WHAT FINK MIGHT DO WITH BGI - FTSE

PRIVATE EQUITY: IMPROVING OUTLOOK
20
In the Markets
require general partners to cancel
commitments if the money is not
invested within the investment period,
which is typically five years. The clock
is ticking, and firms don’t want to lose
the management fees they charge
even on uninvested funds.“If there are
still economic pressures when activity
picks up, you will start to see defaults
or more product trading in the
secondary market,”says Morgan.
Investors in private equity funds make
firm capital commitments at the outset,
but the sponsor does not draw money
down until needed to finance a particular
investment. For their own protection in
this deferred funding model, general
partners have long insisted on draconian
penalties to discourage limited partner
default. Paul Ellis, a partner in the
restructuring and recovery services
practice at PricewaterhouseCoopers, says
every fund is different, but limited
partners in default always lose their
voting rights and typically forfeit 25%-
50% of future fund distributions. They
may be liable for future management
fees on the amount of their original
commitment (including the defaulted
amount), too.“Those penalties are pretty
significant and they affect the reputation
of the investor,”says Ellis.“We have not
seen any significant volume of
threatened or actual defaults.”
Saratoga’s Oberbeck points out that
the severity of the penalties depends on
where the fund is in its lifecycle and
how the early investments have
performed. Investors will be loath to
give up future gains from a successful
fund, but if a fund made its initial
investments in 2006 or the first half of
2007 it may well be under water.“If you
have invested $40m out of $100m but
you think that $40m is worth zero, what
do you lose by walking away?” asks
Oberbeck. “Do you want to be in the
back end of a fund that has lost money?
The carried interest incentives for the
fund manager are not there either.”
Saratoga has not experienced any
limited partner defaults itself although
Oberbeck has heard talk of the
phenomenon. Like Ellis, he suggests
that investors and private equity firms
are talking to each other to work out a
solution acceptable to both. General
partners have to be careful, however;
whatever they do to accommodate
one limited partner will set a
precedent other investors may try to
follow. Notwithstanding the CapGen
case, Oberbeck doesn’t expect
sponsors to resort to litigation. “You
don’t bite the hand that feeds you,“ he
says. “If you sue an endowment or a
pension fund it will be all over the
press. It doesn’t look good.”
Ellis says private equity firms have
become more willing to exchange
information with limited partners,
particularly about valuations and
potential changes to the general
partner’s investment strategy. For
example, in the current environment
many sponsors see opportunities to buy
companies out of bankruptcy, which
may not have been contemplated when
a fund was first launched. “The
underlying concept is understated
value. It happens to reside in the
bankruptcy world at the moment,”says
Ellis. “Limited partners who have not
been involved before are concerned
enough to ask more questions about
why sponsors are doing this and what
the implications are.”
While Ellis acknowledges that
general partners may shy away from
capital calls if they believe limited
partners will default, he has not
encountered any reticence among his
clients. Quite the opposite, in fact:
limited partners are pressing sponsors
to deploy money—they don’t like to
pay fees on unfunded capital
commitments. Nevertheless, sponsors
won’t go out of their way to
antagonise limited partners by
investing in troubled industries such
Frank Morgan, president of Coller Capital in
the US, points out that partnership
documents typically permit the general
partner to call on other limited partners to
make up any defaulted amount, but CapGen
chose to take legal action against two high
net worth individuals instead.“It was a
warning to other larger investors not to try
this,” he says,“I don’t think a lot of defaults
have occurred.” Photograph kindly provided
by Coller Capital, August 2009.
Paul Ellis, a partner in the restructuring and
recovery services practice at
PricewaterhouseCoopers, says every fund is
different, but limited partners in default
always lose their voting rights and typically
forfeit 25%-50% of future fund distributions.
Photograph kindly supplied by
PricewaterhouseCoopers, August 2009.
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