A potential shakedown of the private equity industry has dealmakers worried. When it comes to grabbing the attention of limited partners (LPs), the competition among financial sponsors is as heated ever. That’s because, these days, investors are more cautious and less likely to return to large funds a second and third time.

“That’s the theory and it makes sense,” says LP Chris Yang, a managing partner of Grove Street Advisors. “The reality is it’s an enormously sticky industry.”

As deals begin to percolate in the lower middle market, LPs are beginning to prefer smaller funds, Yang explains. Grove Street is one of those firms. Mergers & Acquisitions spoke with Yang on the trend just ahead of the firm’s announcement that it received $650 million in new commitments that it will invest in private equity funds, especially in the lower middle market.

The funds came from four existing clients and one new sovereign wealth fund relationship, and will be invested in diversified private equity, smaller buyouts and venture funds and technology private equity funds. The firm has used funds to invest in Brynwood Partners, a Greenwich, Conn.-based private equity firm, Sightline Partners, a venture firm based in Minneapolis, Harren
Equity Partners, a Charlottesville, Va.-based firm that invests in lower middle market companies, and other firms. The Wellesley, Mass.-based LP has about $5 billion in assets under management.

Are investors less likely to return to large funds a second and third time?

The short answer is yes. The market has spoken. A large fund in 2007 and in early 2008 is very different than a large fund in today’s market. Part of it is because of mega firms raising less capital. It is taking folks longer to raise even smaller funds. Firms are now realizing that they can’t put all that capital to work or that people aren’t writing checks that large.

Why do more LPs prefer smaller funds lately?

They’re more conservative in their use of leverage over long periods of time. The best of small firms will grossly outperform large funds. Anecdotally, there’s also a greater dispersion of returns, but the quality of small funds will vary quite a bit. You have to measure their track record by how they source and execute deals, or how they monitor businesses and sell them. The challenge is finding the right small firm and identifying the better managers. Blackstone, Bain and KKR their best funds were the smaller to earlier funds. Those are the funds that they raised and generated the track record to raise larger funds. The expectation of what they’re trying to deliver now is quite different than a middle market fund

Is there going to be a shakedown of the private equity industry?

I don’t think you’ll see a drastic shakedown, but I think it’s clear that some changes will be made. Unless something is seriously going wrong at some of these firms, LPs as a collective are limited in their role in terms of what they can do. There are certainly no-fault divorce provisions and that’s basically an opportunity for LPs to shut down a fund.  But that won’t happen unless there’s a reason. If it’s performing poorly, those are sort of nuclear options. I think you’ll see people fade away or gradually disappear than close up shop or do anything radical. People may just not necessarily raise a new fund, or end up managing friend and family assets. But some of the best performers will just raise smaller vehicles.

How has the relationship between LPs and private equity firms changed?

I would say over the last few years, there has been a greater understanding of accountability.  Most LPs are happy to pay fees and carried interest, but only if there’s a good return. There’s more accountability related to performance and that has led to funds needing to generate liquidity in order raise new funds or vehicles. Given where the public markets are, we’re seeing quite a bit of liquidity through M&A and a few IPOs and dividend recaps. We’re seeing cash back, but in a way, there’s probably more clarity around the groups that have been able to perform and those who haven’t. So there’s a bigger divide between the top performers and the under performers. A lot of lessons were learned from the financial crisis. Different funds get different grades on how they deployed capital in the intervening years between the financial crisis, how much capital they put to work and more importantly how they managed the businesses they already owned.

Are inactive funds more common?

Absolutely. It’s the digestion of what happened five to 10 years ago when many more private equity groups were created and in particular, over-funded during the two years leading up to the financial crisis.  Enormous amounts of capital were committed to these funds and in turn, invested at the worst time in the cycle.  Many of these funds have troubled investments in their portfolios and have faced real challenges when coming back to LPs about fundraising plans.  Some GPs will prudently focus on their portfolios first and try to generate real liquidity for their investors.  However, it’s clear that there are a number of GPs that will be unable to raise new funds, which in turn negatively impacts organizational stability.  But given the long life of private equity partnerships, this unwinding of inactive funds will continue to work its way through the system over several years.

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