THE ANNUAL REVIEW 2010 - PEI Media

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page 80 private equity annual review 2010 d i s t r i b u t i o n s Cash back Money started to flow back to LPs in 2010 … assuming they had a mature portfolio of fund interests, reports Christopher Witkowsky Limited partners were given some breathing space last year by their private equity managers, who began to return capital at levels not seen since before the financial crash in 2008. In the first half of the year, the amount of cash coming in to LPs through distributions almost caught up with the amount going out in the form of capital calls, according to numbers from Cambridge Associates, an advisor to private equity limited partners. Cambridge reported in November that during the first half of 2010, capital calls outpaced distributions by only 1.4 times. Money was still being called faster than it was being distributed, but the gap had narrowed to the smallest margin in two years. In 2009, calls for capital by GPs had outpaced distributions by 1.9 times. In the previous year, LPs had had the toughest time in terms of private equity cash management, with capital calls out-pacing distributions by about 2.5 times, the widest margin in the time period Cambridge studied, which stretched back to 1996. Cambridge’s information comes from a universe of about 850 funds. Wilshire Associates, another advisory firm, noted similar flows. It observed a 60/40 split between dollars going out and dollars coming in, based on data from about 450 funds. Private equity portfolios which were adequately diversified across vintage years, therefore, began to have an easier time in terms of cash flow; for these portfolios, the distribution vs. capital call cycle had “normalized”. For less mature programmes, however, the cycle remained imbalanced. The $31.8 billion Maryland Retirement System, for example, in November announced that it had pulled back from private equity commitments in recent months because the “normal cycle of calldowns and distributions [had] been broken since late 2008”. Maryland was likely feeling ongoing pressure because the pension made a big push into the asset class starting in 2008, when it ramped up its allocation to private equity from 5 to 15 percent. Maryland made more than $1 billion of commitments to private equity since it raised its allocation. Unfortunately for Maryland, and the many other institutional investors which upped the private equity exposure between 2005 and 2008, funds raised during this period are well into the process of calling down capital, but are not necessarily returning capital to LPs. Triago, a placement agent and secondaries advisor, found that within the universe of about 200 funds it tracks, capital calls during 2010 outpaced distributions by a significant amount. According to the firm, capital calls accounted for 11.5 percent of committed capital, while distributions were just 6.3 percent. The disparity between Triago’s and the other two advisers’ numbers is likely down to the fact that the universe for Triago’s study consists of funds it sees in the a big call Source: Triago secondaries market, which tend to be from more recent vintages, from 2005 and later. This is bad news for LPs with portfolios biased towards the younger vintages. Anecdotally, limited partners more recently have seen distribution and activity levels rise even further. In January 2011, HarbourVest Partners’ listed investment vehicle reported a dramatic return to activity in its portfolio in December, with large increases in capital calls and realisations. The fund of funds met capital calls totalling $35 million during December from its funds of funds, a direct investment fund and its global secondaries fund. This compares with just $4.3 million in calls funded during November, or $9.2 million during December 2009. The increased investment pace was almost matched by distributions received. 32 exits across the portfolio returned a total of $31.6 million to the HVPE. Steve Belgrad, chief financial officer of HarbourVest Global Private Equity, said the activity levels for December were broadly on a par with those seen in during the highs of 2007. “You are finally seeing the listed private equity fund functioning in the way it was intended, with distributions just outpacing capital calls,” Belgrad said in January. “It feels like the industry has finally turned a corner.” n Triago’s data show distributions as a proportion of all committed capital more than trebling in 2010, but still be ing outpaced by capital calls 8% n Distributions n Calls 6% 4% 6.3% 2% 2.0% 0% -2% -5.3% -11.5% -4% -6% -8% -10% -12% 2009 2010
private equity annual review 2010 pa g e 81 t e r m s & c o n d i t i o n s Terms tug of war The push-pull between fund managers and investors over terms and conditions may not have been as dramatic as some assumed, finds Nicholas Donato Limited partners’ rising negotiating power on terms and conditions was discussed frequently in 2009 and 2010.Tougher fundraising conditions, more GPs needing to replenish dry powder and LP-friendly terms and conditions guidelines released by the Institutional Limited Partners Association were all said to have given LPs the upper hand in many cases. But a study released last year by New York-headquartered law firm Debevoise & Plimpton found there had been no “substantial shift” in terms in the past five years. The study examined more than 200 buyout funds globally, comparing the key financial and legal terms of funds that had final closing prior to the financial crisis, with those closed post-crisis. “LPs and their advisors are vigorously negotiating fund terms these days, in many cases citing the ILPA [guidelines] to support their arguments,” the report acknowledged, adding there was, however, little evidence of an overall industry-wide shift of power towards LPs. The study measured nine key economic terms of buyout funds: the timing of carried interest distributions; carried interest percentages, preferred return rates; management fees both during and after the investment period; sharing of transaction and other fees; joint and several guarantees on GP clawback provisions; interim clawback provisions; and after-tax calculations on clawbacks. On most demands, including the timing of carried interest distributions and carry points, little concession was found to have been made on the part of GPs. giving way LPs did however gain ground on a few issues highlighted by ILPA – most notably on transaction and management fee reductions or offsets. The Debevoise study found many GPs gave way on management fee “step downs”, which had been long-demanded by investors who argue that reduced management fees after the wind-down of a fund’s investment period reflect lower operating costs. Large funds raised after the crisis – those of $2 billion or more – had post-investment period management fees of on average 1.1 percent. Those raised before the crisis charged a fee of 1.24 percent. For smaller funds, the post-crisis funds charged 1.73 percent in management fees after the investment period. Pre-crisis funds charged 1.81 percent. Concessions were also made on the handling of fee offsets, which occur when a GP reduces or cancels management fees as a result of receiving income from break-up fees, transaction and/or monitoring fees Show of strength: GPs and LPs in 2010 continued to negotiate hard on terms charged to portfolio companies. Also found more prevalent in post-crisis funds were more LP-friendly clawback provisions, which allowed fund investors to recover money in the event GPs receive too much carried interest – such as when managers receive carry on successful exits early in the fund’s life. In noting ILPA’s recommendation that GPs should make any necessary clawback payments within two years, as opposed to waiting until the fund completes its last exit, the study revealed 16 percent of the sample funds now provide for the provision compared to the lesser 10 percent of funds offering the provision raised during the boom years. While many GPs have given in to LP demands on fees, however, it may not be enough. For instance the California Public Employees’ Retirement System (CalPERS), a trendsetter in the LP community in terms of negotiations with fund managers, has indicated it may push for incentive-based fees rather than flat management fees. Should that proposal become policy, there will no doubt be further friction between LPs and GPs on the fee front. But is that such a bad thing? After all, a leaner, hungrier group of smart, hardworking managers who merit their fees is good for the industry as a whole – not just CalPERS. The squeaky wheel complaint from LPs of GPs growing fat on fees gets jettisoned and instead there is an unambiguous alignment of interest. No more “heads I win, tails you lose” as one fund formation lawyer recently put it to PEI. n
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