by David Snow
July 3, 2013

Shadow Capital

When private capital forms outside of funds, does it count?

Statistics from the private equity fundraising market tell an important story, but increasingly they don’t tell the whole story.

As you read this, billions of dollars are being earmarked for private-capital strategies around the world. But not all of it will be deployed through traditional third-party limited partnerships. If market participants want to make sense of the changing dynamics in private capital, they need to better chart what might be called the “shadow” market—money invested directly into private companies and assets by institutional investors and family offices, or via nontraditional vehicles that industry data providers often don’t track.

This important point was explained to me in a recent Privcap panel conversation I moderated about the so-called “overhang.” Cambridge Associates’ Andrea Auerbach argued that the infamous overhang in capital commitments might not be receding as slowly as has been widely observed. “This overhang that we’re talking about is on traditional private equity funds that have raised capital,” Auerbach said. What wasn’t being counted, she said, was the overhang of co-investment vehicles. “The number of institutions that have capital earmarked for that could very well swamp this overhang and also create interesting dynamics in certain pockets of the market,” she explained.

In other words, significant money being put to work, but not in the usual, well-documented ways. With a market characterized by larger institutions, including huge new entrants, bypassing limited partnerships in favor of co-investment and direct investment, it is clear that the definition of “capital formation” needs to be broadened.

Take, for example, the recent deal news from Canada, the Saudi Arabia of institutional direct-investment capital, which saw two public entities partner to acquire a business via their direct-investment programs. OMERS Private Equity (affiliated with the Ontario Municipal Employees’ Retirement System) and Alberta Investment Management Corp. will buy the European theater chain Vue Entertainment for C$1.5 billion. The money comes directly from the balance sheets of public pensions and endowments. If we assume that about $500 million in equity is going into this deal, it’s $500 million that in an earlier era would have gone through a fund and been counted in fundraising statistics.

Years ago, before I co-founded Privcap, I was developing the methodology behind what is now called the PEI 300—a widely used ranking of the largest private equity programs in the world—and faced a similar challenge. The core ranking method counted how much equity had been raised by a given GP over the most recent five-year period. But we kept bumping into groups that didn’t primarily raise capital in blind-pool, third-party funds. One firm, American Capital, had raised a substantial amount from the public markets and deployed it in private equity. Another, the CPP Investment Board, got its PE money from the Canada Pension Plan. We expanded our methodology to include “capital formed” where regular fundraising did not apply. Today, the CPP Investment Board ranks 20th among the largest private equity funds in the world, with no regular fundraising at all.

The growth of this “shadow” market won’t reverse itself. In fact, the opening of new markets to the asset class will only increase nontraditional structures. Consider the rush among some large PE firms to create “40-Act” vehicles—publicly listed entities that feed capital from public-market investors into alternative investment strategies. Consider, too, efforts by firms like Pantheon Ventures to create vehicles for “defined-contribution” investors, the 401(k)-like counterparts to defined-benefit plans, to allocate to private equity strategies.

The deal of the future may look like this: An operating team acquires a private business using capital cobbled together from a sovereign wealth fund, a private equity fund, and a collection of investment vehicles raised via public markets and defined-contribution plans. The investments are expertly screened, acquired, and managed, but the capital comes together in ways we are only just beginning to accept as normal.

The good news for the private equity market is that an uptick in fundraising numbers doesn’t fully reflect an even stronger desire among global investors to allocate capital to the asset class. The bad news? Managers of traditional funds won’t directly control the entire measure of this interest, or at least be able to charge full fees against it.

Private capital will continue to become more complex as it grows larger and larger. The bean-counting specialists that emerge to accurately chart its many moving parts will become enormously valuable.

When private capital forms outside of funds, does it count?

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