There’s considerable talk on the streets these days among LPs and GPs alike that the confluence of declining private equity returns with sweeping Enronitis (i.e., contagious fear of another ethical scandal about to happen) is driving more rationality into the private equity marketplace.
The GE Commercial Finance Equity Investment Team has heard many LPs talk about a hope for shift in the balance of power back in favor of investors. We have also heard GPs talk openly about the need to re-establish closer ties to their investor base. The conversations cover a variety of topics, from whether the Patriot Act will have any impact on GPs, to how many funds will be left standing once the write-off climate dissipates, to whether we’re seeing a shift in basic legal terms, to a host of other interesting issues. What’s great is that the current market climate has slowed to a point where everyone has a little more time to ponder worthwhile issues affecting the industry’s potential fate. What’s disappointing, however, is that while many productive conversations are occurring, things are changing in the marketplace, but not always for the better.
Changing Disclosure Requirements?
Enron, Worldcom, Global Crossing, Tyco … regardless of what page of the newspaper you turn to, there is a new scandal that seems to be brewing. Fortunately, the private equity world seems to be reacting positively to these market fears. While not widespread by any means yet, we have noted a number of the more than 220 sponsors that comprise our current fund portfolio are beginning to adopt a broad host of ways to inundate their LPs with more data on the fund’s performance than in the past. These “disclosure leaders” have begun utilizing a number of ways to provide better communication and disclosure to their investors, including: using secure Web sites to transmit current information to their investors, offering quarterly calls to LPs (en masse or individually in some instances) to discuss portfolio issues or answer questions, utilizing e-mail to notify their investors of up-to-the-minute information that they might find of interest, and employing newsletters and other media to transmit information in a more complete and timely fashion. These sponsors are creatively using multifaceted communication vehicles to clearly brand themselves as leaders of a full disclosure philosophy. And, with the possibility of market consolidation occurring in the wake of weakening returns, branding one’s fund as employing an open disclosure philosophy should accrue to the GP’s benefit (and LPs as well).
But beyond marketing campaigns, there are other ways that GPs can calm investors’ fears on the integrity front. For example, we at GE Commercial Finance are encouraging our GPs to certify the partnership’s financial statements as being accurate and complete to the best of their knowledge. A strange request, you say? Not really, when you consider how many corporate investors in partnerships these days are themselves required to certify their financials as part of SEC or other regulatory requirements. It only seems fair that GPs should step up and be counted among those that champion a similar level of support for their own financial reports.
Here is an example where disclosure is quite arguably lacking: Several of our funds’ annual statements fail to disclose beyond a balance sheet line item the names of prior deals that have been written off. As LPs’ staffs change and new portfolio managers pick up these statements, any reasonable person would assume that the most recent portfolio list represents all of the deals the fund has made. Applying a near forensic accounting analysis, however, by scrutinizing statements from all prior periods in detail, oftentimes reveals that this assumption is quite misplaced!
Similarly, we have seen instances where funds communicate well, but only to a limited number of their LPs! While providing a broader level of detail to a larger audience might be at times painful to endure, it would go far in establishing the GP as a champion of better disclosure standards and most assuredly act to better reinforce ties with its LPs.
Changing Winds in the Legal Area?
Over the last 12-18 months, the market has witnessed a number of subtle changes to what otherwise have been near uniform LP Agreements. Such changes include: a reduction in the number of LPs needed to approve material changes to documents (from 66 2/3% to now almost uniformly 50%; plus, new interpretations applied to what, if anything, needs unanimous LP consent), insertion of new and complex interest free loan/waiver of management fee tax conversion structures, broadening of Advisory Board roles well beyond merely advising on valuation and conflict issues, and severely weakened permitted investment sections of LP Agreements.
Here are some other trends we see occurring in the market on the legal front:
* 50% Amendment Thresholds. Historically, amendments typically required unanimous or at least a supermajority vote to pass. A reduced threshold was ultimately achieved due to the GPs arguing, quite reasonably, that nonmaterial administrative amendments were too burdensome to undertake if unanimity was required. We think most would agree that administrative amendments shouldn’t require a 100% vote, but caution is warranted where a reduced threshold is adopted without carefully limiting its application throughout the document.
* Advisory Board Powers. Remember when Advisory Board powers extended merely to advising the GP on valuation and conflict issues? Read through a current LP Agreement and you’ll be astounded to see how many instances Advisory Board members will be called upon to permit the GP to undertake a whole range of activities. Activities that Advisory Board members can now “approve” include: increasing diversification limits beyond those targeted in the LP Agreement, permitting the writing of naked calls by the GP, allowing the GP to make foreign investments or out of strategy investments, and even permitting the GP to duplicate promote charges by investing in other partnerships where the advisory board members believe such investments are in the best interest of the LPs. Where are the old days when GPs and LPs would sit down and know exactly what the strategy of the GP was intended to be, and the GP would then go out and execute against that strategy?
We fear that expectations of Advisory Board member duties have become much larger than anyone could have imagined just a few years ago. And, although these roles have become more robust and more directly impactful on all of the partners in the fund, rarely do the other LPs even know who the Advisory Board members are. Without the right to elect such members themselves, many LPs are fearing that the industry is becoming bifurcated between GPs and their large LPs, whose interests are commonly aligned and protected, versus small LPs who have been limited to no real say in the direction of their own “partnership.” Maybe the move to use more Limited Liability Companies instead of Limited Partnerships merely reflects that the term “partner” is becoming misplaced.
* Lawsuits. A startling trend is arguably taking shape in the market. First, we have begun seeing our first lawsuits brought by limited partners against general partners for claims including fiduciary and contract breaches (e.g., Connecticut v. Forstmann Little). Second, as we witnessed recently in California with CalPERS and in Texas with UTIMCO, private equity issues like disclosing state pension investments, including private partnership names and returns, is becoming more topical and meritorious in the legislatures and courts. Perhaps these trends are nothing more than the market maturing, but it might also portend a reason for all participants to carefully rethink where the market is headed.
Other Items of Note in the Market
Clawbacks. What, you say, you mean those clawback obligations really do work in practice? Well, from what we’ve seen, the answer is yes. A handful of sponsors are already acknowledging that they probably will need to remit excess carried interest payments under their partnership’s clawback provisions due to significant underperformance in later deals. However, LPs be forewarned, we see a desire by new funds coming to market to water down those very same clawback provisions.
Pledge funds. Absent from the market the last few years, we’re now starting to see a plethora of new pledge fund opportunities. Unlike prior years, many of these pledge funds are offering experienced management teams mostly spun out of institutional settings.
Secondaries. As an active buyer of secondary fund interests, levering off of the knowledge we have across the fund marketplace given our portfolio size, we have seen and bid on a number of interesting opportunities. Quality tends to be mixed, and the one common denominator is that sell side pricing expectations still seem to be rather high. Supply is robust as banks look to exit positions due to regulatory changes, and demand side competition is robust, too!
Focus on Portfolio Management. It is amazing how many of our fellow LPs are starting to take a keen interest to utilizing some form of portfolio management system to track their fund portfolio’s performance. While many still utilize Excel spreadsheets, many are migrating to a variety of products on the market to help track performance.
Timothy G. Kelly is a Managing Director with GE Commercial Finance.