Private Equity Forward Forum Takeaways – The Latest Developments in Fund Formation

At the 2024 Private Equity Forward Forum, Cooley partners Jaclyn Rabin and Dave Selden moderated a panel discussion that examined the current private equity fundraising and fund formation landscape, including how the current environment is creating nuances in fund terms, increased investor scrutiny – specifically around environmental, social and governance (ESG) and diversity, equity and inclusion (DEI) – as well as liquidity provisions and the use of net asset value (NAV) facilities. The panel discussed some interesting shifts in investor composition and the continued momentum in general partner (GP) secondaries. Finally, the panel touched on the Securities and Exchange Commission’s continued focus on private funds.

Session panelists included:

• Faris Elrabie – Partner, Devon Park Advisors
• Derek Pease – Director, legal – fund formation, Silver Lake
• Duwain Robinson – Partner, chief financial officer (CFO) and chief compliance officer (CCO), Ascend Partners

Key takeaways

1. Resilient but concentrated fundraising environment. The Cooley moderators began by discussing general fundraising trends. Coming off the 2021 peak, we have seen a rapid decline in fundraising over the last few years. The slowdown in exits, and therefore distributions, to limited partners (LPs) limited LPs’ capacity to commit to new funds, thereby suppressing the fundraising cycle. In H1 2024, 365 funds closed globally, down from 580 funds during the same period last year. However, private equity fundraising has remained resilient – aggregate capital raised rose slightly from $327 billion in H1 2023 to nearly $330 billion in H1 of this year. Fundraising concentration has seen its highest levels in over a decade, as investors continue to make new commitments to the largest managers. However, middle-market funds raised $81 billion, representing 52% of all capital raised in 2024 so far. It continues to be a tough fundraising environment for new managers, but by allocating almost exclusively to established managers, LPs may be missing out on significant potential returns, with top decile buyout funds from emerging managers outperforming established peers by nearly 7%.
2. The private equity investor base is growing, and the “typical” composition is changing. Increasingly, investors outside of the United States – including European investors and non-sovereign wealth fund investors from the Middle East – are looking to private equity in order to get exposure to the US market. A panelist noted that high net worth and ultra-high net worth family offices are investing more frequently in private equity funds and are writing bigger checks when they do, since they have seen that private equity has outperformed the public markets in recent years. One panelist cautioned that sponsors need to consider default protections when admitting high net worth individuals, as the potential for default is greater. There also has been a surge in bank-sponsored feeder funds being raised to invest in private equity funds, along with more appetite from registered investment companies as LPs.
3. Greater focus on ESG and DEI. Panelists noted that private equity investors are increasingly focused on ESG issues, as well as issues related to DEI. There is an increased focused on making sure that private equity sponsors are properly tracking and reporting ESG and DEI metrics and goals. One panelist noted that some sophisticated investors want to see carried interest tied to some sustainability outcomes or goals being achieved. Investors also want to know that buyers of the fund’s portfolio companies will continue to support these same ESG and DEI goals post-sale.
4. Greater scrutiny of fund terms. Given the more LP-friendly fundraising environment, panelists noted that their LPs are pushing back on all “off-market” terms. They also are increasingly requesting side letters, and the typical side letter is becoming more robust, often to deal with increased regulatory complexities. Another panelist said that investors across the board are increasingly sophisticated, and the breadth and depth of their operational diligence and comments on documents does not correlate with the size of their commitment (smaller LP diligence and commentary is just as robust as a larger LP). The panelist also mentioned that changes to prior fund terms receive intense scrutiny from investors and require GPs to provide rationale for any material updates.
5. Investors are focused on borrowing – particularly NAV facilities. Borrowing limits contained in private equity fund agreements are steadily rising in both the US and Europe, with most funds able to borrow against 30% or more of investor commitments. NAV loans, specifically, have become a hot topic, with concerns growing about why and how investment managers are using these debt instruments. The panelists noted that investors oppose the use of leverage to make distributions (which some called a “synthetic distribution”) and are more likely to approve the use of borrowing for the purpose of deploying capital for investments. Investors also are concerned with how the use of leverage will be described in the fund’s reports – specifically, performance. Another panelist remarked that investors do not want the fund sponsors to hard wire the ability to use NAV facilities in the fund documents without receiving approval from the investor advisory committee. He further noted that even if a private equity fund’s governing documents permit the use of a NAV facility, since private equity is a relationship business, it is important for fund managers to be transparent with investors and discuss the reasoning behind using any NAV facility. Nobody wants to be surprised, and it is important for fund sponsors to be proactive with investor discussions to get to a yes.
6. The secondaries market is seeing increased activity, particularly with respect to single-asset continuation funds. In H1 2024, global secondary volume was $68 billion, a 58% increase from $43 billion in H1 2023. The panelists noted that there is a growing trend of fund managers using (primarily single-asset) continuation funds to hold their best assets for a longer period of time in the face of decreased M&A activity. The continuation funds allow the fund sponsors to provide liquidity for those investors who are seeking it, while also raising additional capital and maintaining ownership of their best-performing assets. Another panelist added that a successful secondary will allow the fund sponsor to continue its work with the portfolio company’s management team while also providing the option for liquidity to those existing investors who seek it. They also mentioned that investors are increasingly focused on owning the trophy assets regardless of the actual fund manager.
7. The SEC continues its keen focus on private funds through rulemaking and enforcement actions. The current SEC remains highly focused on private fund advisers, actively pursuing them through rulemaking, examinations and enforcement. This stance is expected to persist at least through the end of this election year. One panelist noted that a challenge for private equity sponsors is to report returns to investors in ways that are both SEC-compliant and understandable. Another panelist said his highest concern was cybersecurity and ransomware, and that he strives to minimize that risk at both the fund and portfolio company levels, along with having proper reporting in place. Another hot topic is recordkeeping, with the SEC focusing intensely on off-channel communications (using personal devices for text messaging or WhatsApp and not capturing these communications). There have been several recent examples of enforcement actions, including the SEC’s announcement in August 2024 that it charged 26 firms some $390 million in penalties for widespread recordkeeping failures.

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