An embarrassment of riches

Last week we wrote about the oxymoron of a moving hard cap. A manager decides on an absolute upper limit to its fund size… and then decides to move it upwards as more capital becomes available; leaving LPs less than impressed.

To recap: oversubscription has become a common “problem” in the modern fundraising environment. In 2015, the total capital raised across all private equity funds was $409 billion. The stated target for all those funds combined when they launched was just $340 billion. That’s nearly $70 billion of excess demand reported by happy general partners, and the trend is continuing into 2016.

Raising commitments of exactly the right amount is no mean feat. “Landing on the hard-cap is like landing a helicopter on a sixpence; you do what you can to pilot it in the right direction, but there is always a chance that you will be blown slightly off course just before landing,” says Janet Brooks, a partner with placement agent Monument Group.

It is no surprise then that there has to be some adjustment when it comes to the final close. But if the hard-cap cannot go up, then the commitments must come down.

Unfortunately, there is no standard way of “scaling back” commitments and it can get messy.

“I don’t think there is a GP out there that has an orderly and structured way of dealing with it,” says a European LP.

The process can range from a pro rata reduction of each limited partner’s allocation – which would seem to be the fairest way – to a fairly arbitrary cull of one or two individual LPs.

One placement agent describes the management of an oversubscribed fund as their least favourite scenario, recalling a situation in which the GP identified two prospective LPs that they wanted to cull in order to remain within the hard-cap. The reason for selecting these LPs was not, in the agent’s mind, particularly reasonable, and yet they were tasked with making the call to explain why there was no longer space for them.

A reduced commitment to a fund – or one that is cut in its entirety – can cause professional embarrassment for the individual at the LP, who will have invested time and money on due diligence and pitched it to the investment committee. It calls into question their connections and access as a professional investor. In what is still a “people business”, it can also cause genuine personal offense.

It is worth noting at this point that LPs have their own part to play. Some will try to “game” the process by initially proposing a commitment of twice the size of the one they intend to make, expecting to be beaten down. However, as Billy Gilmore, an LP at Aberdeen Asset Management, notes: “You cannot get away with that for long – if it goes wrong a couple of times you will get found out.”

Actually landing the helicopter on that hard-cap sixpence is more art than science, say fundraisers. The process of assessing demand is based on early communication with existing investors, says the head of investor relations for one global private equity firm. “From at least 12 months ahead of time you are trying to establish how much new intent you should be working on versus how much demand there will be from existing investors.”

Ironically, funds with excess demand can benefit from the assistance of a placement agent – usually brought in to boost demand – who will be more experienced in terms of judging the pipeline of and can intermediate in what can be an otherwise tense relationship.

While an oversubscribed fund is a badge of honor in today’s market, it is also a challenge to manage it well. GPs should tread carefully.