Aging Funds Let Long-Time Investors Cash Out

For Behrman, the managing partner of Behrman Capital, whose vintage 2000 Behrman Capital III LP fund had already been granted two extensions, salvation came mainly from Canadian pensioners. The Canadian Pension Plan Investment Board, the country’s largest pension fund, pledged $654 million as part of a $1 billion pool to purchase the interests of limited partners who want out. The pool will also fund a new vehicle called Behrman Capital PEP LP that will buy Fund III’s remaining assets, with CPPIB as the fund’s main limited partner.

Life support for the 2001 vintage Willis Stein & Partners III LP involved $220 million in fresh funds from Vision Capital, PineBridge Investments and Landmark Partners to buy the fund’s remaining assets. Fund III will get a new, five-year lease on life and will be jointly managed by Willis Stein & Partners and Vision. The fund’s remaining assets have an approximate value of $300 million, said Stein, the firm’s managing partner, in an interview with Buyouts’ sister Web site peHub.

“This is the right solution that gives those that needed liquidity that option,” Stein said. “At the same time, it’s creating a stable environment for investors that want to stay in.”

Yet a majority of investors in both funds were keen to get out. Big investors, such as pension funds, generally have been eager to concentrate their portfolios and limit their investments to just the top funds. Funds charging management fees long past their investment periods have frozen the liquidity that investors would prefer to reallocate. And because these firms keep charging fees without much new portfolio activity, they drag down an investor’s overall returns.

Yet creative work-outs like those proposed by Behrman and Willis Stein have laid down a path for investors to cash out of aging funds on terms that they hope are fair. At the same time, they create a new way for sponsors to retain their portfolio investments. And in exchange for the cash that is needed to buy out limited partners who want to leave, new investors such as CPPIB and Vision Capital get to buy substantial interests in a new vehicle. This is “an innovative solution that reflects our commitment to meeting the diverse objectives of all our investors,” said Behrman in a statement.

In the case of the new Behrman PEP Fund, the new vehicle comes with additional enticements such as a discounted 0.75 percent management fee and a shorter, six-year fund duration (the carry is 20 percent). Willis Stein III will have similar terms to those it had before the fund’s life was extended.

Such multi-lateral work-outs could lead to fewer “zombie funds,” which siphon off a fund’s remaining value through indefinite annual management fees. Zombie funds are most common when a fund has little chance of earning carried interest on its remaining portfolio companies, and has a negligible hope of ever raising another fund. As a result, such sponsors have little economic incentive to do anything but charge a fund’s annual management fee.

Even though the Behrman and Willis Stein funds outlasted their expected 10 year life-spans, the firms were reluctant to exit hastily from their remaining portfolio investments. Behrman Fund III owned five portfolio companies, while Willis Stein III owned three. According to several news reports, the remaining investments were known to be “in the carry.”

Each fund’s original investors could cash out of their remaining stakes at a level close to the fund’s net asset value, although the exact payout ratios to NAV were not disclosed.

One question for LPs was whether the valuations on portfolio companies were fair and accurate. Since LPs in Behrman had the option to roll their stakes over into a new fund that would purchase the remaining portfolio companies at the very same price that the old funds were selling them, LPs could be relatively confident that the marks were at or near their actual values. And in Behrman’s case, valuations were determined through what it called “a robust and independent auction process.”

Even though investors had the option of rolling their stakes over into a new fund, a majority of LPs decided to cash out, eager to liquidate their remaining holdings and reallocate them to other uses, according to statements from both firms.

For Behrman, the $1 billion new fund will include not only the $750 million to buy Fund III’s five portfolio companies, but also $250 million for add-on acquisitions, according to a statement.

As for returns, Behrman Capital III was garnering a 12 percent IRR according to March 2012 data from the Kansas Public Employees Retirement System, which invested $40 million in the fund. The pension did not report a return multiple.

Willis Stein III was generating a 1 percent IRR, according to December 2011 data from the Florida State Board of Administration, which pledged $100 million to the fund. Florida also did not report a return multiple.

Willis Stein is based in Chicago, while Behrman is based in New York and San Francisco.