With the recession forcing longer than anticipated holding periods for investments, buyout shops are increasingly coming up against capital shortages for existing portfolio companies. This is especially true with struggling companies that will require add-ons or operational improvements to get in shape for sale once the exit market rebounds. To combat this quandary, firms are getting creative about generating liquidity, and annex funds are back on the menu.
Typically associated with venture capital, annex funds usually take the form of a new parallel investment vehicle to an existing fund. In the majority of cases, assuming the annex fund’s formation is far enough along in the investment cycle, permission from limited partners isn’t required, according to David T. Jones, a partner with law firm Proskauer Rose LLP. This differs from top-up or add-on funds, Jones said, which usually pop up while the fund is still actively investing. As such, tope-up funds represent an extension or re-opening of fundraising for the existing vehicle and require the consent of existing LPs.
Annex funds tend to have a narrow investment mandate with the monies earmarked for well-defined purposes, such as follow-on investments in current portfolio companies. The funds can even be limited to investments in specifically designated companies within the portfolio. Buyout firms reportedly going this route of late include
Dilution is a major concern for the original LPs when confronted with the prospect of an annex fund. This is because the vehicle is being set up to participate in the same investments as the original fund but other factors will be different, such as the price of a particular stake being adjusted to reflect current market conditions, or associated fees and other terms related to the new monies being modified from those that exist for the original investors. The dilemma is such that LPs don’t like having to put more money in than originally committed, but they also may hesitate to pass on making a pledge because of the dilutive impact.
So what should general partners take into account before going back to the well?
David Watson, the chair of the private investment fund practice at law firm Goodwin Procter LLP, has come across plenty of LP angst in his experience with annex funds. The first questions that usually get asked are attempts to make sure all other available options have been explored.
“They want to understand why an annex fund is necessary and to be sure that there’s a plan in place going forward,” he said.
But other options for liquidity at the disposal of buyout firms may be even less attractive to LPs. Direct secondary transactions are a possibility. But these deals, which bring a third party into the mix, have their own conflict-of-interest and dilution issues and can cause perception problems among the remaining investors. Enticing new investors with a preferred return is a long shot to win approval from the original investors unless the existing fund’s situation is particularly dire. Recycling or recalling previous distributions can work in a pinch, but LPs aren’t known to relish giving back capital, and such a move has a ‘six of one, half dozen of the other’ feel to it, when compared to participating in an annex fund.
For buyout shops that decide to raise annex funds, Watson believes communication, past and present, plays a big role in whether or not it’s a smooth process.“The biggest factor is how much the LPs trust the GP,” he said. “They are going to look at how well the firm has performed in the past and the level of communication along the way. Firms that have kept the LP in the loop, even when the news was bad, will have an easier time of it.”
In most instances, however, Jones of Proskauer Rose said LPs are likely to be resigned to the necessity of the annex fund if that’s what the GP believes is required. After all, the decision for a buyout firm to raise an annex fund isn’t exactly a hallmark of halcyon days, and even a watered-down return is preferable to none at all.