LPs Push Back On Fund Size, Deal Pace

With liquidity in short supply, power in the ongoing struggle between LPs and general partners has clearly shifted to institutional investors who still have capital to commit to funds. And they’re flexing their muscles in ways that have implications for how fast buyout shops will be able to invest in new deals over the next several months.

Some would like buyout shops to ratchet back fund sizes on pools already raised. Buyout funds managed by Candover, Permira and TPG, which had collectively raised about $55 billion for their latest funds, have recently agreed to cuts that could reduce their fund sizes by an aggregate of $6 billion. Others are considering requests by GPs to extend their traditional four- to six-year commitment periods by an additional one to two years to make up for the current dearth of deals, according to Richard Ellman, a partner at Dallas-based Aldus Equity, which serves as an investment advisor to LPs.

When confronted with new funds, meantime, LPs have started asking for caps on the amount of capital a GP can inves over a given period of time. Popular in the late 1990s, investment caps became a non-issue when the market got rolling in the last upswing, said Jose Fernandez, a managing director at La Jolla, Calif.-based StepStone Group, an advisor to institutional investors. “Limited partners have become much more concerned about how much capital [GPs] can deploy in a calendar year,” Fernandez said. “We’re seeing limited partners ask for yearly caps of no more than 40 percent of capital, and they’re getting them.”

Added Greg Kulka, director of private equity at the New Mexico State Investment Counsel: “Some firms raising a new fund today are using the same [limited partnership agreement] from the prior fund from three or four years ago. Obviously that was a period when everybody wanted to jump in to private equity, so there are terms in there that nowadays don’t look so good.”

Needless to say, institutional investors across the board have become far more sensitive to the issue of how fast buyout firms spend their money. Many are victims of the denominator effect, in which rapidly falling public equity valuations have their private equity portfolios well above target allocation. Others have no available cash to fund their capital calls at a time when selling assets to generate cash is far from an attractive option. The buyout shops themselves have been no help: Capital distributions today are between 25 percent and 35 percent of what they were a year ago, while capital calls are approximately 80 percent of what they were at that time, according to New Mexico’s Kulka.

The upshot? Yet more cold water tossed on a deal market already at a near-standstill due to frozen debt markets and reluctant sellers. And it’s likely that we’ll see more commitment reductions down the road. Between 2007 and 2008, U.S.-based buyout shops raised approximately $475 billion, suggesting enough firepower to buy well over $1 trillion worth of companies. By contrast, buyout shops are on pace to close a total of 568 deals with a disclosed value of $28.4 billion (represented by 128 deals) this year, based on an annualization of Q4 2008’s closed deal total. “There is concern among LPs as to whether [GPs] can manage such a large increase in capital, particularly in this environment,” said StepStone Group’s Fernandez.

Fund Size Reductions

It wouldn’t be the first time that private equity firms have cut their fund sizes. After the dot-com bubble burst, some venture firms found themselves with $1 billion-plus pools to invest but no obvious way to generate a decent return given the lifeless M&A and IPO markets at the time; as today, many investors short on liquidity were pressuring GPs to ease up on the gas pedal. One result was a slew of fund size reductions from such well-known firms as Austin Ventures, Charles River Ventures and Meritech Capital Partners.

At the time, some venture capitalists actually believed their investment model was broken. On the one hand, they faced high valuations on fresh investments given the competition for deals; yet they had few opportunities for blockbuster exits. With little leverage available in the market today, the LBO model is arguably broken as well, at least temporarily. And once again we’re seeing GPs and LPs respond with fund size cuts.

It was global buyout firm Permira that kicked off the recent run of scale-backs. In November, the firm gave investors with liquidity concerns a chance to cap their commitments to Permira IV at 60 percent, after the fund’s largest LP, listed fund-of-funds SVG Capital, asked for a commitment reduction due to liquidity concerns. Fund IV closed on about €11 billion ($14.02 billion) in 2006, more than double the size of its vintage 2003 forbearer. About 10 percent of theLPs pulled money from the fund, reducing the capital pool by about 13 percent, to €9.6 billion from €11 billion, the firm said. SVG Capital reportedly reduced its total uncalled commitments to £343.8 million ($497.8 million) from £796.3 million.

In late December the concessions hit the U.S. LBO market, when TPG sent letters to investors outlining an optional commitment reduction plan for its $19.8 billion TPG Partners VI, which closed in 2008. Under the plan, LPs can scale back their commitments by up to 10 percent, while those that opt to stick with their original pledges would be rewarded with smaller management fees. The Los Angeles City Employees’ Retirement System opted to scale back its $25 million commitment by the full $2.5 million allowed. TPG’s fifth fund closed on $15 billion in 2006.

And just last month, London buyout firm Candover began conversations with LPs about dialing back the size of its Candover 2008 Fund, which had an original target of €5 billion ($6.4 billion). The firm’s 2005 predecessor had targeted €3 billion and closed on €3.5 billion. Citing the economic backdrop, Candover said the most likely outcome for the 2008 vehicle would be commitment reductions for LPs that have already pledged money to the fund. As for the €1 billion it had pledged to the new fund through its publicly-listed vehicle Candover Investments plc, the firm said its own commitment “reduction is likely to be significant.” The new fund has already raised €3 billion to pursue deals valued between €500 million and €5 billion.

Buyout professionals like to point out that past downturns produced some of their best investment opportunities. If so, LPs may later regret that they threw lassos around buyout shops at exactly the wrong moment.