As Good As It Gets For Private Equity Fund-Raising

This article originally appeared on Forbes.com.

General partners who hit the road in 2016 to raise new funds continued to find healthy appetites among investors. They raised $589 billion in capital globally, just 2% less than in 2015. With more than $500 billion raised each year since 2013, it has been a banner period, with capital pouring into every PE sub-asset class.

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One notable trend, summarized in Bain & Company’s newly released Global Private Equity Report 2017, was the surge in megabuyout funds—those raising more than $5 billion—as 11 megafunds closed to raise $90 billion. Such funds hold great appeal to large institutional investors that want to put a massive amount of capital to work and limit the number of funds and relationships they must track and manage. For example, Advent International set out to raise $12 billion, attracted more than $20 billion of interest and settled on $13 billion.

The numbers bear out investors’ enduring affinity for private equity. Historically, private equity has ranked as the best-performing asset class, delivering an 8.3% median net internal rate of return (IRR) over the past decade for public pension funds vs. 5.3% for their total portfolio, according to Preqin. The most recent Preqin survey found that 89% of limited partners (LPs) expect to commit the same or more capital to private equity over the next year as they did in the recent past.

High-performing general partners (GPs) have been taking advantage of sterling market conditions to negotiate more favorable terms with LPs. Some have broken convention for hurdle rate, the minimum rate of return for a fund required before the manager begins taking carry. CVC reportedly plans a hurdle rate of 6% for its Fund VII, compared with the industry standard of 8%. Advent International removed the hurdle rate outright from its latest fund, which closed on $13 billion, although that decision was offset somewhat by the fund’s switch to the more LP-friendly European waterfall structure.

It’s another story for PE firms that don’t operate in the rarified upper atmosphere but instead have to duke it out in the middle of the pack. GPs are hurrying to raise capital now, before conditions take a turn for the worse and they risk getting scratched off investors’ lists for consideration.

Perhaps the biggest lesson for PE firms in the realm of fund-raising after the financial crisis: Craft a very sharp articulation of your strategy for success. To that end, it helps to lay out a process as rigorous as (if narrower than) any process in due diligence or operational improvement.

For example, an infrastructure firm on the verge of launching its next fund-raising effort learned LPs worried that its strong returns entailed risks that were unusual for the infrastructure sector. At the same time, market dynamics in the firm’s target sectors were changing, and the firm aspired to a larger size for its next fund—both of which might require redefining its deal sweet spot. Working with Bain, the firm developed a fund-raising strategy that would reaffirm its ability to generate exceptional returns with appropriate risk. The process relied on five components:

  • Interviewing investors to understand how LPs perceive the firm relative to competitors, how they view the landscape for funds in this set and what their risk and return expectations are.
  • Profiling the risk and return performance of leading infrastructure investors to understand the firm’s position relative to key competitors.
  • Assessing relevant risks, including the effect of commodity and macroeconomic swings on the portfolio, with a stress test of the largest positions.
  • Reflecting on past investments to identify any threads of success that can help refine its deal sweet spot and differentiation. The firm also dissected past deal returns to show where and how the firm has added value as an owner.
  • Distilling the fund strategy into a short, compelling narrative that shows prospective investors how the PE firm stands out from the rest of the pack.

From this process, the firm gained a clear understanding of what the target LPs sought in an infrastructure fund. With a sharply defined deal sweet spot and sources of differentiation at hand, the firm was able to crisply communicate how it could generate outsized returns, as well as its risk/return philosophy. The firm raised about 40% of its target capital within three months of launch and held a final close just over a year later, having raised significantly more than the target amount.

As it gets harder to find good deals at the right price and to generate great returns, PE firms that have pulled off that feat—and that can succinctly convey how they use insights from past deals to generate great returns in the future—will have an edge in pulling in capital.

Hugh MacArthur, Graham Elton, Daniel Haas and Suvir Varma are leaders of Bain & Company’s Private Equity practice.