Don't let the sun set on your LP relationships

Until very recently, funds were routinely raised in record time, and comfortably surpassed targets and even 'hard-caps'. Those days are long gone: Erstwhile titans have had to scale back, with Permira's once record-breaking fund down to about EUR 9bn and TPG trimming its financial services fund from $6bn to about $4bn. Time is proving the problem endemic, trickling down into smaller, mid-market funds.

Never in the history of GP/LP relations has communication been so important. That's why it is such a shame so many GPs are putting their heads in the sand. The furore surrounding LP defaults in December caused one of two reactions in GPs: increase your communication with your investors (thumbs up) or avoid rocking the boat altogether by postponing any capital calls for 12 months (big thumbs down). The second approach was forced upon a number of GPs, who had received letters 'suggesting' they refrain from asking for money for the next 6, 12 even 18 months as they were 'unlikely to get it'. This horror scenario caused others to adopt the second reaction: heads in sand, thumbs firmly down.

This is the wrong reaction. "In challenging times, LPs tend to be more demanding, requiring greater transparency within the portfolio and with more frequent update and analysis," says Richard Seewald of CEE fund of funds Alpha Associates. "Savvy GPs tend to be more proactive in facilitating information via frequent update meetings/calls and are able to manage expectations within the LP base more effectively. In the current environment this approach is highly valued."

"It is very important to keep close to your investors," says Joanna James of Advent International. "Keeping them informed on a regular basis establishes trust, so if you tell them you have a problem as soon as possible, it means they'll trust you down the line when you tell them that everything is okay," she says, speaking of the situation nowadays where LPs are questioning GPs on portfolio management.

In addition to its annual investor meeting, Advent Central Europe holds two further meetings of its Advisory Board, which is made up of its top ten investors. Says James: "It sounds like a great imposition, but actually it pays huge dividends. In fact before we released our year-end figures, I personally rang our ten largest investors to talk them through everything. If GPs are not already in regular communication with their investors, they need to change their methods. Now is certainly not the time to be bureaucratic and expect investors to wait for annual reports - it's their money after all."

LP defaults aren't GPs' only worry - in fact one that warned its GPs off capital calls has since proved willing and able to honour draw-downs, indicating December's fear was greater than the New Year reality. Another new problem plaguing GPs is banks withdrawing credit lines, or making them so expensive as to make them too punitive to run. One lower mid-market UK GP had Barclays increase the fee for its fund (less than GBP300m) ten-fold, from GBP 50,000 per annum to GBP 500,000. "They clearly didn't want our business any longer," the GP said.

Eggs in many baskets
Of course fundraising has always been about LP diversification, and is now more so than ever. ECI Partners, another UK mid-market buyout house, defied markets to close a sizeable GBP430m fund at the beginning of the year, even though it only began formally raising after the Lehman collapse. The investor attributes its success to its diversification, saying it caps its largest investor in any one fund to 10%.

Mid Europa Partners tripled the number of its LPs for its third fund, closing with 63 investors. The second is nearly fully invested, and the third just a fifth of the way through, meaning the buyout house is a long way off seeking fresh funds. Mid Europa has regular informal interaction with its LPs in addition to its annual AGM and has successfully drawn capital since the crisis began. "We are making a call now for Fund II; the last one for Fund III was in November, and we had no problems with people honouring their commitments. The investor base appears to be loyal and there has been minimal secondary activity; such trades as there have been readily found interest from among the existing base" says Craig Butcher of Mid Europa.

Investors in Advent's latest fund no investor has more than 7.5%, which is less than in previous funds. "It is about not putting all your eggs in one basked," James stresses. "Just as you wouldn't invest a third of your fund in one deal, you shouldn't allow a quarter of your commitment come from one investor," she says. Advent's largest investors in its latest fund are GIC Special Investments, AlpInvest Partners, California State Teachers' Retirement System and the EBRD.

The diversification is in stark contrast to Advent's debut fund, which raised $60m in 1994, when the market was very nascent and LPs dominated by a small handful of institutions.

When a hangover is good
In the past, the capital overhang that had plagued the industry has been seen as a malicious driver of pricing. Now, however, it may prove the saviour for many funds. A recent study suggested that firms needing to come to the market in the next two years will struggle. With LPs difficult to squeeze money from right now, this time is all about capital conservation.

"GPs should focus on smaller, better-priced add-ons to the existing portfolio rather than new deals," says Warren Hibbert, partner at MVision Private Equity Advisers. "GPs should think carefully about their business model and how they may need to adjust to smaller deals going forward. This is not only not due to the limited amount of dry powder left, but because they may have a smaller next fund and this also makes sense relative to the amount of debt available."

Advent closed its fourth fund in April 2008 with EUR 1bn, its hard cap. To date the firm has made only one capital call, and is less than 10% invested, meaning it has ample dry powder from which to invest.

Funds lacking investable capital have to cope with the big problem LPs are facing: liquidity. It started out with a two-pronged problem plaguing many LPs: a lack of strong private equity returns pumping distributions back into LPs' coffers, and liquid publicly listed investments seeing valuations nosedive, meaning LPs' portfolios were relatively overweighed in illiquid, private equity assets. The recent EMPEA/Coller Capital Emerging Markets Private Equity Survey done in association with IE Consulting revealed that 38% of LPs with current exposure to emerging markets private equity expect the dollar value of their new commitments to be lower in 2009 than in 2008, mainly due to cash constraints and an over-allocation to private equity.

The two-pronged predicament is three-pronged for a small minority of LPs that are themselves listed. SVG Capital was the most conspicuous example of this in December, when the LP catalysed Permira's well publicised fund reduction. Secondaries specialist Coller Capital is now the largest shareholder of SVG Capital, having participated in a £70m private placement, bringing its stake to 24%. Full privatisation by Coller may be on the cards: such was the fate of early-stage tech investor Prelude Trust less than a year ago. In May 2008, the early-stage tech investor cited "declining asset value, difficulties in raising further funds and the increasing cash required by portfolio companies also suffering from the harsh credit climate" as the reasons for selling the portfolio to a Coller-controlled fund for £24.2m. Conditions frighteningly similar to those vexing players today.

The so-called denominator effect is being gently mitigated by new valuations that see private equity underlying assets' valuations eroded by a move to fair-value accounting. But some GPs are proving slow to finalise figures and so the final status of many LPs' portfolios is not yet apparent.

This switch from mark-to-market to fair-value guidelines has caught many, though not all, firms off guard. "Some firms are less plagued by the change in valuation guidelines. Advent in particular say that the fair market value approach has not caused a major change in their methodology," James says. Butcher too says their methodology has made the transition smooth: "Our LPs appreciate our level of transparency and disclosure. In addition to seeing them annually at our AGM, we provide quarterly reports that show a variety of valuation metrics. This allows them to clearly identify the impact of the assumptions made and makes it easier for them to assess the valuation."

Fundraising: an endurance sport
Despite these difficulties, it is not impossible to raise money: in fact the EMPEA/Coller Capital research further revealed that over three quarters of LPs involved in emerging GPs will commit to additional fund managers in the next five years - half within the next two. That said, the road to a new fund will be long, and GPs should prepare for a marathon and not a sprint. "This is a patience game," says Warren Hibbert, partner at MVision Private Equity Advisers. "You need to expect to be in the market for a minimum of 12 months on top of what it would typically take to raise." He stresses the importance of continued support from your existing investor base. "It is critical for a firm to be able to continue as a successful business. Lack of support from existing LPs will be a determining factor in the failure of GPs in the next 12-18 months."

These LPs may help get momentum going: one GP about to enter fundraising mode is considering selecting a 'core group' of trusted LPs to provide initial capital available for investment. This will not form a formal close, it would simply be avaliable should any pipeline opportunities materialise. As and when this pipeline builds up, the GP hopes other new investors will be more inclined to get involved "since they can see what they're buying into". The management fee would only kick in after a certain critical mass is reached, meaning the initial LPs are rewarded for their risk by effectively having their costs cut.

Any activity this year is likely to be slow, fairly painful and limited to top-tier GPs. "The top performers in the region will have an already diversified LP base and will likely be able to raise from that base going forward albeit at terms that will be more LP friendly," Seewald says. Hibbert adds: "This year will be very quiet, with 20-50% of existing LPs committing on 20-75% of what they did last time." Hibbert also predicts that with valuations remaining shaky until Q1 2010, a large number of funds will build-up by the end of next year, all waiting to raise or in the market. "This will only be partially matched by LP 2010/2011 allocations, leading to the dissolution of a number of average GPs."

Ouch. Most industry players agree any attrition will be those new to the market, and / or those with patchy track records. Only time will tell.

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

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