Until recently, managers of private equity funds in the developed economies have generally been able to raise funds throughout the economic cycle (even if the size of funds was a little dependent on the prevailing circumstances). This was because institutional investors with an allocation to private equity aimed to maintain diverse exposure to private equity funds established across a range of vintage years. However, the current economic circumstances are not like anything seen in recent decades. The result: the desire of many institutional investors to make regular commitments over time is being overshadowed by other imperatives, disrupting their normal strategies, and signalling potentially tougher times ahead for private equity managers planning to raise new funds.
Active secondary market
The acquisition of secondary interests in international private equity funds has risen significantly in recent months (although there is currently much less activity in respect of secondary interests in Australian private equity funds). Many observers believe it will increase even further during 2009. There are two main factors driving the secondaries market.
First, with the rapid decline in value of public equities and other asset classes, many institutional investors are finding that their existing commitments to private equity exceed their target allocation. Quite a few institutional investors are reducing their level of private equity investments to combat this ‘denominator effect’ (so-called because the value of an investor’s overall portfolio, or denominator, shrinks relative to or more immediately than the value of its investments in a particular asset class). For example, the Harvard endowment fund was reported late last year to be seeking buyers for up to US$1.5 billion of its private equity investment portfolio. We would expect institutional investors with over allocation issues to have a depressed appetite for commitments to new private equity funds or less favoured managers at least until their allocations are realigned with their targets.
Second, many institutional investors need to generate cash to meet other obligations. In some cases, investors need the cash to service debt or meet other liquidity pressures which are unrelated to their private equity assets. In other cases, the impaired prospects for exits in today’s market mean that investors with established private equity portfolios are less assured of being able to ‘self fund’ draw downs made by one portfolio fund with the distributions from others.
Although the secondaries market might look like a convenient path for investors to create liquidity, the transaction process is not always smooth sailing. For example:
- the increased volume of secondary opportunities and considerable uncertainty about underlying asset values is driving prices down, with reports of secondary transactions occurring at discounts to net asset value of 50 per cent (or greater)
- the governing documents of a fund often restrict the timing of a sale (for instance, only allowing the transfer to occur at a month, quarter or year end in order to streamline the resulting accounting and tax calculations), but the current circumstances are requiring flexibility to assist strained investors to exit and less troubled investors to take their place, and
- in multi-vehicle funds where a parallel vehicle co-invests along side a main fund, further complications can arise, particularly where the seller has a tax, legal or regulatory profile that made it a suitable participant in one vehicle, and the purchaser has a different profile and would prefer to be a participant in another vehicle—the complications include:
- the potential need to amend the governing documents of the fund (which may or may not require approval from the other investors) in order to facilitate the redemption of the seller’s interest in one vehicle and the issue of a corresponding new interest to the buyer in the other vehicle without being tripped up by, among other things, prohibitions on redemptions, limits on new commitments after the final close date or the cost of capital provisions for new commitments (which ought not apply to new commitments on such sales), and
- the need to shift a proportion of the existing underlying assets from one vehicle to the other to maintain the correct co-investment ratios between the vehicles (which needs careful consideration from a tax perspective and also in terms of ensuring it does not inadvertently affect carried interest entitlements).
Capital calls, default remedies and other fund terms
Historically, defaults on draw downs have been a rare occurrence, but this is changing in respect of many international private equity funds due to liquidity constraints, and some investors in such funds have been notifying managers that they may not be able to meet a draw down and requesting that managers defer making capital calls.
In the past, the draw down and default provisions in the governing documents of international private equity funds were not a primary focus. However, these arrangements are now being scrutinised much more closely by all parties. In particular, managers may want greater flexibility to be able to draw down funds further in advance of an anticipated transaction in order to allow them time to deal with any default. On the other hand, investors are seeking terms to help them manage the current situation, such as longer grace periods for defaults and caps on the amounts that may be called within a given time frame.
Investors with strong financial positions are also looking for:
- greater certainty that the default regime is going to provide adequate remedies in the event of a default by a fellow investor (particularly having regard to the laws in some jurisdictions, including Australia, where it is possible that a court might refuse to enforce customary aspects of the default regimes on the grounds that they are unconscionable or out of all proportion to the harm, and consequently a penalty rather than a genuine pre-estimate of damages), and
- pre-emptive rights in the event of a sale of the interests of a defaulting investor.
In relation to fund terms generally, managers of some international private equity funds have responded to investor concerns by the inclusion of some belt tightening provisions, such as reductions in caps on reimbursement of organisational expenses and tighter control of the investment policy (eg reductions in permitted exposure to some higher risk categories of investment).
There has also been some focus by managers and investors in international private equity funds on borrowing limits. In some cases, investors have sought lower caps on permitted borrowings. In other cases, with limited access to debt for individual portfolio company investments, managers are exploring whether the equity required from investors can be reduced by introducing gearing into the investment structure at the fund level (where lenders might have security over the entire portfolio of fund assets and also over the undrawn commitments of investors) rather than the individual portfolio company level (where the recourse of the lenders might be limited to the assets of that company).
Cancellation of commitments
Some investors in international private equity funds are also seeking a reduction in the size of their commitments to existing funds. In response to such a request, Permira, a leading European private equity firm, recently offered investors in one of its flagship funds, Permira IV, the chance to reduce their commitments by 40 per cent. The terms of the offer required the participating investors to continue paying management fees on their original commitment and forfeit 25 per cent of their future distribution entitlements (which will instead be directed to the investors who did not cancel). Ultimately, 90 per cent of investors in the fund chose to maintain their commitments (with the total fund commitments reduced by 13 per cent to €9.6 billion from the original €11.1 billion). Those investors were rewarded by Permira with an offer to increase their exposure to Permira IV by taking up the reduced commitments in return for a waiver of the management fee on any uptake.
Similarly, global mega-buyout firm Texas Pacific Group recently offered its investors the chance to scale back up to 10 per cent of their commitments to its most recent US$19.8 billion buyout fund, but went one step further by taking a 10 per cent cut to its annual management fee.
Candover, one of the United Kingdom’s largest private equity firms, also recently announced it was considering giving its investors the opportunity to reduce their commitments to Candover’s latest fund. Candover 2008 Fund closed in August 2008 with €3 billion of commitments, €1 billion of which was committed by Candover Investments plc, the UK-listed investment trust which owns and invests in funds managed by Candover. In this case, the move appears to be driven by Candover itself, with Candover Investments announcing that the reduction of its commitment is likely to be significant.
Deferral of management fees
Faced with the prospect of a challenging fundraising environment, some managers may follow Bain Capital’s lead in its recently reported proposal to temporarily defer management fees from some of its older, invested funds. In this case, a temporary suspension of fees would allow the United States buyout firm to free up uncalled capital for follow-on investments in existing portfolio companies requiring additional funding rather than, for example, seek to raise new capital for an overflow or annex fund.
In a similar vein, United States buyout house Madison Dearborn Partners was recently reported to have deferred management fees for its latest fund (for which it is still seeking commitments). In this unusual move, Madison Dearborn hopes to reach its US$7.5 billion target size (downgraded last year from the original US$10 billion) by extending the fundraising window without starting the clock on the management fee.
Most favoured nations
Managers are limited in their ability to respond to requests of distressed investors because ‘most favoured nations’ provisions in favour of investors under the governing documents of the fund or side letters may require that any proposed special treatment of one investor also be afforded to some or all of the others.
Alignment of interests
The incentives for key members of the investment teams of managers and their motivation to stay for the life of a fund could have been adversely affected by actual or anticipated losses on deals done to date and, consequently, diminished prospects of ultimately earning carried interest. Both managers and investors may need to consider changes to the incentive arrangements to keep interests aligned. Measures which may be considered include:
- managers restructuring remuneration of the key members of the team to reward performance which falls short of full recovery of losses, and
- investors releasing managers from the usual restrictions on raising new funds so that a new fund can be established with a fresh start on the carried interest.
Other alternative asset funds
Investors might seek to give a greater weighting to other types of investment fund, such as turnaround funds and distressed debt funds. Interestingly, in 2008, some international private equity managers even raised funds to buy the distressed debt of their own portfolio companies from the banks at a steep discount, but with the benefit of hindsight it seems that in some cases the discounts were not steep enough.
Fundraising outlook
What will this all mean for international private equity fundraising in 2009? We would expect the following:
- managers may be aiming to demonstrate their deal flow and capacity to close transactions in an environment where there is only limited access to debt funding, and emphasising the opportunities to buy good assets at comparatively low prices
- many investors will be looking to first sort out their own liquidity needs and any over allocation issues
- there will be a flight to quality, and even the top quartile performers may need to scale back fund sizes given expectations for reduced deal size and volume, and a smaller pool of capital available from investors
- investors with cash to commit will have stronger bargaining positions and may be invited to commit to funds to which they have previously had limited or no access, and
- there could be pressure on well established management fee and carried interest arrangements.
This article was written by Ben Davey, Partner and Ben Plotnik, Senior Associate, Corporate.
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