Institutional Capital Flees Buyout Funds​

By Jake Rickman​

What do you need to know this week?

The Financial Times published an alarming article on Monday reporting on the record rate at which institutional investors such as pension and sovereign wealth funds have been exiting their position in private equity (PE) and venture capital (VC) funds.

In total, $33bn of institutional capital in private funds has been sold between 1 January and 30 June this year, compared to $19bn in the same period last year.

The reason? Wider market volatility in the public equities market has left institutional investors with more exposure to private capital than their risk tolerance permits. Additionally, the terms of most private equity investments entitle the PE fund managers to make a “cash call”, which is where the institutional investors have to hand over cash to the PE fund so that the PE management can use it to acquire companies.

To minimise their exposure, these institutional investors are selling their stakes in PE and VC funds on the “secondaries market” at a discount, ranging between 71% to 86% face value on average. The buyers? Typically special kinds of investment funds that focus on buying secondary stakes in PE funds.

Why is this important for your interviews?

This article helps illustrate (1) the role of key stakeholders in the PE market, which is valued at $9.8tn globally and is a substantial source of fees for City law firms; and (2) how the wider market views PE in light of the present economic uncertainty.

Institutional investors are the single biggest group of investors that buy stakes in PE funds, which in turn use the cash to acquire companies for the purpose of selling them later.

These institutional organisations hold substantial sums of cash, much of which comes from you and me in the form of payments to insurance policies and pension deductions from our monthly pay cheques. These institutional investors manage this pool of cash and hope to make it grow so that there will be enough in the future to meet insurance and pension pay-outs.

To make the pool grow, they invest across the market, from government and corporate bonds to the public equities market, to real estate and, of course, in private equity. Before market conditions became more uncertain in the past nine to twelve months, PE investments tended to offer the most growth. However, as inflation and interest rate uncertainty have grown steadily and eroded market confidence, institutional investors (known for their relatively low risk tolerance) increasingly see PE as too risky, especially in the event of a recession. Taken together, this largely explains the capital flight.

How is this topic relevant to law firms?

Private equity activity is one of the biggest sources of fees for commercial law firms. Not only do private equity-led transactions engage the City’s corporate practice groups to advise on the acquisition or disposal of companies, but many law firms bring in tens of millions of pounds advising PE funds and institutional investors on how to structure fundraises.

The recent developments highlighted in this article pose a fundamental threat to City law firms’ ability to generate fees: if PE funds cannot raise as much cash, there are fewer fundraisers to advise on and less cash available to deploy on acquisitions, which translates into less transaction activity.