Private Equity in North America: the Vistra perspective

9 April 2020
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Scott Kraemer, Marcia Rothschild and Stephen Smith examine the North American private equity landscape in light of Vistra’s latest research study into the sector

At the beginning of any year, the broader funds industry, including private equity (PE), awaits the release of data from the previous year with a measure of anticipation. Quarter-by-quarter there are ebbs and flows, and strong movement in one quarter may be curtailed in another – indeed, the short-term data can often be contradictory. But the state of play over 12 months arguably gives a better sense of the temperature of the sector.

 

When Preqin and Pitchbook released their figures for 2019, the instant reaction might well have been that it was a very strong year. Yet again, North America stood head and shoulders above its global counterparts with regard to fundraising. According to Preqin, North America reached an all-time fundraising high in 2019 at $350bn – a 2.8% increase on the previous year.

And the US alone was responsible for a vast amount of that figure – with Pitchbook data showing that a total of 202 PE funds closed with $301.3bn in commitments.

But once you start to dig beneath the headline figures, the true state of the sector starts to reveal itself – and it’s rather more complex.

One of the most significant statistics relating to US PE was the decline in the number of funds closed compared with the size of funds themselves. The 202 funds closed in 2019 had an average raise of just under $1.5bn. Compare this with 2017, the previous record year, when 257 funds closed at a total $241.7bn – an average of just over $940 million.

In simple terms, there were fewer funds in 2019, but on average they were far larger than only two years prior.

It is perhaps no surprise, then, that responses to our own recent research study, ‘Private Equity: Where Challenges Meet Opportunities’, had already identified this as a key trend. Indeed, bigger funds sizes was seen as the second-largest trend shaping the PE industry – identified by 38% of respondents – beaten only by the general political climate (39%).

This is a view that tallies very much with what Vistra is seeing in North America and it’s worth setting this in a broader context. While huge funds are being raised – often successor funds breaking a firm’s previous records – the smaller funds are having more trouble raising. This is true not only in PE, but also in hedge and more generally.

The pressures facing all managers – including continued regulatory change and requirements around economic substance and transparency – are making it more costly to operate fund structures. And this is a more challenging burden for smaller managers to bear.

 

Cautious or optimistic

All of these factors are set against a global backdrop of investors generally being more cautious – not least because of the aforementioned general political climate, including the as-yet-unfinalized issue of Brexit. Yet there also remains a measure of optimism that opportunities are being created. This apparent contradiction is evidenced by our study, with 59% of respondents saying that market trends are making investors more cautious, yet 55% saying they are creating opportunities.

We have seen some interesting shifts on a domestic level with regard to allocation to alternative assets that show an appetite for PE irrespective of cautiousness. In Canada, for example, some of the larger pension funds, including Canada Pension Plan Investment Board (CPPIB), have increased their allocation to PE.

Admittedly, the top decile of fund managers are going to market and oversubscribing and getting bigger and larger commitments than ever before – but this is to the detriment of the smaller funds who are probably struggling to tap into that liquidity in the marketplace.

More broadly, any cautiousness in North America has led to longer fundraising cycles, with investors taking longer to commit.

 

Legislation, regulation and ILPA principles

In our research study, when it comes to how general trends in PE are changing and influencing investor behaviour, 63% of all respondents cited increasing regulation and 59% increasing transparency as key factors. Considering the ongoing pressures caused by the growing compliance burden, this comes as no real surprise.

This is arguably being felt more in North America, however, at least in part because of the revised guidelines from the Institutional Limited Partners Association (ILPA) which were introduced in June 2019 and have added to the administrative workload.

There is also something of a conflict, however, in that the guidelines aren’t mandatory, and GPs may well be prioritising other legislation as a matter of course. Yet a demand for ILPA compliance by US institutional LPs is beginning to bear, most notably on the larger managers.

Despite this, only an average of 32% of respondents to our study said they were fully compliant with ILPA principles, which shows there is some way to go, especially if LPs start mandating compliance.

Even within North America there are some country-by-country differences. From a Canadian perspective, it is our experience that mid-market managers already feel they have enough of a compliance burden to deal with, and ILPA, unless mandated, is a lower priority.

 

 The shift to outsourcing

The pressure being brought by LPs when it comes to compliance with ILPA is only one way in which investor power is manifesting itself – and this is especially true when it comes to outsourcing.

Across GPs surveyed in our study, an average of 72% currently outsource one or more functions to a third-party service provider. Significantly, of those GPs that don’t currently outsource, 7% planned to do so in the next year, with 79% saying they will do so in the next two-to-five years. One of the main drivers for this is coming from LP demand, with 84% of LPs saying they want their GP to outsource, and 67% saying they are keen to influence the decision of which provider to use. Indeed, there are industry-wide examples of LPs actually specifying which service provider the GP should use.

With regard to the nature of services being outsourced, our study showed a broad range, with tax compliance, SPV accounting and regulatory compliance being the three most common. But from a North American perspective we have identified some clear trends across our business.

Notably, we are seeing increased demand for anything relating to economic substance, including board directorships, payroll processing and registered office requirements. We expect the increased focus on this area, and subsequent requests for support, to continue in the coming years.

Increased attention on anti-money laundering has, unsurprisingly, led to an increase in requests for AMLO and MRLO services. And we are also seeing a trend towards preferred providers or ‘one-stop shops’ – with bigger funds looking to consolidate admin firms for a whole host of reasons including economies of scale and simplified reporting and management.

Outsourcing in Canada, in our experience, seems rather more nascent, with managers interested more in supplemental services as opposed to full turnkey solutions. That said, across all our North American operations, we are seeing the increased appetite for outsourcing that came through in our research study.

How this will play out is always a matter of interest. But it isn’t uncommon for managers to outsource certain functions to dip their toes in the water. Alternatively, they may start their outsourcing journey by partnering on a smaller fund or a specific strategy that they’re testing out.

 

The US as a resurgent market?

One of the more unexpected results to came out of our study was that, with regard to established markets, an average 65% of respondents felt that the US was going to have the biggest resurgence, which seems an unusual perspective on a market that is already large.

Likewise, the US was also seen as the market that has become more domestic, with 64% saying that is the case, indicating a tendency for US players to stay closer to home. 

It’s difficult to exactly pin down a reason why respondents felt this way. Our analysis, however, is that the global approach is becoming more costly – so those who are managing in multiple markets, in multiple locations, through multiple structures are subject to considerable costs. This is leading to a drive towards streamlining approaches in order to make the same returns with lower structuring costs. Which in turn may lead to an increased reliance on markets that are familiar.

The North American market, because of its sheer size, is a fascinating market to be in and to watch. While we may expect a continued shift towards larger funds and for smaller managers to face challenges getting funds off the ground, one thing is for certain – we can never be sure what any 12-month period will deliver.

 

The full report Private Equity: Where Challenges Meet Opportunities can be viewed here