Maybe not so bad after all – August 2022 | Issue #188 – Fundraising and the Fund Financial Outlook: It’s Complicated | Cadwalader, Wickersham & Taft LLP

[author: Chris van Heerden]

The fundraising perspective has become more complicated in recent months. No question, the annual data looks good. For example, PitchBook reports that 191 U.S. PE funds raised $176 billion in the first half, which is an annualized annualized figure ahead of the fund’s worth of about $340 billion last year. More broadly, global private capital raised in the first half totaled $645 billion, according to Preqin data, which is down from 2021 but the industry is poised for another year of more than $1 trillion US dollars ready.

However, those numbers are in the rear-view mirror at this point, and a variety of factors cloud future prospects:

  • The record pace of fundraising over the past 18 months is reportedly exhausting LP bandwidth. PitchBook highlighted the topic in its most recent issue Q2 PE breakdown, noting, “This is perhaps the busiest fundraising market in history.” Some LPs have reportedly used up their full-year 2022 allocations in the first half. However, PitchBook notes that the top platforms are successfully struggling through the turmoil to close flagship fundraisers.
  • The velocity of capital, particularly in the buyout market, is slowing. Lowering the stake and slowing the exit means slower return of capital to investors to recycle the proceeds into new exposure. The overall business cycle suggests that entries and exits are likely to remain lower.
  • A challenging IPO market contributes to the decline in exits. July’s 10 US IPOs were the slowest month since January 2016, with proceeds of $339 million, according to Bloomberg data.
  • A valuation disconnect between public and private markets partly explains the drought in IPOs and may have a lasting effect. This valuation disconnect is evident in the fact that only one of the more than 70 U.S. IPOs completed to date in 2022 has been priced above the marketed range, resulting in the fewest above-range prices in two decades, according to Bloomberg . Buyout exits via IPOs are likely to remain muted until private and public views on valuations converge. Reuters covered the same issue this week in “Dreaded “down rounds” slash startup valuations by billions.”
  • Declines in public markets may result in LP portfolios being more heavily weighted towards private strategies. According to the theory, LPs that inadvertently overweight private investment may reduce new private capital allocations through what is known as the denominator effect. Broad market private fund performance data is reported with a significant lag, but we suspect that relative performance differences between public and private funds are not significant enough to significantly impact fundraising at this time. Year-to-date, the S&P 500 is down 10.9% and the Bloomberg US Aggregate Bond Index has returned -8.8% in total. We don’t see these returns as being totally out of step with the private fund return figures mentioned in Q2 earnings calls.

In assessing the importance of these factors to the fund financing market, we believe there are a few key points to consider. First, buyout funds don’t define the entire industry. According to Preqin data, the broader private equity category accounts for 58% of the dollars raised in private markets year-to-date, while 15-20 years ago private equity funds often accounted for 65-70% of private equity raised in any given year . We see the trend of expansion accelerating in the future. For example, KKR & Co. Inc., a pioneer in the buyout industry, reported that 40% of the company’s new capital raised in the second quarter went into infrastructure and real estate strategies. Similarly, Rede Partners recently reported in its first personal loan report that 82% of LPs surveyed expect to increase personal loan allocations in the coming year. Challenges in raising capital for buyout funds should not automatically be attributed to other strategies.

Second, the link between fundraising and the volume of fundraising works with a lag. For new facilities that we closed in 2021, the average date between the LPA execution and the closing of the credit facility was approximately 220 days. This leads us to conclude that robust fundraising activity in the first half has already laid the groundwork for continued growth in fund lending originations in the second half.

That’s not to say developments in fundraising are insignificant. Fundraising schedules are expected to lengthen, more fund closures are expected to push into 2023, and the 2023 calendar could also stack up to compete for limited LP attention and allocations. However, these points are more relevant to the fund’s funding outlook for next year than they are for 2022.

Fundraising aside, the availability of bank balance sheets for the remainder of the year will be a key determinant of fund funding levels. The particular concern is that deposit outflows could lead to greater sensitivity to risk-weighted asset inclusion. (On this point, we previously covered capital facilitation transactions as a balance sheet management tool.) In the second quarter, total bank assets fell 1.1% ($255.9 billion in BankReg data. The decline in assets was the largest since the first quarter of 2009, and the decline in deposits set a new historical record.

But here, too, nuances matter. The overall decline in assets was largely due to the reduction in cash and securities holdings. In fact, loans & leasing saw the biggest dollar gain ever this quarter, up 3.7% ($410.6 billion). C&I loans lead the growth. Bank C&I’s loan exposure rose $48.0 billion in July, while Treasury and mortgage-backed securities declined $35.3 billion (home loan exposure also rose), according to the Fed’s latest H.8 data.

The overall trends affecting balance sheet allocation are intuitive. The 2022 fee operating environment was challenging as revenues from investment banking, asset management and mortgage origination came under pressure. The regime change in interest rates and the uncertainty surrounding QT have made investing in fixed income more of a challenge. On the other hand, higher interest rates allow banks to switch to higher-yielding assets through loan growth, leading to gains in net interest margin and net interest income.

While the pace of deposit outflows and sensitivity to risk-weighted assets will be important to watch going forward, we see no negative impact on lending trends in the data so far. Of course, specifics vary between institutions. However, we expect credit growth to continue to be an important driver of bank earnings.

Headlines have become more cautious in recent weeks. We believe that participants in fund financing should expect a mixed-speed market. Certain sponsorship platforms and strategies will continue to have greater traction in fundraising than others. On the lender side, the development of origination capability will also vary between institutions. While this is less consistently positive than the past two years, we expect aggregate demand for fund financing loans and the supply of available capital from lenders to support continued growth through the end of the year.

About Paige McCarthy

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