GOLDMAN: The Private Equity World Is Shrinking

A common theme in the private equity world as asset prices have risen is the apparent lack of opportunities to find good value in new investments.

Now, Goldman Sachs analysts are warning clients invested in big, publicly-traded alternative asset managers about a "private equity cliff," and they say the big fees that fund managers collect from investors are at risk.

The chart below shows the "cliff" Goldman is talking about.

The dark blue bars on top show the billions of dollars in capital that have been raised by private equity fund managers since 2010. Goldman estimates that total funds raised and deployed in 2013 will hit $45 billion, up from $37 billion in 2013.

However, the dark blue bars show that capital from previous private equity investments – which has benefitted from rising asset prices – is being returned to shareholders faster than funds can raise new money.

In other words, assets under management are shrinking, which means fees derived from management of that capital will shrink as well.

"As more invested capital is pulled out of the ground, we see risk to fee-paying AuM and potential for choppiness in fee-related earnings," writes Goldman analyst Marc Irizarry.

While private equity fundraising is on the rebound, it's nowhere near pre-crisis levels, when the capital that is now being returned to investors was initially raised, as the chart below illustrates.

And even though fundraising is nowhere near pre-crisis levels, that hasn't restrained the rapid growth in the number of funds trying to raise money in recent years.

As the next chart shows, the number of private equity and real estate funds trying to raise money these days is up 25 percent from 2010.

Put these three things together, and you have the recipe for a shrinking private equity market.

"Amid higher markets and higher valuations, we expect managers to be more selective, deploying capital at a more measured pace," writes Irizarry. "Commentary from credit investors such as OAK’s Howard Marks and FIG’s Pete Briger suggests to us opportunities to deploy capital at reasonable valuations are scarcer, and accordingly, disciplined managers are raising relatively smaller funds (e.g., OAK’s $5 bn Fund IX) and delaying their investment periods."

So, what are private equity firms trying to do in order to mitigate this "cliff"?

First, firms are launching smaller, more targeted funds.

"Our comparison of invested funds (i.e., “older” funds) and funds currently in their investment period shows sub-$3 billion funds are increasingly common (now 46% of committed capital vs. 29% previously)," says Irizarry.

Second, firms are seeking "more permanent sources of capital" than the typical private equity investor, writes Irizarry:

Permanent capital vehicles and insurance partnerships provide non-traditional solutions to the “cliff.” FIG has highlighted the potential of permanent capital (REITs, BDC’s) to bolster management fees, kicking off 2013 by raising $764 mn of new equity for Newcastle, adding to fee-paying AuM in PE. The firm aims to raise at least $5 bn in other vehicles that would likely accompany and co-invest with sector-specific funds such as WWTAI or a senior housing or nonperforming loan fund. Meanwhile APO now manages nearly $16 bn for Athene, a re-insurer and partner of APO. Athene is growing significantly via acquisitions such as Presidential Life ($4 bn of assets) and Aviva (expected to add $35 bn to the platform if it closes).

APO benefits in two ways: 1) an asset allocation fee on all $16 bn of Athene Asset Management’s AuM and 2) management and performance fees for the approximately 1/3 of AuM that is managed in APO credit funds. We expect other managers to leverage this channel more given an estimated $1 tn insurance outsourcing opportunity (as per industry sources).

Finally, Irizarry says, bigger funds are investing in smaller funds in order to capture "hidden fee-related earnings." Irizarry cites, for example, Oaktree's investment in DoubleLine.

"This AuM is not necessarily consolidated into the firm’s total AuM, but does provide another source of cash earnings and helps diversify the businesses," Irizarry says.

The investment landscape is changing, and private equity firms are adjusting. If they don't, they stand to lose out on those fees the industry loves so much.