NYC PE chief: For LPs, fund revamps are ‘tails you lose, heads you lose’

Limited partners are taking a decidedly negative view of the fast-growing business of restructuring older private equity funds.

“Most GP restructurings that have crossed my desk, and [many] have crossed my desk over the last couple of years, have been bad deals for LPs,” said Alex Doñé, who leads New York City‘s $10.5 billion PE portfolio, at Pension Bridge in Chicago on July 26. “There’s no way to sugarcoat this.”

Doñé’s characterization is particularly true of restructurings initiated by general partners who are unlikely to raise new funds, Pension Bridge panelists and outside sources said. The deals extend life preservers to firms whose reputations are “already shot,” one LP told Buyouts.

“Each one is different,” said LP Capital Advisors Managing Director Allen Waldrop, who spoke on the same panel as Doñé. “When you’re dealing with people who have less to lose, whether it’s your career [or something else], it makes it more difficult.”

Firms usually initiate restructurings toward the end of a fund’s life (generally 10 years with one or two one-year extensions). Rather than unload an aging fund’s remaining assets in a fire sale, which could weaken returns, a GP will seek outside capital from new investors for more time, and more money, to manage them out.

Existing investors face a choice: sell their fund stakes to the new investors (often at a discount to their value) or roll their interests into special-purpose vehicles with a new term, say, four years. The new fund is capitalized by new investors, giving the GP more time to sell the investments. The GP often receives new fees and the chance to earn carried interest as part of the deal.

In recent years LPs have pushed for the ability to essentially do nothing: simply roll their fund interests into the new vehicle on the same terms as before. In this case, the only real change is the fund’s life is extended.

Speaking at Pension Bridge, Brian Murphy of Portfolio Advisors noted the option of “doing nothing” made it easier for LPs and GPs to complete recent transactions. One recent large deal, the restructuring of First Reserve Fund XI, allows existing LPs to roll their interests in the restructure vehicle on a no-fee, no-carry basis — essentially enabling them to do nothing.

Some LPs question the fairness of the process, however. So-called zombie GPs, who are unlikely to raise new funds, may run a process that limits the value of their holdings, one public-pension LP told Buyouts. Even if LPs take the do-nothing option, the restructured fund’s governance is likely to favor the new investors.

“LPs who’ve gone through this understand [that] by the time you get those options, you’ve already lost,” said the LP.

In many transactions, none of those options are appealing, sources told Buyouts. Some say restructurings reward managers who fail to live up to the terms of the original investment vehicles. Yet doing nothing keeps a lackluster fund in an LP’s portfolio until its remaining assets are sold, which can take years.

“It is usually a situation where ‘tails you lose, heads you lose.’ That’s how we think about it,” Doñé said on the panel. “These are solutions for GPs to extend their lives. And to me, what many GPs fail to remember is that their primary fiduciary duty is to the fund and not themselves.”

New wrinkles

Despite these issues, the volume of restructuring transactions is growing rapidly. Last year, GP-initiated secondary transactions accounted for around 13 percent of secondary-market deal volumes, a report from investment bank Evercore says.

Nigel Dawn, who leads Evercore’s private capital advisory group, told Buyouts in January he expects restructurings to account for as much as a quarter of the market volume in the coming years. Other secondary-market sources indicated their funds, or GPs’ funds, will direct more capital toward restructurings.

The recent glut of fund restructurings places a greater burden on LPs, many of whom lack the experience or resources to properly value a fund’s underlying assets, said panelists at Pension Bridge. A decade ago, LPs rarely assessed individual portfolio companies, said Shawn Winnie, a senior portfolio manager for the State of Michigan, on a panel at Pension Bridge.

Further complicating matters is the variety of fund-term and side-letter provisions many investors require of their general partners, which can slow a transaction as it enters legal negotiations.

“The idea that everyone is signing the same documents, that everyone’s getting the same deal, has completely changed in the last 10 years,” Winnie said. “The types of transactions you’re seeing among limited partners, and the things you have to dig into, have become substantially more complex.”

Winnie is leaving State of Michigan in September to launch an independent practice to consult with LPs working through GP-led restructurings.

Though complex, restructurings do offer a solution to the problem of zombie funds.

“Funds extend and extend. The median private equity fund right now is lasting 13 years, which means a lot of private equity funds are lasting longer than 13 years,” said Goldman Sachs Managing Director Harold Hope, speaking on the same panel as Murphy. “It’s a headache.”