia-Pacific Private Equity Report 2020 that the funds that weathered the GFC the best were those which did one or more of the following:
- Did a larger proportion of buyouts.
- Did bigger co-investments than other funds.
- Were able to pick better companies.
- Avoided exits during the GFC.
- Did few deals during the GFC but started to invest again in 2009.
In the GFC, size mattered for deals but not for funds.
Nonetheless, there remained deep sentiment in the Investor community that some of the fund terms of the pre-GFC years significantly favored general partners (“GPs”) as a result of a GP-friendly fundraising environment, and accordingly, had to be scaled back to fulfil the industry’s objective that funds should be long-term partnerships aligning the interests of both fund managers and Investors to deliver superior returns.
In addition to defaults on capital calls, Investor cooperation, whether in new fundraisings or in selected cases of Investor activism in existing (troubled) funds, leading to renegotiation of terms (such as capping fund sizes or reducing management fees) became the new imperative.
The Institutional Limited Partners Association (“ILPA”) also provided a platform to achieve this.
In September 2009, ILPA published the first version of its Private Equity Principles — ILPA Principles 1.0, which was the culmination of ongoing discussions and consultations among Investors. It was amended as ILPA Principles 2.0 in 2011 and again as ILPA Principles 3.0 in 2019.
The industry had already seen a weakening of the negotiation power of GPs due to the reduced flow of money into new funds in the aftermath of the GFC. But the power pendulum in the negotiation of fund terms had also begun to swing from GPs to Investors post-GFC especially in light of ILPA.
Broadly, the ILPA Principles 1.0 focused on three key areas:
- Strengthening alignment of interests between GPs and Investors.
- Enhancing fund governance and Investor protection.
- Improving transparency and Investor reporting.
In the new fundraising climate post-ILPA, it almost became a new normal for Investors to provide fundraising GPs a checklist to tick off whether or not their fund documents were in compliance with the ILPA. And such checklist was modelled on the ILPA Principles. This was a tough period for fundraising as GPs had, unsurprisingly, considered the ILPA Principles to be generally unreasonable and a significant deviation from the market norm. In particular, the following points were huge areas of contention:
- A move towards the European fund-as-a-whole (or even superfund-as-a-whole which thankfully is now almost extinct) carry structure over the US deal-by-deal carry structure or hybrid deal-by-deal carry structure.
- Significant carried interest protections for the Investor such as strict 100% escrow, clawback and guarantee requirements.
- Requirement that management fees must be justified and only cover a fund manager’s reasonable operating costs and expenses.
- As management fees should not be a profit, a GP should fund its commitment directly rather than funding its commitment through a waiver of management fees.
- In removal processes for the GP, changing the review process from a final and non-appealable court decision to a preliminary determination and, in general, reducing the suggested thresholds for Investor consents in cases of no-fault divorce, no-fault dissolution and no-fault termination.
Investors, in contrast, considered many of the standard market terms established in the pre-GFC years to be too GP-friendly and believed they had to be recalibrated to create a better alignment of interests between GPs and Investors, according to the same article.
Fast forward to today, it will be reassuring for GPs to note that after the pendulum swung so much in favour of the Investors post-GFC and ILPA, it very quickly regained equilibrium and arguably in recent years, has even swung back again to the GPs. That being said, although ILPA now does not hold the influence it had post-GFC, a number of the terms that it pushed for back in 2009 have largely remained to this day albeit in a slightly watered down version, i.e. European fund-as-a-whole carry structure, escrow and clawback, management fees and removal.
KWM Experience from the COVID-19 Outbreak
The recent COVID-19-hit financial markets are reminiscent of the 2007-2009 GFC, with liquidity and solvency being two major issues that both fund managers and Investors need to grapple with. Central banks and governments globally have been quick to address these issues by passing emergency measures to inject money into economies to keep them moving and to avoid the credit crunch experienced during the GFC. Whether these measures will continue to keep the liquidity moving within markets until the COVID-19 situation subsides remains to be seen.
Fundraising in recent years, in particular 2015-2017, has seen successful fund managers gaining the upper hand again in the fundraising power dynamic. But with the ongoing US-China trade war, which has been exacerbated by the COVID-19 outbreak, fundraising volume in Greater China declined in 2019 and there has been a weakening of the negotiation power of fund managers in Greater China. However, some fund managers were under less pressure to raise funds given record levels of dry powder.
We have seen fund managers who had targeted to close funds in the beginning of 2020 forced to push back their closing dates as Investors have pulled back due to COVID-19-related market volatility. Some fund managers who have closed funds after the outbreak of COVID-19 have managed to do so by offering COVID-19-specific provisions in their fund documents (as discussed below). But some funds that have closed recently have already seen some Investors defaulting on capital calls.
To avoid this scenario, it is anticipated that some Investors will request that fund managers avoid making capital calls until the COVID-19 situation subsides. Such requests were commonly seen during the GFC, with fund managers having to decide whether to accept such request or make the capital call and strain the relationship with the Investor. To sidestep this difficult position, it appears that some fund managers have taken pre-emptive action by making capital calls early before Investors can make such requests. While it may appear that fund managers who were able to close funds before the outbreak of COVID-19 were lucky to do so, they can only be considered lucky if they did not buy overpriced assets when financial markets were at all-time highs prior to the recent crash and the Investors in their funds are still able to meet future capital calls.
Fund managers who closed funds at the end of 2019 or the beginning of 2020 and have not yet made capital calls, and ironically including those who tried to close funds earlier but were unable to do so, may actually be rewarded for closing later. Provided that the Investors in their funds are still able to meet capital calls, these fund managers are well-positioned to take advantage of what could be a buy-low opportunity. However, fund managers may need to structure their deals differently and may need to plunge more equity into deals if the credit market dries up and institutional financiers become reluctant to underwrite risk at the same levels prior to the COVID-19 outbreak.
In fact, drawing a comparison to the GFC, buyout funds from 2008 and 2009 had median net internal rates of return of 13.4% and 14%, respectively, which were higher than the three previous years, according to data tracker Preqin. Accordingly, fund managers who are able to close funds now may be in a better position to deliver returns for Investors, compared to fund managers who closed earlier.
KWM Innovations for Fundraising
Drawing upon our experience from the 2007-2009 GFC, which is directly relevant to the COVID-19-hit financial markets, we have worked with our clients in coming up with a number of COVID-19-specific mechanisms that fund managers can consider in order to fundraise effectively during the COVID-19 outbreak.
Fund managers eager to close Investors, who hesitate due to COVID-19-related market volatility or who need to invest according to specific internal asset allocation requirements, can consider including COVID-19-specific provisions in their fund documents including one or more of the following:
- delaying the start of the investment period, which would otherwise start on the first closing, to a later date agreed between the fund manager and Investors;
- holding regular meetings with Investors to discuss the start of the investment period and to showcase the pipeline of deals (which may be lost due to any delay in starting the investment period to entice Investors to start the investment period);
- during this pause period, the fund manager should still be able to call capital for costs and expenses but not fees (including management fees);
- having a long stop date when either the investment period will automatically start or Investors can withdraw from the fund; and
- giving Investors the ability to withdraw or pausing the investment period if future pandemic events occur again. One should be clear on the definition of pandemic. We have seen some clients link this to an objective standard e.g. a World Health Organization declaration.
On the one hand, fund managers can close Investors, and have certainty that they have capital commitments from Investors. It is also a great marketing story to say that you managed to fundraise during such difficult times. On the other hand, Investors can retain control over what fund managers can call capital for, and have comfort that they can control what happens in the event the COVID-19-related market volatility does not improve.
Drawing from our experiences during the 2007-2009 GFC, fund managers can also consider taking more drastic steps, such as offering incentives to first closing Investors including one or more of the following:
- discounts on fees and carry;
- co-investment rights; and
- Investor-friendly protections (for example, fund manager removal mechanisms).
But fund managers should be wary of what they offer to first closing Investors. First closing Investors will likely request to retain such incentives in subsequent funds. In addition, subsequent closing Investors in the current fund will likely request for the same incentives, which will lead to “salami slicing” negotiations.
Further, if such incentives are offered to first closing Investors, fund managers should be clear in their documentation that such incentives are solely linked to the COVID-19, in order to retain the power and flexibility to strike out such incentives in subsequent funds and to not offer such incentives to subsequent closing Investors in the current fund.
Based on the fallout from the incentives that fund managers offered during the GFC, fund managers need to be careful about what incentives they offer, and must know what their bottom line is whilst being steadfast.
Fund managers are facing a challenging fundraising and deal making environment. But unlike the 2007-2009 GFC, Investors have a recent point of reference that may be directly relevant, and fund managers should be more willing to buy assets during the COVID-19 outbreak given the strong returns after the GFC. Arguably, the biggest mistake which some fund managers made during the GFC was to not buy enough assets when they were on sale at a deep discount. Ernst & Young reported that the median return of a 2009-vintage private equity fund was 13.9% compared with 8.1% for a 2006 vintage fund. The question on all fund managers’ minds right now is whether this time is different from, better than or worse than, the GFC. If the damage from COVID-19 is limited, assets bought now will look like bargains a year from now, but if COVID-19 is worse than the GFC then asset prices could still go down a lot more.
It can be difficult psychologically for fund managers to buy assets when noone else is buying and risk being wrong alone and some fund managers may fear that COVID-19 could be worse than the GFC, but as the GFC showed, it sometimes pays to be a contrarian.
In addition, compared with the GFC, private equity funds now have far more dry capital than they had during the GFC. According to Preqin, private equity funds, including venture capital (“VC”) funds, had US$1.45 trillion in dry powder as at the end of 2019, more than double what they had five years ago. Therefore, fund managers should be in a position to take full advantage of any asset price drops, although this increased competition may lead to smaller discounts than we saw during the GFC.
Since the GFC, VC funds have also become much bigger in Asia, especially in China. During 2009, VC fundraising in China was US$3.4 billion. In 2018 VC funds in China raised US$25.6 billion. VC fundraising in China cooled off slightly in 2019 and was down to just over US$12 billion, but that is still more than 3 times what it was during the GFC. Therefore, VC funds in China should now have much more dry powder to buy assets than they did during the GFC.
In the first quarter this year, VC deal value fell by more than half to US$3.8 billion, but there was a more than six-fold increase in VC deal value from February to March as the Chinese economy re-opened according to the Asian Venture Capital Journal.
In this past February, VC deal value in China was only US$410 million, but in March it reached US$2.5 billion, with Investors hunting for bargains in start-ups, especially those in the biotech and education sectors – for obvious reasons. With the Chinese economy re-opening sooner than other economies in the West, the same trend is likely to play out in the West.
The caveat to this silver lining is that many Investors will not be able to take advantage of the opportunity to buy assets as they will be strapped for cash given losses on their current investments. This is especially the case for Investors who went into the COVID-19 outbreak on leverage or have portfolios heavily slanted towards public markets.
But Investors who have money available are trying to keep the track record from 2008 and 2009 (as discussed above) in mind and continue to put money into new private equity funds, according to Jill Shaw, managing director at consulting firm Cambridge Associates. She says “[w]e’re going to see more patience [than in 2008].”
In addition, many Investors see private equity as the asset class best prepared to thrive during the COVID-19-related market volatility, as 52% of Investors surveyed in Eaton’s March 2020 LP Pulse Survey said they believed private equity is the most appealing alternative asset class going forward. “There’s a general feeling that private equity could be a well-positioned, steady-hand Investor during the recent COVID-19-induced volatility” Martenson said in the survey.
So long as the economy recovers without undergoing a long recession, fund managers and Investors who survive the COVID-19 outbreak will benefit from the contraction in deal multiples. Downturns present great investment opportunities for those who survive to take advantage of them.