In the first week of October, the Wall Street Journal reported that JC Flowers & Co.’ marked down an unrealized loss of nearly $2 billion on its $6.5 billion fund. The news for limited partners was pretty grim, although some cheer could be found, as JC Flowers, less than a month earlier, held a $2.5 billion first close for its follow-up effort. It’s perhaps a sign that while the LBO world wallows, the fundraising market is not so easily shut down.

With that said, new obstacles are cropping up every day, and if a firm does not have a sufficient track record or a brand name in lieu of results, it is going to be tough sledding in the months to come. The challenge confronting limited partners is twofold. As stock investments deteriorate, the amount that LPs are able allocate to equity investments has also dropped off. Considering the volatility of the stock market, institutions also might be more inclined to leave some cushion, which would very likely come at the expense of their less liquid alternative assets.

Perhaps more poignant, several LPs are likely receiving letters from their general partners very similar to the note JC Flowers delivered. With credit drying up, many PE portfolios have suffered. This pullback is magnified by the fact that so much money was directed to large-market and mega-market funds, which have been hit particularly hard. Evidence can be found in the form of TPG Capital’s $1.35 billion loss on its investment in Washington Mutual, which fell apart less than six months after the infusion, or Cerberus Capital Management’s string of duds, including GMAC or Chrysler. Kohlberg Kravis Roberts, meanwhile, in a filing with the SEC, divulged that its portfolio lost $1.2 billion in the first half of 2008.

In light of how much money was directed to the upper ends of the asset class, the struggles there don’t reflect well on limited partners. “These institutions are generally laggards. They wait to chase whatever is hot until it’s basically over, and then whenever it comes down they get burned,” Amit Chokshi, managing member at Kinnaras Capital Management LLC, says.

But the struggles of the market have also forced investors to take a harder look at where they place their money, which means established players who can demonstrate a history of performance will continue to see interest.

Accel-KKR, for instance, in the second week of September closed on $600 million for its third fund. The firm, which focuses on growth-oriented plays in the middle-market technology space, had originally targeted $450 million for the vehicle, and was forced to apply a hard cap to the effort.

Ben Bisconti, managing director of Accel-KKR, believes LPs will be very discriminating and will look for established results. Regarding his own fund, Bisconti mentioned that Accel-KKR did not generate returns based on a structure that relied on credit when the credit markets became unhinged last year. This sober strategy will no doubt become more prevalent in the coming years.

Speaking to the market, Bisconti does not believe the present storm will prove disastrous to competent GPs with a track record. Nevertheless, he warns, “New funds will have a more difficult time.”

Mike Kelly, managing director at investment advisory firm Hamilton Lane, believes fundraising will slow down in the coming year. “Not as many [private equity] will close [funds] at the amount that they were hoping for,” he says.

Kelly also expects that institutional investors will take their time in deciding which funds to back and he predicts they “will be narrower in their focus.”

Randall Fojtasek, a partner at Brazos Private Equity Partners, LLC echoes that sentiment. Brazos, which held a final close on $700 million for its third fund in September, targets closely held and family controlled businesses in the southwestern US. This narrow concentration, and the firm’s sector focus spanning five industries, has provided strong returns, Fojtasek says, a factor LPs took into account.

As with any dislocation, new opportunities emerge. Shawn O’Brien, managing director of placement agent Wedge Alternatives, discussed the complicated fabric of distressed investing. He warned against throwing oneself “headlong into” the investment class, but says, “Now is probably the time to start making investments in that area.”

Of course, one could argue that such a strategy would underscore the “laggards,” reputation institutions have built for themselves.

For those GPs who aren’t inclined to completely alter their strategy, many will likely fine tune their blueprint to appeal to limiteds.

Hamilton Lane’s Kelly notes, for instance, that GPs in this environment “will be more focused on growth, with the expectation that the economy may snap back more quickly.”

Growth investments, as Accel-KKR’s Bisconti alluded to, are also less reliant on credit, making the play especially appealing in stagnant debt market.

Austin Ventures made a move in this arena recently, when the VC firm dedicated $600 million of its $900 million fund to “growth buyouts.”

New faces?

It is easy to imagine that there will be a sharp decline in the number of new GPs that will launch for the next several years. O’Brien believes there are still opportunities for lift-outs “from established teams with established funds.” An obvious example would be the existing PE arm of Lehman Brothers, Lehman Brothers Merchant Banking, which is headed by Charles Ayres and now needs a new home.

O’Brien, however, doesn’t expect to see another “golden child from Goldman” launching a new fund anytime soon, a reference to the fundraising market’s excesses when seemingly anyone with a  Goldman pedigree was able to corral a billion or more in relatively short order.

In a clear reversal of last year’s froth, more private equity firms are now chasing fewer dollars. And the turnaround makes it clear that the task of a capital raiser is about to become significantly more difficult.

Over the years, PE firms have recognized the importance of establishing overseas contacts. However, the ease of finding capital closer to home, has meant that many fundraisers have grown to rely on US limiteds.

O’Brien notes that now GPs will have to put more effort into establishing more geographically diverse investment pools. O’Brien, who does a lot of work in the Middle East and Europe, cautions that such an undertaking may be more difficult. He cites that foreign investors have largely seen their investments in the US perform terribly. A McKinsey & Co. report, meanwhile, estimates that sovereign wealth funds have invested $60 billion in financial services over past 18 months, and have lost $14 billion of that investment. As a result, foreign investors have understandably sought to become much more discerning.

In addition, since such a large portion of available foreign capital comes from sovereign wealth funds, many private equity funds do not make investments large enough to warrant the attention of the wealth funds. “They are looking at co-investment opportunities and are looking at opportunities to invest at the GP level,” O’Brien says.

The good news to emerge from the squeeze facing LPs is that, despite the pressure, it allows institutional investors the opportunity to separate the wheat from the chaff. Hamilton Lane’s Kelly suggests biggest boon to limiteds is that they now have more time to consider where to put their money.

“You get more opportunity to spend time with the group, and see how they are able to work through issues together. In tough times you can better assess how a group is doing.”

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