Can a globalising investor market for private equity help the leading houses fulfil their funding needs? Charlotte Edmond reports

For an industry that had a reputation as aggressive, the private equity market has been easily cowed by some basic maths. In the last two years, many buyout houses have suffered a painful lack of exits, limited options to invest and little prospect of raising new capital. In such an environment, the so-called denominator effect dictated many of the moves of buyout houses.

The concept is simple. A few years back and the idea of being 'overweight' in private equity was virtually unheard of. But following the collapse of Lehman Brothers in September 2008 and the ensuing chaos in the financial markets, institutional funds found their private equity investments outperforming other assets. And as the value of their overall portfolios fell, private equity investments grew as a proportion of the total assets.

Increasing investments in public markets to redress the balance and meet prescribed quotas was a tougher option than selling off private equity commitments to the secondary market. Coupled with the decreased appetite to maintain commitments in private funds, throughout 2009 and much of 2010 buyout houses looking to raise funds faced a brutal market.

Figures from the British Private Equity and Venture Capital Association (BVCA), the UK's main representative body for the private equity industry, demonstrate how hard it has been to raise funds, with just £265m raised by association members from overseas pension funds in 2009, compared to £6.96bn in 2008. Similarly, levels raised from insurance companies, another major investor in alternative assets, also plummeted, from £1.78bn in 2008 to £711m in 2009 – a far cry from the boom years in which institutional investors were falling over themselves to put money into private equity and the major houses successfully pulled off a series of record-breaking fundraisings.

Relations between private equity firms and investors would soon became a good deal less cordial, with some limited partners struggling to make good on their commitments. In the wake of the banking crisis, a number of major houses, including Permira, effectively allowed their investors to write down some of their commitments rather than risk open conflict with their backers.

However, the outlook for fundraising is generally regarded to have brightened considerably over the last six months, in part because 2010 saw a return in the exits required to provide a return to investors, even if sponsors had to lean heavily on secondary buyouts and rising share valuations to stop funds being overweight in alternative assets.

Part of this brighter mood is an expectation that a globalised market for private equity fundraising can compensate for a shortfall from Western investors. In addition, the large houses are looking to the key emerging economies in general and sovereign wealth funds in particular to provide their financial backing.

Civil unrest aside – there has been some debate over whether the private equity industry will be compromised by backing from controversial sources like Libya's Gaddafi regime – this trend is expected to continue.

The BRIC countries, and in particular Brazil, have seen interest from private equity, with houses including The Blackstone Group, Warburg Pincus and The Carlyle Group increasing their presence in the country in recent times. Asia, likewise, has seen a number of well-known US and European houses establish branches to help raise funds. Yet even if the outlook has brightened, with so many buyout houses looking to raise money, debate continues over how many will be successful.

"We are coming out of a very difficult time post-Lehman. Many traditional private equity investors still have a limited appetite; investors are keen to support the top managers but the gap is now being partially made up by sovereign wealth investors," comments Simpson Thacher & Bartlett funds partner Jason Glover. "It's still a tough market, with too many managers looking to raise capital compared to the number of investors available. There are simply not enough investors for everyone to reach first closing and undoubtedly some managers will fall by the wayside."

However, recent months have seen BC Partners close its ‚Ǩ4bn (£3.5bn) fundraising (advised by Glover alongside his former colleagues at Clifford Chance (CC)) – the largest fund to be raised since Lehman – as well as Montagu (a Macfarlanes client) hitting ‚Ǩ2bn (£1.8bn) at its first closing, suggesting there are investors out there for the right fund.

But if a more globalised funds market can ease funding shortages, there is widespread expectation that fundraising will be slower and more document-intensive as both sides attempt to head off the tensions and risks that were exposed during the financial crisis.

In this vein, the Institutional Limited Partners Association, a body representing private equity investors, released new guidelines in 2010 in an effort to address what is perceived to be an imbalance of power between sponsors and their backers. How market practice will settle in this regard remains open to much debate. The emergence of sovereign wealth funds also raises further complications for lawyers as such backers have different expectations in terms of confidentiality, governance and fiduciary terms.

Kirkland & Ellis funds partner Mark Mifsud comments: "As some US pension funds/endowments and other traditional investor classes withdraw from private equity they are replaced by other types of investors with differing requirements from those usually anticipated. Thus, the market is evolving to fulfil these needs and we are beginning to see green shoots with more transactions, fundraisings and more sources of capital in more diverse areas."

Potential investors are also generally looking more closely at funds' track records and strategies. This obviously generates more work for funds counsel, both for the investors and for the fund, with more due diligence required.

Glover comments: "Ten years ago, about a third of investors used legal counsel to support them through fund negotiations – it's probably more like two thirds now. We are seeing a considerably higher legal spend, with funds being heavily negotiated by more investors using greater legal resources." He estimates over the past decade a "conservative estimate" has seen legal fees on a fundraising double.

There is much debate within the private equity community over the extent to which this internationalisation of the funds market will change the dynamic among the legal advisers. The near-monopoly that SJ Berwin used to enjoy in the City funds market has long gone, with CC under Glover's former leadership being widely regarded as becoming a top-tier player in the European market.

For years the prediction was that US law firms, with the obvious advantage of access to American investors, would quickly break into the European market. However, it was not until Kirkland recruited a three-partner funds team from SJ Berwin in 2007 led by Mark Mifsud, along with fellow partners Justin Dolling and Richard Watkins, that much progress was made. The three are viewed as having transferred highly successfully to Kirkland, bringing a number of clients to complement the US law firm's sizeable roster.

As such, the hire of Glover by Simpson Thacher – Wall Street's unquestioned top dog for private equity – to launch a City funds practice was arguably the most-touted lateral seen in London in 2010. The appointment followed on from Simpson Thacher's recruitment of highly-regarded corporate partner Adam Signy from CC, a move that has reinforced the US firm's scope to lead on deals in Europe for key clients like Blackstone and Kolhberg Kravis Roberts & Co. Simpson Thacher has also indicated that it ultimately would like to have as many as three partners covering funds in London.

Other US firms seen as intent on carving a position in the European funds market include Weil Gotshal & Manges and Latham & Watkins. For lawyers, it is just as well that there are signs of revival in the lucrative funds market, as there will be no shortage of competition in future.

Legal Week's annual Private Equity Forum will be held in London on 13 April. For more information click here