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An increasing number of private equity firms are deciding to halt fund raising or returning money to their investors. This is unprecedented. What does this mean for the market? And how does it affect investors?

The good times are over - it's official. When private equity houses start giving commited capital back to investors, we know we're in for trouble. Many VC firms - some of them high-profile names - have announced that they are giving the money back. (And that's after having spent months on the fund raising trail convincing investors that they can generate great returns.) Never has this happened on such a scale.

CrossPoint Venture Partners raised a $1bn technology fund, only to pull it earlier this year. Well known US and European investor Geocapital Partners had to abandon its $500m fund raising back in January and recently returned the $200m it had already raised. In March, New York-based Insight Capital Partners offered investors in its Insight Capital Partners Europe I fund their cash back. It had decided to shift the fund's focus away from European software. Most recently, Epartners, which had raised $650m for its Epartners 2 fund, capped its investments at $130m and released investors from their remaining $520m commitment.

All have claimed that, in the current climate, it's impossible to make the returns they had expected when they started fund raising. With the stock markets slowing, one of the most popular exit routes has dried up. Plus, as company valuations have dropped, it has suddenly become much harder to place investors' capital in a good home.

Deal flow doldrums
‘If deal sizes halve then general partners of funds will need to find more deals to fill their portfolios,' says Stephan Breban of actuaries Watson Wyatt. ‘In some venture circles this is a real issue. A team cannot suddenly find the capacity to manage twice as many situations.'

Early-stage technology funds, already buffeted by the tech downturn, will find it particularly tricky to keep up an acceptable deal flow. ‘The amount of money you need to put in to get a material stake in a business is far less these days,' says Larry Levy of Protégé, an incubator and accelerator company specialising in European early-stage ventures. In recent years some VCs have overstretched themselves by involving themselves in too many investments at once, he adds. ‘But today VCs are having to work much harder to get companies on to the next stage. They can't afford to spread themselves thinly now.'

Finding double the number of new investment targets will challenge the research capabilities of most managers. The current state of the economy has plusses for start-ups and later stage ventures, such as low interest rates, but these are matched by adverse factors: a collapse in business-to-consumer and now business-to-business inititiatives, and the vagaries of the stock exchange. There are backable ideas out there, but they may be hard to find and much in demand. Not every VC has the contacts or the reach to do this.

We're already seeing the evidence of this. The latest figures from the National Venture Capital Association in the US show that VC investments dropped in the last quarter of last year. The last three months of 2000 saw investments total $19.6bn - a 31 per cent decrease on the previous quarter and a fall of 20 per cent on the same period of 1999.

The current environment could also stem the recent trend towards sector specialisation. As deal flow dries up, firms with a sector focus have found it difficult to invest according to their original investment approach. In an extreme case, Carlyle Internet Partners Europe was forced to change its strategy - and name. Launched in the middle of dot.com mania in October 1999, it raised a $693m internet fund. It managed to invest $137m, but earlier this year decided to concentrate on pure technology companies rather than the internet. It has since removed the ‘Internet' from its name.

High expectations
Private equity firms may not normally get the sympathy vote, but they have been hit hard from both sides. First, they've been hit by investor expectations. Private equity has finally raised its profile and is increasingly seen as a viable, high-return asset class. Capital is now flowing in, just as the level of unexploited opportunities is drying up. This means that firms are hard-pushed to invest the capital they have raised. Investors want to know why firms are so inactive. And then second, by business owners. Even if a firm does find a winning concept, it might well find the owners reluctant to sell. ‘Markets have fallen and initial public offerings (IPOs) have dried up,' says Breban. ‘Many vendors are simply not prepared to sell at discounted prices.' The sentiment among many entrepreneurs is to wait until values rise again - however remote the possibility.

‘If in 1999 people were told that their company was worth £50m, and now they learn its value is only £25m, they will sit tight. Their business might suffer from lack of investment - but they don't see it that way,' says Breban.

Can't wait for ever
A lack of spending opportunities for managers puts them in something of a bind. They could be reduced to watching and waiting. If so, there's a limit on how long they can hold back from the fray. ‘Most private equity funds allow a manager a predetermined time to invest,' says Ray Maxwell of fund manager Invesco. ‘If, at the end of the agreed period, only some of the earmarked funds have been invested, the outstanding amount is cancelled.'

The traditional fund vehicle operates over ten years, during which targets are chosen, money committed, and (all being well) cash plus profit returned to investors. In recent years this cycle has shortened. But the time available for managers to take stakes is still measured in years rather than months - and so waiting on the sidelines for a while is acceptable. But too long a delay is bad news. Questions will certainly be asked if money is not being drawn down. ‘There's no immediate issue but tension can build up over a period of years,' says Maxwell. ‘There's a pressure to invest if cash is lying around.'

Delaying investment can have a negative effect on IRR. Once an institution has committed cash to fund, it is legally obliged to ensure that it is available, even if the fund does not draw the money down straight away. If that cash is sitting in a low interest account waiting for the fund to draw it down, it isn't generating the best return for investors.

There's also the delicate question of management fees, which are usually payable early in a fund cycle - and independent of cash spend. Investors should start asking questions if they have paid a management fee and yet their capital is idle. ‘A management fee is normally a function of commitment rather than investment,' says Maxwell. The fee is a percentage of money committed. If the fund is forced, for whatever reason, to return cash to investors, institutions should also expect a refund on the management fee.

Down to details
So what are the legal issues for investors when this happens? ‘The usual contractual terms for a fund may well say that new investments cannot be made beyond the initial five or six years,' says Josyane Gold of lawyers SJ Berwin & Co. ‘But you cannot prescribe how often an investment should be made within the initial period. Investors understand their managers need flexibility. And there has to be an allowance for the economic cycle. There are bound to be leaps and lags.'

In theory, investor and manager have an identity of interests. Once money is drawn down, neither benefit from hanging on to cash unnecessarily. Generally, money is normally drawn down as needed - so a manager doesn't actually have cash sitting unused in the fund's bank accounts. (Some VCs investing small amounts might be handed money to use over a period of time.)

However, neither institution nor manager want to invest rashly in a portfolio of lemons. ‘There's a balancing act. Pension funds and other investors don't want to pressure managers into making duff investments, but obviously the private equity houses want to be seen to be active,' says Gold.

That's not to say investors in a fund don't have teeth. A typical fund's terms and conditions allow backers to remove the manager on payment of compensation - typically a year's management charge. In theory, this action would be open to institutions dissatisfied with an over-passive house - a kind of ‘no-fault divorce', according to Invesco's Maxwell.

But this is very rare. There are more effective means of obtaining redress. The most obvious is market forces. ‘If there is no performance from a private equity house, there is no enduring relationship with investors,' says Gold. A failure to invest means a failure to provide returns, and there will almost certainly be no follow-up fund. The business relationship will dry up, and the money will flow elsewhere. The funds that have returned money have pre-empted the repercussions of poor performance. Their investors can now allocate their money elsewhere, keeping the door open for future investments.

The beneficiaries will be other fund professionals, quite possibly in other sectors, and perhaps in asset classes other than private equity. The drop in public markets has, for some institutions, upset the balance between their quoted and unquoted investments. Whereas they were once fully committed in publicly traded stock, now they may be underweight when compared to their alternative asset allocation. So the temptation will be to reallocate funds to stocks.

Time to retire?
If a fund fails to locate acceptable targets, what it does next depends on its reputation and market savvy. Some houses have infinitely flexible relations with its backers, and can change agendas with relative ease. But less fortunate managers will simply retire hurt. The next few months could see a number of retirees.

‘There's a strong possibility some weaker houses in early-stage venturing will move out of the market altogether,' says Levy. ‘There are too many VCs in the field. There's a real danger of overkill. Some will fall away.'

There's another side to the dwindling opportunities available in private equity. Some managers think of raising a fund - and then duck out. Institutions are taking a greater than usual interest in the reasons given for such false starts. Are houses declining to raise funds because they can't spend what they take in? Or is there another explanation: that they can't attract backers?

Figures from private equity research house Venture Economics could back this up. They suggest that US funds are likely to raise only half the amount they raised last year. The totals, says the report, will drop from around $90bn to just $40bn to $50bn.

‘Good funds with phenomenal franchises will raise money but may take longer than usual at the moment,' says Ray Maxwell of Invesco. ‘If you're outside the top bracket you may well be deferring the matter. Of course, the key thing is how a fund justifies its decision not to raise funds. Some managers believe investors will think more of them for concentrating purely on existing portfolios. Cynics say that attracting new cash is too much of an effort for some managers - so instead they're just sitting on their hands.'

And managers will need to think hard about the size of their funds. Big is by no means beautiful in today's market. 'With the larger - £500m plus - venture funds, one has to question whether they can be deployed effectively,' says David Currie of fund of fund manager Standard Life Investments. There may not be enough venture opportunities to go around to justify raising large volumes of cash.

Not all bad news

However, there are still some promising sectors. Now the dot.com model is being abandoned, old-style businesses may make a comeback. ‘There's a broad mix of traditional companies across Europe,' says Currie. ‘Someone with a turnaround strategy in, say, Spain could find a very effective home for their money. It's a very fragmented food distribution and supermarket industry there.' There is scope, he says, for building up a business and perhaps merging it with a similar one in another EC country.

‘There were a lot of people at the peak of the high-tech frenzy raising funds,' says Currie. ‘Some of those people had no experience. It was a sign we were at the top of the market. That sort of frothiness has gone now.' David Currie, Standard Life Investments

The current downturn could turn out to be positive for private equity as a whole. Sure, some investors may well have had their fingers burnt. But the next 12 months or so are likely to see an increasing level of professionalism and - importantly - focus in the private equity market. There's little doubt that fund raising is tougher now than a year or 18 months ago. Only the best people will be able to raise funds. Back in 1999, comparative novices were seeking to raise money for private equity - and, on the whole, they were successful. ‘There were a lot of people at the peak of the high-tech frenzy raising funds,' says Currie. ‘Some of those people had no experience. It was a sign we were at the top of the market. That sort of frothiness has gone now.'

Private equity firms don't like having to hand money back to investors - some might argue that it damages their reputation. However, a more reasoned view would be that it's a responsible, professional response to fears that good investment opportunities and exit routes just aren't available at the moment. Not spending a commitment looks smart when compared to a rival with a basket of bad eggs. The watchword is: quality.

‘A manager has to match the expectations of his investors,' says Currie. ‘If he invests £5m out of £10m and gives back £50m, that's fine. People won't worry about the other unused £5m. But if he spends £10m and gives back £5m - that's a different story.'
 
Frederick Price is a journalist specialising in business, finance and the law. He is also a solicitor and lecturer at the College of Law