First Reserve fund revamp approved by LPAC over CalPERS objections

  • CalPERS cites ‘conflicts of interest’ in objection
  • Says firm collected over $500 mln in fees from Fund XI
  • Proposed plan now goes before full LP base

First, Thomas H. Lee Partners; now, First Reserve. CalPERS, the largest public pension fund in the U.S., is again forcing an issue of critical importance to the private-equity industry into the spotlight.

California Public Employees’ Retirement System, the overseer of nearly $300 billion of assets, is objecting to a proposed restructuring of First Reserve’s Fund XI. It says the plan benefits First Reserve, the Greenwich, Connecticut, PE firm, and secondary buyers in a fund that isn’t expected to provide original investors — including CalPERS itself — with a return.

How to manage the remaining assets of older funds is a hot-button matter for PE. And the dispute comes after CalPERS also argued with TH Lee, the Boston PE firm, about accelerated monitoring fees.

The proposal for Fund XI places the fund’s remaining assets in a special-purpose vehicle capitalized by new investors who would pay management fees and carried interest.

Resources and motivation

First Reserve has collected more than $500 million in management fees from its 11th fund, and continues to collect fees from other funds it raised in recent years, said Real Desrochers, head of private equity at CalPERS, in a letter to First Reserve.

So, he said, the firm should have the resources to keep its Fund XI investment team motivated to manage out remaining assets in the final months of its term.

The proposed restructuring “will provide First Reserve enhanced economics in the form of a reset carried interest for a fund in which original investors are not expected to receive a return of capital on their investment,” Desrochers wrote in the June 30 letter viewed by Buyouts and addressed to Bill Macaulay, the firm’s chairman and co-CEO. Buyouts obtained the letter through sources outside of CalPERS and First Reserve.

“We view this proposed restructuring … as primarily benefiting First Reserve and the secondary buyers.”

Despite CalPERS’s objection, First Reserve’s plan recently was approved by the fund’s limited-partner advisory committee, according to three people with knowledge of the matter.

The restructuring proposal now goes to the full LP base for a vote. The plan requires approval by two-thirds of the Fund XI LP base to move forward. If approved, each LP will then vote to either sell its stake in Fund XI or stick with the general partner in the restructured vehicle.

CalPERS is one of 11 Fund XI limited-partner advisory committee members that voted on the plan.

“The letter is another example of CalPERS’s efforts to hold private equity firms accountable,” pension-system spokesman Joe DeAnda told Buyouts this week in response to questions about the objection. “We believed a decision was made lacking the full picture.” DeAnda declined to comment further.

First Reserve met with the LPAC several times to review the proposed restructuring and incorporated some of the feedback into the final proposal, according to a person with knowledge of the talks. For example, the original plan floated in April called for the restructured Fund XI to have a five-year term. That was reduced to four years after First Reserve’s discussions with the LPAC, the person said.

The firm also spoke with a large majority of LPs in the fund to get feedback prior to launching the effort.

Fund XI closed on $7.8 billion in 2006. It’s been a weak performer, generating a negative 9.8 percent internal rate of return and a negative 0.66x multiple as of Dec. 31, 2015, according to data from Oregon Public Employees Retirement Fund.

The goal of the restructuring is to return investors’ principal, First Reserve said in a letter to LPs in April.

The deal

The proposed restructuring would place remaining Fund XI assets into a newly created special-purpose vehicle. How much value remains in Fund XI is unclear.

Secondary buyers Pantheon and Intermediate Capital Group have offered to buy out existing LPs in Fund XI. Those buyers would become LPs in the restructured Fund XI and would pay management fees and carried interest. (It’s unclear whether Pantheon and ICG are the only secondary buyers in the deal.)

Fund XI LPs that don’t want to sell can roll their interests into the restructured fund on a no-fee, no-carry basis.

It’s not clear what price the secondary buyers are offering for existing fund stakes. Pantheon and ICG declined to comment. Each member of the LPAC either declined to comment or did not return requests for comment.

Lazard is working as the adviser on the restructuring process.

CalPERS objections

In the letter Desrochers makes clear that CalPERS believes First Reserve should simply let Fund XI run its natural course. The fund term ends this year, though the fund has two one-year term extensions.

“CalPERS would propose a simple extension of the fund, and would also be amenable to granting limited recycling for the remaining assets,” Desrochers wrote.

Desrochers argued that First Reserve has the ability to give the investment team on Fund XI incentive to manage out the remaining investments. The firm collected more than $500 million in management fees from Fund XI and continues to collect fees from its other funds.

“The senior [principals] of the fund, in CalPERS’s opinion, have existing resources available to incentivize the next generation of First Reserve personnel,” Desrochers wrote.

Desrochers also argued that some of the remaining assets in Fund XI are publicly traded securities, which could be distributed to existing LPs without the need for an additional four years to sell them off. He also said the firm is valuing remaining assets at the bottom of the cycle, when those valuations have now rebounded.

LP solutions

In a process separate from the Fund XI restructuring, First Reserve is raising an annex fund to support portfolio companies in Fund XII, which closed on $9 billion in 2009. Fund XII was producing a negative 8.1 percent IRR and a 0.73x multiple as of Dec. 31, 2015, according to Oregon’s performance data.

Fund XII LPs would be able to commit to the annex fund on a no-fee, no-carry basis, First Reserve said in the April letter to LPs. The firm also wants to extend the “follow on” investment period on Fund XII for one year. It’s not clear whether the firm has received commitments for the annex fund or received LPAC approval for the extension.

The two processes are First Reserve’s attempts to move the two funds through a “lower for longer” environment, the firm told LPs in its April letter.

“We remain convinced that it will take some time before we see a sustained recovery in the energy macro environment,” the firm said in the April letter. “Thus, Fund XI faces a timing mismatch (in the final year of its initial term), and there are potential incremental capital needs for select Fund XII portfolio companies.”

Action Item: Reach First Reserve IR Chief Cathleen Ellsworth at:

Photo: Calpers headquarters is seen in Sacramento, California. Reuters/Max Whittaker