Increased Capital Calls and Diminished Distributions for Private Equity LPs
Returns for private equity investors suffered their worst decline on record in 2008, according to a study issued by London-based research firm Preqin. Limited partners ended up paying more money into buyout funds than they took out. The Financial Times reported that general partners made $148 billion in capital calls from limited partners, but only distributed $63 billion in returns. Concerned about their ability to meet future capital calls in the face of diminished expectations for distributions, institutional investors appear wary of increasing their exposure to private equity.
Hampered by the decline in markets, private equity general partners continue to scramble to find profitable exits. A recent Dealogic analysis reviewed by The New York Times reveals that exits from portfolio company investments by private equity funds generated only $20.8 billion in the first half of 2009, down from $115 billion in the first half of 2008. General partners have also achieved little success in finding attractive acquisition targets. Even when private equity firms have identified valuable buyout opportunities, tight credit markets have hindered them from financing the deals. CNNMoney.com writes that only three loans were given to leveraged buyout funds in the first half of 2009. Lenders’ reluctance to finance leveraged buyouts have forced private equity GPs to adjust their deal structures, relying more heavily on equity investments (and corresponding capital calls from their LPs). Apax Partners LLP, for example, recently bought the personal financial information provider Bankrate, Inc. for around $571 million in cash.
An increase in capital calls, decrease in distributions, and the scarcity of debt financing for deals have made it difficult for firms to raise financing for new funds. The Dow Jones Private Equity Analyst found that during the first half of 2009 general partners only raised 50% of the capital that they raised during the first half of last year. For those investors that have decided to commit to new funds, however, at least one study suggests that limited partners increasingly have been able to negotiate more investor-friendly terms in the funds’ limited partnership agreements. Last year’s large discrepancy between the amount of capital calls and distributions seems to have emboldened institutional investors to seek greater contractual rights and better financial terms from general partners.
Evidence from a research report issued by Preqin in July suggests that limited partners have successfully negotiated more favorable terms in fund partnership documents in at least some cases. Preqin discovered that there has been a reduction in the average management fee demanded by general partners to 1.8% (compared to an average of 2% which had held steady for the past several years). Limited partners have also been able to win some concessions on restrictive covenants. Preqin indicates that there has been an increased prevalence of both “key-man” and “no-fault divorce” clauses in limited partnership agreements.
A key-many provision allows limited partners to suspend their obligations to make further capital contributions for new investments if certain key personnel at the general partner leave the fund or otherwise neglect to spend sufficient time and effort managing the fund’s investments. (When Steven Rattner left the Quadrangle Group in February to head Obama’s auto industry task force, his departure triggered a key-man clause in a fund’s limited partnership agreement.) No-fault divorce clauses permit a specified majority (often 75%) of a fund’s limited partners to vote to suspend their obligations to make capital calls, remove the general partner, or even terminate the partnership, if they determine that the general partner is no longer acting in the interests of the fund.
Although there is a growing secondary market for private equity fund interests, private equity as an asset class remains more or less illiquid. Limited partnership agreements typically bind investors to a 10-year commitment, often with an option to extend their commitment for up to 3 years until all portfolio investments have been exited. Moreover, investments in private equity funds take between two to seven years to generate returns for their limited partners. While it’s likely that institutional investors are leveraging what they see as an increase in negotiating power to extract concessions from general partners, it’s also possible that investors are reassessing the risks that buyout funds pose for them as an asset class. After a year of continual capital calls from general partners, institutional investors may have a renewed appreciation for contractual mechanisms that permit them to halt capital calls – and thus stanch the bleeding – during tough economic times.
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