The balance of power

When the titans of the buyout world start admitting they are no longer in the driving seat when it comes to discussions with their investors, we know the private equity industry is facing more than a few issues. “Going forward, LPs will be heard much more and their concerns of deal fees, size of funds… will have to be addressed,” Carlyle Group co-founder David Rubenstein was quoted as saying at last month’s SuperReturn conference. “The pendulum will have swung… for the next few years, they have the balance of power.”

Such comments are a reflection of the scale of the problems emanating from many firms’ current portfolio companies, some of which have been laden with too much debt, were acquired at the top of the market at eye-watering valuations. and others of which are feeling the economic squeeze sweeping the world.

Whenever there is a downturn, the debate always returns over whether LPs can negotiate better terms on funds and gain greater power in their dealings with fund managers. Some clearly agree with Rubenstein that the change in who wears the trousers in the GP-LP relationship has begun. “The power balance between general partners and limited partners has shifted,” said Johnny Maxwell, head of fund of funds at Allianz Private Equity Partners at the SuperReturn gathering. “This is an opportunity for private equity firms to endear themselves to their investors, but at the moment no one has taken the chance to stand out from the crowd.”

Yet the real situation is far more complex than this implies. The environment in which both LPs and GPs are operating is totally different from any they have seen before. Not only has the financial crisis escalated into a worldwide slowdown, but the industry’s usually reliable sources of funds, such as pension funds, insurance companies and, in particular, endowments, are now facing problems of their own.

The rapid fall in value of their investments in other asset classes, such as public markets, has left many of them overallocated to private equity to a substantial degree, a difficulty exacerbated by some institutions’ overcommitment strategy. As many as two-thirds of private equity fund investors are expecting to reach or breach their allocations by the end of 2009, according to a study put out at the end of last year by Coller Capital. Nearly a third of US investors expect to be overallocated to private equity this year, the report found.

Liquidity drought

We’ve been here before – the dotcom crash in the early part of this century had a similar impact, albeit on a smaller scale. But what is making this problem worse still is the fact that distributions have all but gone as exits have dried up, so those institutions relying on returns to reinvest in private equity are facing serious issues with liquidity. Add to this the use of debt by some investors to financve capital calls and/or using 2008 budgets to commit to 2007 funds, and it’s easy to see why some LPs will find themselves struggling to meet capital calls when they arise.

“There are some investors that have been overshooting their available capital on credit lines – some fund-of-funds have been committing to funds before raising their own funds because their LPs wanted to invest in part-invested funds of funds,” says Rainer Ender, managing director at Adveq. “It gave them some visibility. For the funds of funds, it helped them raise successor funds quickly, but they are now facing problems because they may not have the money to meet capital calls.”

“LPs relying on distributions will face problems, as will many of those that used leveraged structures to maximise their commitments,” adds Lucy Nicholls, partner at Adams Street Partners. “They simply won’t get funding to do this now.”

Default position

Given the difficulties a large number of LPs are facing, it’s hardly surprising that talk of defaults is rife. At the end of last year, some were even suggesting that some LPs were considering reneging on their commitments deliberately, especially in funds that had only invested small amount of their capital.

There were even rumours that events had taken such a turn for the worse that the reputational risk associated with defaulting had disappeared. Had this been the case, the relationships between LPs and GPs would clearly have broken down as the important trust element of it would have disappeared – indeed, late last year, a number of buyout firms sent letters urging their LPs to work with them.

Fortunately for the industry, much of this rumour hasn’t translated into reality. “I don’t know of many deliberate defaults, although there has been some talk of it,” says Nicholls. “There is still a reputational issue here. It would be very short-termist simply to refuse to honour capital calls. If a defaulting LP wanted to invest in the future, GPs would not view them favourably. There have been instances of default where the LP simply hasn’t had a choice and I’ve heard of LPs asking for more time. Broadly speaking, GPs have been prepared to help LPs in the latter camp to the extent that they can.”

Yet the fact that there has been so little investment activity may be part of the reason defaults have so far been rare. “I am hearing in the market that those defaulting are the newer ones and that there are some who are being very difficult in their relationships with GPs in the hope that more established LPs will bail them out, but it’s not a widespread problem,” says Mark Spinner, head of the private equity team at Eversheds. “The real test will be when the debt markets start opening up and capital calls start coming through.”

“We haven’t seen many defaults yet, but that could be in part because there has been so little M&A activity over recent months,” says Mark Cunningham, managing director at Helix Associates. “If deals start picking up again, we may see more.”

What all this demonstrates is that, this time around at least, the idea of a pendulum swinging back to LPs doesn’t really apply. Those looking to commit to new funds may find they have a more receptive ear than they have over the last few years (see box-out), but fund investors with their own problems are in no position to make big demands of the GPs.

“In situations like today’s the negotiating strength normally refers back to the sources of capital,” says Cunningham. “LPs are looking closely at the terms and conditions in limited partnership agreements. But there are a number of LPs with liquidity issues, which means that power hasn’t shifted entirely in their favour. They are requesting increased information from GPs, such as clarity about their investment pace, so that they can negotiate their positions.”

It’s good to talk

It’s a totally different environment from that we’ve seen in the recent past and both sides of the equation are having to adapt to a new reality. “Over the last three years, GPs have been doing well across the board and so they have had good support and backing from their investors,” says Mounir Guen, CEO of MVision. “In today’s market, where there is a huge amount of uncertainty and volatility, no-one quite knows what the best action is in the short-term. It’s not that there has been any shift in power, just that the support GPs had isn’t necessarily there any more.”

What’s happening is increased communication between GPs and LPs. Fund investors are increasingly asking for information on portfolios to try and assess their own positions.

“We are in a fortunate position in that we had sold most of the investments from our first fund and had made only three investments from our new fund before the credit crunch hit, so our LPs’ exposure to the falling market is limited,” says Joseph Bergin, partners at NBGI Private Equity. “That’s not the case with a lot of other GPs where things are not as rosy. In the last few months this has resulted in a demand from LPs for the most up to date information on the financial position of their private equity portfolio companies as they are trying to get a picture of their overall exposure. Everything is moving so quickly, they want a reconfirmation of the health status of portfolio companies.”

“LPs are currently worried about valuations,” says Rob Barr, partner in the client service team at Pantheon Ventures. “The problem they have is that the figures are looking relatively healthy so far, but their information is based on September valuations – the reporting based on the end of year valuations hasn’t come through yet. Given the likely falls in valuations in the last quarter of 2008, LPs are looking at how they should discount their portfolios now – and this is very difficult.”

This time lag in reporting valuations is a source of frustration for some investors, who believe that more could be done to support investors. “Generally, there has been a clear effort on the part of GPs to communicate more and disclose more,” says Ender. “If we ask, we get full valuation reports and an explanation of how the valuations have been arrived at. However, the industry in general needs to improve on the speed and timeliness of its reporting. It is unacceptable to be reporting September valuations until the end of March – we all know that valuations have plummeted further since then. As an end investor, if you are sitting next to the person that is responsible for public markets investing and your boss asks you both for portfolio updates, it reflects badly on private equity if your colleague is reporting bad news and yet you’re still saying things are pretty positive as of September.”

He adds: “When markets are volatile, GPs must give LPs first estimates. Investors need structured information to put into their own systems, so they can understand their own positions.”

Communicating bad news

On the whole, though, many GPs seem to be living up to expectations and in some cases, exceeding them by managing the flow of information to ensure LPs are forewarned and therefore forearmed. “Most GPs are doing a good job of communicating with LPs in our experience,” says Nicholls. “In some cases they are doing better than expected. Most have done investor calls in which they have explained their valuation methodologies and outlined the plans for their portfolio companies. The best ones started early on and provided the information that we needed. They are ensuring that there are no nasty surprises – it really helps if there is bad news to come out of a portfolio to get a call in advance to explain what is going on.”

Helen Steers, partner at Pantheon, agrees. “GPs are managing our information requests well, and in some cases they have provided more information than we asked for,” she says. “They understand that we have a duty to report to our investors. This will be a testing time for investor relations people – many of whom haven’t had to communicate bad news like this before.”

There is clearly a concerted effort of the part of many GPs to be pretty upfront about the issues in their portfolio. But how are they dealing with LPs that have liquidity issues? We’ve already seen one solution. When Permira’s main investor, SVG, found that it was facing problems with liquidity and was likely to have to launch a rescue rights issue, the firm had to act fast.

The result was a kind of “managed default”, allowing investors the chance to cut their commitments by up to 40%. There is a price for this flexibility however: investors must forgo a quarter of any profits and pay a management fee on their original commitment amount. As many as 18 of the firm’s investor accepted the offer, including SVG. TPG has also offered investors the chance to reduce their commitments by 10% on its US$20bn buyout fund and it has cut the size of its US$6bn fund raised for distressed financial companies by 25%.


But cutting fund sizes is generally seen as a last resort. GPs are instead attempting to work with LPs to find alternatives. One is to sell LPs’ commitments. “Where LPs are really having difficulty meeting schedules of capital calls, they are asking GPs to help them find buyers for their positions,” says Cunningham. But that’s far from easy in today’s environment the secondaries market is awash with unwanted portfolios.

“The secondaries market is tough for LPs at the moment,” adds Cunningham. “They are finding that even when a portfolio position gets indicatively priced, another portfolio comes up in the market. The values are way down in any case – below 50%. Yet there is very little actual buying activity because there is still so much uncertainty as to what the year-end valuations are going to be.”

Given the unwillingness to cut fund sizes and the difficulty in selling, for the meantime at least, the only other option is to give LPs more time to meet their capital calls. Many fund investors are asking GPs for best estimates of investment pace to help them anticipate capital calls. Some are also asking GPs to delay drawdowns and most LPs believe that the managers are being as accommodating as they can, although there is some concern about LPs trying to dictate investment pace.

“One worrying phenomenon we are seeing is attempts by LPs to influence the investment activity of GPs,” says Nicholls “LPs should be delegating the investment decisions to the manager, yet some are asking GPs to hold back. If GPs see good deals they shouldn’t be stopped from investing as these could be great opportunities. I think this is more of a problem in smaller funds, where GPs tend to be more concerned about upsetting their LP base.”

On the whole, however, it seems as though communications between GPs and LPs has improved, if anything. And that, say some, simply demonstrates the strength of the private equity model. “The quality of communication is improving,” says Bergin. “Private equity houses are in any case much better equipped than public companies to provide their investors with the information they need because of the private nature of the communications. The pressure of the current, more challenging, environment has helped to raise the quality of the communications with investors.”