The private equity industry had a difficult year in 2002. Local and global issues combined to painful effect to produce the most hostile fundraising environment that many in the business had ever experienced and certainly since the early 1990s. The industry was caught between the horns of ongoing economic and financial uncertainty and dismal conditions in traditional venture sectors like technology and telecoms. It was no great surprise that European fundraising in 2002 fell almost a third on the previous year: firms announced 57 final fund closes worth a combined total of E27.4bn.
The story, however, is not unrelentingly gloomy. Closer examination of last year’s fundraising patterns reveals much stronger performances in some sectors than others. It offers the prospect that the year ahead, while hardly stellar, may mark a flattening in the steep fall that started towards the end 2000. The venture capital industry looks doomed to another dismal year but the buy-out sector is much better positioned for the months ahead.

Fundraising figures
AltAssets’ fundraising data are based on final closes; the value of funds that were closed to additional outside investors during 2002. The methodology differs slightly from the way the European Venture Capital Association (EVCA) collects its data, which is based on ‘new’ money collected during a given year and includes interim closes. But the comparison is perfectly adequate to illustrate the scale of the fundraising downturn. Europe’s private equity industry managed to collect just over half the historical peak of 2000.
Almost as disconcerting as the fall was the composition of that total. More than 70% of the value of funds raised in 2002 came from just 15% of those 57 final closes. Nine mega-funds (funds of more than E1bn) comprised E19.6bn. The heavyweight buy-out specialists, including Cinven, Bridgepoint, Candover and Barclays, were the driving force behind the year’s activity. It was reflective of a flight to quality by institutional investors where the flavour of the year was the established brand name, buy-out firms.
It is not easy to find a positive spin on these aggregate figures but there should be some consolation in a comparison with the US private equity industry. US fundraising in 2002 was roughly $65bn (E60bn), a fall of nearly 70% on its peak of $211bn in 2000. Beyond providing some comfort, however, the regional differences also go to the heart of the problem afflicting the private equity industry. The venture capital sector, early stage investing in high-risk technology companies, is almost generationally damaged. And venture capital has historically been a much larger part of the US industry than the European.

Sector differences
Buy-out and venture firms in Europe raised an almost equal number of funds in 2002 but buy-outs accounted for more than two thirds of the total value of fundraising. There were 17 buy-out and 16 venture funds closed in 2002 but the former accounted for 69% of the total value raised while the latter made up just 6%. Nothing could demonstrate their divergent experiences more starkly. Back in 2000 the two sectors raised roughly comparable amounts.
Venture firms are generally smaller than buy-out firms and that alone explains some of the difference in their relative fundraising performance. Early stage investments do not require the same amount of capital as investments in mature, cash-generating businesses. The late 1990s saw a number of mega-venture funds but the landscape has radically changed since then, both in terms of what investors think is appropriate and in terms of valuations for early stage businesses. The effect has been to shrink the average size of venture funds and the trend will continue for as long as the giant funds are still handing back to investors some of the capital they raised at the peak.
There are other ways, however, of demonstrating how much more difficult venture funds are finding the marketplace than buy-out firms. The time funds spent in the market, for example, is a good measure of institutional interest in a firm because it measures enthusiasm independent of fund size. Once again, venture firms fared worse than buy-out. More than 80% of venture funds closed in 2002 were in the market for more than 12 months. The mega buy-out funds also generally took longer than a year but the mid-market funds almost all closed in less than 12 months.
The success of firms’ fundraising relative to their initial target also provides a measure of market conditions. Only 12% of buy-out firms that announced a final close in 2002 fell short of their target and 64% closed above. In contrast, 56% of venture firms closed below target and only 19% closed above. Once again, the story is emphatically clear. Venture capital firms are struggling to revive investor interest after the battering that followed the implosion of the technology bubble. And the signs are that it will be a long time before the scars are fully healed.
Venture firms, however, were not the only to struggle in 2002. Generalist funds, looking to invest across a broad range of stages and sectors, also suffered. Some 57% of the 14 that held final closes had to settle short of their target and they accounted for only 10% of the year’s fundraising total. Even more disappointing was the performance of funds of funds. Ten closed in 2002 but eight of them were below target. They have been hit hard by the general downturn in the market and the competitive effects of the explosion in their population over the last few years.

Regional differences
The regional breakdown of fundraising in 2002 showed a continuation of recent trends. The UK accounted for by far the largest share of total funds raised, some 77%, mainly because it is home to all but one of the major pan-European funds that closed during the year. It was followed by France, with just 12% of total funds. There was a big drop back to the other regions. Germany, in particular, had a miserable year, reflecting the mounting uncertainty about the legislative environment for private equity firms. The breakdown, however, should not be interpreted as a sign of the final destination of the capital. The pan-Europeans may be based in London but their interest in the local continental European markets has been growing significantly in recent years as the UK itself became more crowded.

The outlook
The purpose of this brief overview has been to show that while the overall fundraising figures make for pretty bleak reading, a more detailed analysis yields a little more cause for optimism. The implications for the private equity industry over the next few years are not wholly dispiriting. Buy-out firms look set to increase their share of total fundraising at the expense of the other sectors and may manage to hold the line at 2002 levels. Local conditions should be broadly supportive – investment activity was gently gathering pace towards the end of the year, the quality of firms in the market is generally high, and there are plenty of cheap assets looking for buyers across Europe.
It is the global factors, those broader economic and financial uncertainties, which pose the major risk. A further collapse in quoted equities, a double-dip recession in the US or stagnation in Europe would hurt investment of almost every shape and size. But economic and financial fragility, within certain bounds, may also help to underpin the case for private equity. Institutional investors have traditionally been attracted to the asset class because of its capacity to generate superior risk-adjusted returns. That remains the case but in present conditions there is a new premium on private equity’s ability to generate absolute returns. It is no good producing stronger returns than public markets if those returns are deeply negative.
The promise of absolute returns explains some of the enduring institutional interest in private equity but it is reinforced by a handful of other factors. There is, for example, a growing belief in the logic of the European buy-out story. The region is not as private-equitised as the US and the creeping process of economic liberalisation brings with it a wealth of opportunities well suited to the best buy-out firms. The local markets have matured enough to sustain country-specific funds, better able to access mid-market and small transactions that should prove a source of rich value going forward. They look set to form an increasing share of the fundraising total over the medium-term, possibly at the expense of the firms targeting the increasingly competitive large end of the market.
Equally, the difficulties felt across the asset class over the past few years have accelerated the professionalisation of the industry. That has not come cheaply and some investors have suffered but it has begun the overdue of shaking out of some of the weaker players. There has been and will continue to be a consolidation and a public burial of past excesses but the outcome will be a stronger industry. Reporting standards are improving across the private equity universe, there are more intermediaries servicing novice investors, and a gradual improvement in transparency. Real liquidity will continue to prove elusive but in most other respects the asset class is growing up.
The year ahead will be hard work for everyone on the fundraising trail. Not only is there simply less capital around to be in invested in the asset class but those charged with allocating that capital have also become more discriminating. They have seen the pitfalls of the asset class exposed with brutal clarity since the unreal days of the late 1990s. History will probably judge 2003 like 2002, as a year defined by a further unwinding of the imbalances inflated during the late 1990s, but it may also produce some cause for hope against an otherwise gloomy backdrop.
Chris Davison is head of research at AltAssets in London