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Special report: Outlook 2019

New firms, more minority stakes possible in 2019

For investors, exits likely to slow as rising interest rates and trade wars take their toll

Steve Rosen said capital structure will be most important now that the market cycle has entered a mature phase.

Private equity investors should see more new firms spring up as executives leave established firms to strike out on their own in 2019.

The coming year should also see more private equity firms selling minority stakes in their firms as a way to raise cash to build their businesses, as well as middle-market firms supersizing their funds, observers said.

At the same time, macroeconomic factors, such as trade wars and rising interest rates, could dampen exits, especially through mergers and acquisitions. Meanwhile, managers are expected to continuing adding credit to their lineup of investments not only to satisfy investor demand for income but also to create a source of private equity deal flow, industry insiders say.

"This is a very full market cycle," said Steve Rosen, Cleveland-based CEO of private equity firm Resilience Capital Partners. "Some industries are on their way up. Some companies are still performing well and hitting highs. But capital structure matters more now than when you are in the beginning of an upcycle."

First funds raised by new private equity firms worldwide totaled $35.9 billion raised by 278 funds in 2018 through Dec. 13, from $57.9 billion raised by 440 the year before, according to London-based alternative investment research firm Preqin.

More new firms formed by private equity executives leaving established firms should come to the market with their first funds in 2019, said Sanjay R. Mansukhani, senior manager research consultant in the New York office of Towers Watson Investment Services Inc., a subsidiary of Willis Towers Watson PLC.

The reason is that it is a good time for private equity because it could provide better returns than public equities, and investors have capital available and interest in investing in private equity, Mr. Mansukhani said. These factors have shortened the time it takes to raise a fund.

Indeed, the average time spent to raise a fund dipped to 15 months for funds raised in the first three quarters of 2018 from 16 months in all of 2017, Preqin data show. Not only are funds closing quicker but most (71%) met or exceeded their fundraising targets in the first three quarters. Some 30% of funds exceeded their fundraising targets by 125% or more in the same period.

More willing to take the risk

"Before you might have thought about it but the reality hit you that it would take two years" to raise a new fund, Mr. Mansukhani said. Now with the abundance of capital available, executives are more willing to take the risk and strike out on their own, he said.

Graham McDonald, Edinburgh-based head of private equity at Aberdeen Standard Investments, agreed.

Younger private equity executives are spinning out of firms to form their own because "private equity is not always the best at succession planning," Mr. McDonald said.

Private equity industry executives also expect more private equity managers to sell minority stakes.

"We expect the universe to grow," Willis Towers Watson's Mr. Mansukhani said.

There is a growing number of managers that are in the business to take minority stakes in private equity firms "and that is only going to accelerate," he said.

In November, Investcorp announced it was starting a business to take stakes in private equity firms. Other managers that already are in the business include Neuberger Berman Group Inc.'s Dyal and Goldman Sachs Group (GS)'s Petershill Group.

Private equity managers are looking for liquidity to grow their firms by adding businesses such as credit funds or funds to invest in smaller transactions, Mr. Mansukhani said. Private equity firms also are seeking cash to keep their younger executives from leaving, he said.

There is a huge increase in capital flowing into private equity to finance the increasing number of companies choosing to remain private rather than go public, said Anthony D. Tutrone, New York-based managing director, global head of the alternatives business at Neuberger Berman.

"Our belief is that this will not stop and the private markets in the future will be multiples of what they are today," Mr. Tutrone said.

One way to capitalize on this secular trend of the growth of the private markets " is to invest in the beneficiaries of the capital" flowing into the private markets and buy stakes in the best money managers, Mr. Tutrone said.

Such sales of minority interests in general partnerships raise different questions for investors.

Limited partners will have to decide whether they will continue to back these managers that, for example, had offered one investment strategy and now have two or three, Mr. Mansukhani said.

Are the interests of these managers still aligned with LPs in the original strategy, he asked.

Investors will have to determine whether their managers will have the resources and time to bring on a separate team dedicated to the new business line or whether the same team of investment professionals will manage the new offerings as well, he said.

Middle-market private equity managers will continue to raise larger and larger funds in the new year, said Chris LeRoy, New York-based partner and U.S. head of private equity for transaction advisory services at Ernst & Young LLP.

A couple of years ago, the private equity middle market was defined as funds ranging from $500 million to $1.5 billion. Now private equity middle market managers are raising funds in the $2 billion to $4 billion range, industry executives said.

"This round of middle-market funds could be very different in terms of size," Mr. LeRoy said. "It's a function of how hot the market is."

The next generation of larger middle-market funds gives the managers the ability to invest in bigger deals, he said.

A $2 billion fund, for example, can invest maybe $175 million or so in each deal, while a $3.5 billion or $4 billion fund can invest $200 million to $250 million in each deal without co-investments, Mr. LeRoy explained.

Transactions could slow

Still, in 2019, transactions could slow depending on "investor confidence" in light of uncertainty caused by macroeconomic factors including global trade wars, the U.K.'s exit from the European Union and U.S.-China relations, he said.

Private equity transactions in 2018 were "off-the-charts,'' both in terms of number and the value of deals, he said.

"I think there are businesses they want to transact ... what they are keeping in the rear view are macroeconomic issues at play that could impact dealmaking in 2019," Mr. LeRoy said.

"Absent the macroeconomic factors, we would expect solid (transaction) activity in 2019 as well. There's a strong pipeline (of transactions), tons of dry powder and available credit with light covenants."

It's a good recipe for increased transactions, he said. Still, private equity firms are expected to take a wait and see approach into the new year before they enter into transactions, resulting in fewer mergers and acquisitions.

There are a tremendous number of mergers and acquisitions that were being prepared in the fourth quarter of 2018 for the first quarter of 2019, Mr. LeRoy said.

"I am not an oracle, but if there is world indigestion in global trade, I could see a world where those deals are delayed," he said. "I'm cautiously optimistic in how the first quarter could play out."