Managers finding tougher fundraising environment

Private market managers' fundraising is slowing, hit by the roller-coaster ride investors have been on since the first of the year.

The drop in both equities and fixed-income markets is pushing some institutional investors' private market assets above their target allocations. That's causing asset owners to scramble to be able to continue investing in private markets, including private equity, private debt and real estate. And many are cutting the capital they can commit to these asset classes.

For example, venture capital funds worldwide raised a combined $54 billion in the first quarter, down 8.8% from the year-earlier quarter, Preqin data shows. U.S. private equity funds raised a total of $64.8 billion in the first quarter, down 26.8% from $88.5 billion a year ago. The declines illustrate a reversal of fortunes for managers and other industry executives who had early in the year predicted that 2022 would be the biggest fundraising year yet for alternative investments.

"Investors remain underallocated to alternative assets against their targets," said Michael Arougheti, New York-based co-founder, CEO and president of alternative investments firm Ares Management Corp. "However, recent trends have put investors at or over their target allocations to private equity."

Stephen Nesbitt, New York-based CEO of alternative investment consulting firm Cliffwater LLC, said he has seen reductions in new capital commitments due to the denominator effect, which is when a decline in public markets pushes up the value of investors' alternative investment portfolios.

To secure capital needed to continue committing to opportunities, some asset owners may sell some limited partnership interests, boosting transaction volume on the alternative investment secondary markets, Mr. Nesbitt said.

Other asset owners are increasing their targets to the alternative investment asset class to allow them to continue investing, Mr. Nesbitt said.

CalPERS, effective July 1, will be increasing its alternative investment allocations, boosting real assets by 2 percentage points to 15% and private equity by 5 percentage points to 13%. Pension officials are also adding a new 5% allocation to private debt.

However, during a June 13 investment committee meeting, new CalPERS CIO Nicole Musicco, who joined the Sacramento-based pension plan in February, said that the rough markets, and consequent loss of total plan assets, has resulted in its alternative investment asset classes closing in on their higher targets.

As of March 31, CalPERS' $62.3 billion real assets portfolio accounted for 13% of total assets, which is at the asset class's prior target but below its new 15% target. CalPERS had $52.2 billion in private equity as of March 31, which was 10.9% of the portfolio, close to 3 percentage points above its former 8% target but still below its new 13% target.

However, since then, CalPERS' portfolio has dropped further, down 10% from the beginning of the year, in line with market declines, Ms. Musicco said. The portfolio had dropped only 4% as of March 31, she said.

The $454.8 billion California Public Employees' Retirement System, Sacramento, is not the only asset owner to experience the denominator effect this year. In May, the $21.8 billion Los Angeles City Employees' Retirement System trimmed its expected private equity commitments to a total of $1.1 billion for fiscal year 2022 from $1.4 billion. LACERS made the change to reflect the plan's smaller asset size, which increased its exposure to private equity, CIO Rod June told the board in May. LACERS had $22.6 billion in assets as of Dec. 31.

In May 2021, LACERS had increased its private equity allocation by 2 percentage points to 16%. As of Feb. 28, 16.3% of its assets were invested in private equity. By April 30, LACERS' $3.9 billion private equity portfolio accounted for 17.67% of total plan assets, according to LACERS' latest performance report.

LACERS officials are currently working with the plan's general investment consultants, which are re-evaluating the pension plan's interim asset allocation targets included in its five-year asset allocation implementation plan, Mr. June said at the board's June 14 meeting. When the board adopted its asset allocation, the plan was underfunded to alternative investments and so the pace of adopting higher interim targets was slower, he said.

Since LACERS' actual allocation has changed quite a bit, making it now overallocated to private equity, staff is working with NEPC LLC to possibly change the implementation of the interim targets, Mr. June said.

"From a liquidity perspective, we are fine," he said. LACERS is still able to take advantage of investment opportunities caused by the market dislocation, Mr. June added.

Fundraising in 2021 "broke all kinds of records" and is expected to slow this year in comparison, said Matt Segal, Chicago-based assurance partner, national private equity co-leader at accounting and advisory firm BDO USA LLP.

"That said, the fundraising landscape is shifting," Mr. Segal said. "We are seeing a proliferation of megafunds."

Thirteen U.S. megafunds, defined as funds $5 billion or larger, raised $143.4 billion in 2021, up from 12 funds that raised $119.4 billion a year earlier, according to PitchBook Data. In the first quarter, two U.S. private equity megafunds raised $25 billion, PitchBook shows.

Megafunds spiked in 2021 as a result of private equity firms raising larger funds at a faster pace, according to a PitchBook analysis released in January.

"This is becoming a bit of a balancing act for LPs because … investors are being tapped to commit capital and are finding themselves overstretched, so they are asking GPs to delay fundraising," Mr. Segal said.

It's always harder to raise capital when the markets are choppy, said Paul Lanna, a partner in Coller Capital Ltd.'s New York office. "I hear from a lot of LPs that they are struggling to find capital and find time to recommit to new funds."

How the drop in the public markets affects investor perception and allocations to private equity and how that affects returns is an open question, Mr. Lanna said.

"Whether the public markets downdraft will filter into private equity returns … we will see how that goes," he said.

U.S. private equity, for instance, produced eye-popping returns in the short term, with a 46.5% internal rate of return last year, moderating quickly down to 22.6% IRR for the five years, 18.6% IRR for 10 years, 13.8% for 15 years and 14.8% for the 20 years ended Dec. 31, PitchBook data shows.

Alternative investment returns are lagged by at least a quarter, and investors such as CalPERS generally compare alternative returns with real-time public markets.

One result of the denominator effect on LPs is that there will probably be sellers on the secondary markets and a good opportunity to buy secondary interests, Mr. Lanna said. Coller Capital invests on the alternative investments secondary markets.

But that won't happen immediately, he said.

"We always think it (the denominator effect) will have an impact" and cause investors to sell limited partnership interests to keep their allocations to alternatives in line with the targets, Mr. Lanna said.

"But I don't think LPs react that quickly," he said. "It's not something they would do on a quarterly basis. If the public markets stay depressed for a while, it could have an impact."

Still, this fundraising environment differs from the past because the larger managers have been diversifying their investor base, increasingly raising capital from retail investors, insurance companies and other non-traditional alternative investors, industry insiders say.

Indeed, limited partners' negotiating power is attenuating as GPs look for additional, non-traditional sources of capital to meet these megafund targets, said BDO's Mr. Segal.

"It may appear that fundraising is slowing, but fundraising timelines are also lengthening as GPs look to soak up a lot more investor capital," Mr. Segal said.

Jonathan Gray, New York-based president and chief operating officer of Blackstone Inc., acknowledged in the company's first-quarter earnings call on April 21 that some institutional investors had been challenged to keep up their commitment paces, particularly with managers over the last few years raising larger funds quicker, before cash is returned to them from investments in prior funds.

But Mr. Gray said that Blackstone's "fundraising momentum has never been stronger" despite the fact that private equity returns have also pushed LPs above their target allocations. He expects Blackstone to be on target to raise a new crop of flagship alternative investment funds that are targeting a combined $150 billion.

Not only is Blackstone raising capital broadly across a number of strategies including real estate, secondaries, credit, infrastructure, life sciences and raising capital all over the world, it is also raising money from retail and insurance company clients, he said.

Blackstone raised $4 billion to $5 billion per month through March 31 in three perpetual vehicles, including a real estate investment trust and a non-traded business development company.

And Mr. Gray said he expects its retail investor base to grow.

"We are in the early innings of our buildout in this vast and underpenetrated market," he said.