Alternative fund consolidation: what’s the impact on financing?

Alternative fund consolidation: what’s the impact on financing?

Following last year’s record activity in the European private equity market, the spectre of soaring inflation and rising interest rates has put the brakes on growth in the wider alternative funds market.

“During the first part of this year [2022], we continued to see fundraising going well – the market was buoyant and interest in the fund finance market was high,” says James Hamelin, a director at RBS International. “Over the past six months – as people have continued to grapple with the fallout from Russia and Ukraine, increasing inflation, and increasing interest rates – we’ve definitely seen that momentum start to slide. Everyone accepts we’re entering a period of greater uncertainty.”

While central banks are hiking interest rates to combat inflation, the alternative fund market’s expansion is forecast to slow. Preqin’s biennial ‘The Future of Alternatives’ report predicts that annual growth will ease from 14.9% between 2015 and 2021 to 11.9% over the next five years.

During the slowdown, Hamelin expects the United States to fare slightly better than Europe and the Asia-Pacific region, with sectors such as infrastructure and private debt performing better than those more exposed to inflation, he adds.

Delaying distributions to investors

“We shouldn’t underestimate the impact of consolidation on the market,” says Dr Stewart Hotston, Sponsor Coverage Director at NatWest. “Big funds grow disproportionately bigger compared with the rest of the market and find it easier to fundraise.

“Anecdotally, where we’ve really started to see a slowdown is below that super-large top tier, where people have started to look at extending investment windows because they’ve got cash that they still need to spend but aren’t sure about spending it during the current period of volatility.”

Andy Roberts, Senior Director at RBS International, highlights that quarterly valuations are yet to reflect increases in market uncertainty. While Roberts doesn’t expect portfolio re-ratings to affect sentiment among institutional investors, he does think there will be pressure on valuations.

“Funds are likely to hold on to their assets for longer, which in turn means they’ll delay distributions to investors,” he says. “Historically, investors have recycled distributions into allocations, so if distributions slow down then that might change sentiment.”

Seeing the ‘A’ but not the ‘M’ in M&A

Consolidation continues to be driven by specialist funds being bought by larger players that find it easier to raise finance, says Hotston. The larger firms benefit by being able to make a splash in sectors such as the energy transition. General partners (GPs) in niche funds, meanwhile, free up some of the cash they had tied up in their funds and gain access to platforms and scale, both of which are useful when they come to raise their next fund.

“Funds are likely to hold on to their assets for longer, which in turn means they’ll delay distributions to investors. Historically, investors have recycled distributions into allocations, so if distributions slow down then that might change sentiment”
- Andy Roberts, Senior Director, RBS International

Hamelin points to the example of real estate funds bolting on debt funds. “With banks retrenching from that lending space, we’re going to see big opportunities for debt funds to deploy capital,” he says.

And, according to Hotston: “Most consolidation will be from the mid tier to the top tier, rather than within the mid tier. I don’t think that will thin out the mid tier because there are always people coming into that space.”

Roberts adds: “When you think of acquisitions, you normally think of them in terms of mergers and acquisitions or M&A. Here, we’re seeing the ‘A’ but not the ‘M’ – we’re not seeing mergers among mid-tier fund managers.”

Looking towards further consolidation

With interest rates predicted to rise above 4% in both the US and UK, Hotston believes the ensuing distress could stoke further consolidation. “I think that’s going to lead to some bargain-hunting by people with a lot of capital to deploy,” he says. “If they see funds at 80% of their net asset value (NAV) then they’ll go for it.

“Those guys who have got a track record in being super-niche and really, really good at one thing will be fine. It’s the people who are truly mid-sized – they’re no longer a specialist, they’ve tried two or three strategies – who will find someone comes and knocks at their door.”

Roberts thinks that smaller and mid-tier funds might struggle to raise capital and may see a bigger house coming in and bringing investors with them as an opportunity. “Ultimately, the larger manager wants the product, and they can provide the infrastructure themselves,” he says.

Finding finance for GPs’ commitments

As the size of funds grows, the commitment that needs to be made by GPs is growing with them. “If you’ve got a £20 billion fund and you’ve got even just a 1% GP commitment then that’s a substantial amount of money that the GPs have got to find,” points out Hotston. “One of the knock-on effects from that is GP financing conversations, because otherwise they’ve got to put that money away for 10 years, or potentially longer in continuation funds.

“A large number of funds have done public issuance or private placement,” he continues. “Some have even listed specific funds in order to manage the investment commitment of GPs.”

While consolidation is having an impact on financing at the GP level, those effects aren’t filtering down into the capital structure of the funds themselves. “Most of the time, it’s the fund managers that are consolidating, rather than the fund vehicles themselves,” explains Roberts. “These acquisitions don’t actually change the fundamental structure of the funds.”

Making sure staff are retained

Once a niche fund has been swallowed by a larger player, how can the new owner keep staff incentivised? Roberts expects that there may be changes to operational and support functions due to economies of scale, while decision-makers and deal-doers are likely to be retained with “golden handcuffs” through incentives to make sure they have skin in the game, and they will be rewarded for upside in the fund’s performance.

“That’s key because if your deal-doers walk then you’ve got a problem,” he says. “Investors buy into the fund managers. It always comes down to the due diligence you do when you acquire a business: who are the movers and shakers, and how can you retain those key people?”

Hamelin adds: “It depends on the type of person you are as well – did you enjoy working in a smaller, more nimble team, or are you open to the wider opportunities in a bigger firm? With the younger generation, they’ll also be interested in the larger fund’s attitude with respect to environmental, social, and governance (ESG) issues.”