The Modern Fundraiser: The problem of oversubscription

The number of private equity funds finding themselves oversubscribed at fundraising has been following an upward trajectory since 2009, with 260 managers facing the problem of demand outstripping supply in 2014, compared with 83 in 2009. In the first nine months of 2015, 183 funds have been oversubscribed, according to PEI Research & Analytics, meaning this year could top even last year’s total.

But while oversubscription may seem like a fundraiser’s dream at the start of a process, working out the criteria that should be applied when it comes to choosing which investors make it in, and managing the communications challenges associated with those decisions, can be far from easy.

Audrey Klein is senior managing director and head of fundraising at Aerium Finance, the European real estate fund manager. She says: “One of the things that GPs must be aware of is that investors talk to each other; so besides the fact that it’s wrong just to shut somebody out without any warning, it’s not great PR for the GP to just decide not to deal with an investor’s questions… because they never know what’s going to happen next time around.”

She points out that, by handling the process badly on any particular fundraising, the GP damages relations with investors and its reputation within the broader investor community for future funds.

“Communication is really important,” says Klein. GPs should be upfront with investors about their timetables, and if a LP is taking too long on due diligence, especially relative to others, they should be informed sooner rather than later that they risk getting left behind. GPs can “get really cocky” and ignore questions from certain LPs that they don’t need, but that can result in reputational damage down the road, she warns.

One of the first challenges can be to identify the potential for oversubscription early enough in the process to be able to manage expectations. Often the managers of over-subscribed funds find themselves facing accusations of over-marketing when they realize, further down the line, that many of the new leads they have been chasing down might have to be turned away.

Equistone Partners Europe closed its fifth fund at a €2 billion hard-cap in April 2015, exceeding its initial target of €1.75 billion and completing the process in just six months. Approximately 80 percent of the capital committed came from existing investors, but the oversubscribed fund followed a previous fundraising that closed in January 2013 at €1.5 billion after nearly two-and-a-half years on the road.

Would the firm have been wise to conduct less marketing? Equistone fundraising and investor relations partner Christiian Marriott says that, in the end, the firm only had to turn two investors off completely.

“Our last fundraising took a long time, because we were just coming out of Barclays and it was at the height of the eurozone crisis. It was quite hard to come from that experience and then not market to too many people, because our job is to de-risk the process and secure the capital base of our business for the next 10 years. I don’t think there was any other way to do it.”

What he does advise against is letting slower-moving investors drift, instead of proactively keeping in touch with them and constantly making them aware of the timeframes others are working to. Otherwise he says there is a risk that when those investors do get their ducks in a row, they will be disappointed to find out they have been left behind.

HOW TO SAY NO

There are a few important criteria that should be applied by GPs faced with the problem of deciding which LPs to turn away.

“Managers should ideally have clear and fair guidelines, so that you are not only being fair, but also being seen to be fair,” says Andrew Bentley, a partner at Campbell Lutyens, a placement agent.

“For example, investors will understand if you treat existing investors in a slightly preferential way to newer investors, and you may also decide to distinguish between those that commit to the fund earlier and on time and those that don’t. That is also a good way to manage the timetable.”

Some managers seek to diversify their investor base and so give preference to LPs coming in from parts of the world not currently in the fund.

“In setting allocations it is understandable to give preference to X or Y geography, but really only if you have been clear on your strategic aims from the start. Ultimately the GP has to right to accept whoever they want into the fund, but the aim should be to leave no LP feeling upset, because LPs, if treated badly, can remember that for a decade or more,” says Bentley.

Klein says the LPs that are going to be real partners, and may be able to invest across multiple products longer term, are the ones to take forward. She adds: “The other criteria should be diversity, because it’s really important to have diversification of types of investors, and investors from different areas and different parts of the world.”

Howard Beber, a partner with the law firm Proskauer, and co-head of its investment funds practice, echoes the sentiment that some level of LP diversity is good in a fund: “You want to look at your LP base, and in most cases it’s important to have a good mix of endowments, sovereign wealth funds, funds of funds and so on, because often those groups invest in cycles, and you don’t want to be over-concentrated in one type or another.”

Still, managers should always provide special attention to their current LP base, says Jeremy Lytle, an investor relations partner at ECI Partners, which closed its 10th buyout fund, ECI 10, at the hard-cap of £500 million in five months last year, having been significantly oversubscribed.

“Really, most people end up giving priority to existing investors. Some people may use the fundraising to change out certain LPs, or target new geographies, but one of the aims of the fundraising is really to hit the hard-cap as quickly as possible and then get back to the day job. The easiest way to get there is to look after your existing investors.”

He adds: “We spent a lot of time with existing investors first, finding out how they were positioned, and then you can start to get a feel for the level of demand. If you’re getting a re-up rate of 80 percent, which is what we were getting last summer, then you quickly know where the holes are.”

For new investors, the ECI approach was to encourage them to move quickly. Lytle says: “For the bigger prospective investors, we said if you can drive hard and get into the first close, and give us a strong indication of your demand and level of appetite, then we can accommodate you. That inevitably ends up moving along some of your existing investors too, some of whom may be waiting to see what the level of demand is.”

At Equistone, investors coming in to the first close and proposing to commit an amount of money that was less than €100 million were given their allocation at that stage, whether they were new or existing LPs.

Marriott says: “We didn’t tell anyone we were going to do that, and in fact we said we couldn’t guarantee allocations even at first close, because even by that time we had started to believe that we were going to be oversubscribed. So for some people that was a positive surprise, because they were expecting to be scaled back, but it meant that the first close took us to roughly 75 percent of our hard-cap.”

At final close, new investors were scaled back less than existing investors who might reasonably have been expected to have made it into the first close, but did not meet the timetable. One thing Equistone was committed to was a hard-cap that was immovable, and which was set out in the fundraising documents at the outset.

“We made a conscious decision to set up a hard-cap up front, and we did something that I think is becoming more common, which is that we put that hard-cap in the private placement memoranda, which means that in the offering document you are committing to an amount of money that you will not go above. The concept of movable hard-caps can be pretty frustrating for a lot of LPs,” says Marriott.

Bentley says bumping up the fund size is tempting but not always a good option: “Managers should be cautious about it when the fund size sits at the heart of the proposition that you have sold to LPs, because if someone has taken this to investment committee on the basis of a particular strategy, and then you take it outside of that segment or blur the lines, then the whole proposition becomes a bit compromised and LPs will justifiably feel irritated.”

For him, the biggest no-no in an oversubscribed fundraising is setting LPs up for a fall in front of their own investment committees.

He cautions: “Managers should be reading the book well enough to judge when to slow down the marketing so that they minimize the oversubscription problem at the end. Some oversubscription is often unavoidable but the key point is to avoid letting LPs going through final investment approvals thinking they have got a specific allocation, and then end up not being able unable to provide that. Communication of the pressures in advance so they are forewarned is important.”

Beber concludes: “Where I have seen trouble is when GPs were perhaps not as forthright, and then at the last minute they had to disappoint people, which is a quick way to upset people and damage relationships with investors who might otherwise have been prospects for successor funds.”

Foresight and forewarnings, alongside clear, consistent and fair communication, appear to be the key things to bear in mind if you are to avoid upsetting the investor base and burning bridges for future raisings.

This article appeared in pfm’s The Modern Fundraiser magazine, published January 2016.