Shaken and stirred

Permira's announcement in December 2008 to allow its LPs to reduce their commitments by up to 40% has triggered a discussion on what a GP should do if a major LP is in danger of defaulting. It was hailed from one side of the pitch as a fair way out and condemned from the other side as nothing to be proud of. Whether Permira's move will attract a true following remains to be seen, though just a month on, TPG Capital announced that it will cut its $6bn financial services fund, by 25%. The US government's move into the space was cited as the reason, though it is actually the second fund TPG shrank, after allowing LPs in its $19.8bn TPG Partners VI to reduce commitments by up to 10%.

While Permira's and TPG's move suggest that this problem is one for the big guys, there is evidence of cracks showing across the entire industry. Many mid-market GPs have opted to avoid making any capital calls in 2009 to "avoid the issue altogether", while those currently on the fundraising trail are managing expectations. Nordic GP CapMan has just announced a first close on EUR203m for its ninth buyout fund, and has indicated that it does not anticipate exceeding the size of its previous EUR440m vehicle - an about face in sentiment, given most buyout houses have increased fund sizes by 40-100% or more in the last five years.

The make-up of an investor base will impact the scope and size of problems this year. Jeff Montgomery, managing partner at mid-market media specialist GMT Communications Partners, has seen GPs being concerned about this issue for the past 3-6 months: "If you have a lot of pension funds or fund-of-funds among your LPs, it is in the best interest of everyone if the GP works with his LPs. On the other hand, I have heard of some GPs even calling for more than they need to keep going if there is a delay in the delivery by its LPs," he says. Jeremy Lytle, investor relations director of ECI Partners, who recently closed its ninth fund on £430m, believes that mid-market buyout funds should not have to feel the need to reduce their size. "We have always tried to cap the largest investor in any of our funds to 10%," he says.

GPs have to find a way to appease all LPs, since one problematic investor can rock the entire boat. "There are some LPs bearing a grudge against the mega buyout funds, feeling they have been let down. This adds to the difficulty GPs face when dealing with defaulting LPs. In some cases, if a GP is lenient on an LP who defaults it can upset other LPs who are meeting their obligations," says Richard Sachar, managing director at placement agent Almeida Capital.

Such widespread disdain could have long-term repercussions. Thomas Liaudet, principal at placement agent Campbell Lutyens, believes that many LPs will not risk investing in a Permira fund again. "Several of the reactions I saw in the industry to this were of shock and horror. Nobody expected this move," he says.

A few have reported LPs wanting to get closer to the fund via its advisory committee. "LPs may increasingly want to veto investments," says Ian Warner, investment fund partner at Pinsent Masons. Liaudet is expecting some LPs "to put pressure on its GPs to restarting investing sooner than later as they believe 2009 might be one of the greatest vintages ever".

That panic combined with an abysmal market overall has led many to predict the implosion of up to two thirds of the buyout industry. A recent study by Boston Consulting Group and IESE Business School suggested that up to 40% would fail to raise another fund, while the large buyout chiefs not only agree, but suggest the figure will be even higher.

Bargaining power

A shocked investor community is taking a fresh look at fundraising. Whether current funds in market are large or small, first-time or experienced, one can safely say that LPs have the upper hand in the game. More attention is on the "what ifs" before an LP agreement is signed. Montgomery believes that, again, the larger funds will be hit the hardest: "We expect that LPs will put pressure on large GPs to reduce fees, especially management fees."

Sachar believes that while there is a shift in power towards LPs, he does not think that there will be concerted action to change the way the industry works. "I have not seen the impact of the LPs' bargaining power and believe that when the market picks up, LPs may allow the GPs to go back to their old ways," he says. Warner thinks that cutting management fees is not the way to go: "Now is the time to pay proper fees to manage possibly difficult investments," he says.

In fundraising, a study done by Almeida Capital in the fourth quarter of 2008, 78% of 150 global LPs stated they would maintain or even increase their commitment to private equity (unquote" 26 Jan, 2009, cover). "For me, this is more what LPs want it to be like, rather than what they will actually be able to commit," Sachar states. Liaudet agrees: "A high amount of LPs reacted very slowly, in fact they are still adjusting to the new world. I have seen LPs agreeing to commit a certain amount to a fund only to reduce it before the agreement is signed." The LPs of ECI, which started its fundraising only a week before the industry entered several weeks of bad news led by the Lehman collapse, took out more time for due diligence, looked closer at valuations and asked more questions. "We had a number of prospective LPs deferring a decision to 2009 but the ones that had problems told us right away," Lytle recalls. ECI's ninth fund consists of 90% returning investors, showing that some experienced GPs can still hold together their investor bases.

Be traditional or be unique

It seems that in the current climate, average doesn't cut it. The times have clearly changed. Lytle believes that there are certain types of private equity houses in the position to attract commitments: "If you are an established name in the mid-market, have a successful long-term track record and a good portfolio, you should be alright." In detail, this means that "LPs are examining with great care the underlying performance of a fund and the banking implications for each company," says Montgomery. "It doesn't take much of a variance from profit targets to lose value," he adds. Pinsent Masons even advised an experienced buyout house against the launch of its fund simply because the model wasn't right for these times. An idea has to be very good and unique to attract capital.

Maiden funds are having a very tough time. "We are currently advising four first-time funds on their launch and things are difficult," Warner says. The market may recall a number of spin outs over the last couple of years - largely from the VCT community - some of which have been conspicuously quiet regarding any fundraising successes.

Difficult times cause people to shake, and then move. The extraordinary announcement of Michael Queen replacing Philip Yea as 3i CEO is likely to be just one of many significant people moves, with large buyout chiefs indicating a handful of senior executives are currently looking to jump ship - largely because their carry is under water. Sachar believes a generation change is on the horizon for buyout houses: "If a fund does not pay carried interest, we will see younger staff either spin out or ask the older staff to leave the fund and make room for the next generation."

In the end, it comes down to this: "Do what is best for your fund and communicate openly and transparently with your LPs. No one likes surprises," concludes Montgomery.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• People
• UK / Ireland
• DACH
• Nordics
• France
• Southern Europe
• Benelux
• CEE
• Media