This article originally appeared on Forbes.com.
There is a hint of something new and unfamiliar in the air on the fund-raising front this year. It’s a scent of optimism, and it’s coming from private equity limited partners (LPs) that are giving off signals that they may be ready to increase new PE commitments enough to jolt fund-raising out of the flat trend it has been in since 2009.
As we describe in Bain & Company’s Global Private Equity Report 2013, much of that larger appetite for private equity reflects LPs’ desperate hunger for yield that will help boost their overall portfolio returns at a time when bond yields have been at historic lows. Facing rising obligations to the retirees and institutions they were formed to help support, pension funds, endowments and other LPs are increasing their diet of PE as the asset class that will remain the likeliest to serve up supersized returns going forward.
For many LPs, this will mean raising their target private equity allocations. Among all US public pension funds, for example, average allocations increased from 7.5% at the beginning of 2012 to 8.3% in January 2013. The increase was even larger among the biggest pension funds with total assets over $5 billion. Since last year, their PE allocations have gone up by nearly one-and-a-half percentage points to 9.7%.
Rising public equity market valuations have also lifted the ceiling on private equity allocations for many LPs. As assets in their overall portfolio expand, LPs can take advantage of the so-called denominator effect and increase their PE numerator to keep it at the same proportion of the total asset base.
This loosening of the private equity purse strings is encouraging news for GPs that are currently on the road trying to raise new capital. But do not look for fund-raising to pick up significantly until PE markets see an upswing in exits and deal activity. It is only after GPs can convincingly demonstrate their capacity to whittle down the piles of dry powder and begin to send LPs reliable streams of returns as they cash out of earlier investments that the fund-raising party will really swing into high gear.
How high is “up”? According to Bain’s analysis, unless there is a major increase in deal value, it is not clear that the private equity industry needs more capital. Taking a holistic view of the current level of deal making, we estimate that the PE industry today is putting to work approximately $100 billion in buyout equity capital around the world. New fund-raising, meanwhile, has accommodated a high proportion of new deal making since the economic downturn. Globally, GPs raised $78 billion, $79 billion and $88 billion in buyout capital in 2010, 2011 and 2012, respectively. Thus, if fund-raising accelerates a bit, the PE industry would be at equilibrium, with money coming in about equal to money going out.
Overall, it’s a picture of good health—except for the many GPs that will not be likely to meet their aggressive fund-raising goals. They will continue to face a ferociously competitive environment for bringing in new capital. In North America and Europe alone, GPs already on the fund-raising trail are trying to raise capital for 228 buyout funds that collectively aspire to bring in $212 billion, or more than twice as much equity capital as the entire industry is putting to work annually in buyouts at its current pace. As more GPs join those already on the fund-raising trail, the sums they seek will far exceed the industry’s capacity to absorb.
LPs will be open to committing capital to GPs that are active across a wide spectrum of fund types, but the private equity firms that succeed will be able to show that they possess four essential qualities. First, obviously, are a demonstrated record of strong results and a deep understanding of its sources. Second is a stable and successful core team that has a clear plan for succession. Third, a GP needs to be able to describe what makes its investment model distinctive and demonstrate that it has a repeatable model for creating value post-acquisition—including a proven ability to execute growth strategies. Finally, GPs need to have “skin in the game” and other clear incentives that align them closely with LPs’ interests.
Even with LPs penciling in more private equity commitments in 2013, GPs will need to bring their “A game” with them on their fund-raising roadshows. Anything less than that will likely result in a shutout.
Written by Hugh MacArthur, Graham Elton, Bill Halloran and Suvir Varma, leaders of Bain & Company’s Private Equity Group.