Never?
After a flurry of press reports on buyout fund size reductions and on high profile Limited Partners requesting capital call delays, normalcy has settled in – i.e. capital is being called to fund new transactions and to fix the balance sheets of existing transactions. Fund size reductions have been limited, and those that have been done involve complicated terms and reductions only about 20%. Investors should expect the capital commitments they have in place will be called.
Some have postulated that General Partners who have very large commitments to their own funds will be slow to call capital. While we believe the participants in the industry will be very deliberate in everything they do, we believe this capital will get called – and at a materially faster pace in 2010 and 2011. The reality is that in most funds the General Partner commitment is equal to 1.0% of total committed capital. Most management fees are in the range of 1.5% to 2.0% of committed capital until the end of the investment period, and then the fee is generally calculated on capital actually invested and appropriately reserved – i.e. the fees earned are larger than the capital committed. If the General Partner does not call capital, this capital will eventually fall out of the fee base – reducing management fee revenues.
In addition to the loss of current revenue, the General Partner would lose the opportunity to earn carried interest on this capital if it is not called. Even if fund performance looks weak at the moment, General Partners are eternal optimists with confidence in their ability to turn a portfolio around. Any net gains above a preferred rate of return (commonly 8%, or above zero if there is no preferred rate of return) generally go 20% to the General Partner – a powerful incentive to invest all the capital. The capital is never going to earn a carry if it is never put in the ground, and the sooner it is put in the ground (in interesting transactions) the greater opportunity to compound out to a carry producing rate of return.
Now, Later?
So when will capital be called by buyout funds and for what purpose? There are a variety of potential uses for the uncalled capital, each of which are addressed below and each of which will drive different timing of cash flows:
- For fees & expenses
- For defense of over levered companies
- For add on acquisitions
- For new transactions
Fees & Expenses: If management fees are paid inside the partnership out of committed capital, a good rule of thumb for a fee reserve is the number of years left in the investment period plus five additional years multiplied by the fee percentage. For example, a fund with two years remaining in the investment period with a 2% management fee would require a 14% reserve ((2 years + 5 years) x 2%). This capital would be called down as needed based on the fee formula for the fund in question. General Partner’s can recycle realizations from the portfolio to pay fees and invest 100% of committed capital, but in the current environment they are going to be reticent to take this risk. As a result, we anticipate that fee reserves will stay on the high side for the foreseeable future. If fees are paid outside the partnership – through a direct bill to the limited partner – this reserve is not required.
Defense: Lenders large and small have delayed significant restructurings if not forced to do otherwise through a bankruptcy or company cash crisis, rightfully waiting and/or hoping for a better day. Regulators have not, by and large, penalized this behavior as they have other and bigger issues. We believe a more normal, leveraged lender/borrower relationship will develop in 2010. “Good companies/bad balance sheets” will be addressed. Current company run rate revenues and cash flows (many benefitting from operating expense reductions), and a new long term business plan and projections will drive a revaluation of the business and a restructuring of the balance sheet. For most stressed buyout credits with private debt and relatively simple (if over levered) capital structures – this will be done out of court on a consensual basis. If the General Partner is willing (and able) to put in new equity significant opportunity for debt reduction and future gains exists. If no new money is forthcoming, the General Partner will be marginalized.
Capital calls to defend a portfolio we would estimate at 50% of the amount of equity capital already in companies that are under stress. We would exclude from this calculation companies whose results and management appear too weak to support any sort of restructuring – although numerous examples exist of General Partners putting good money after bad to keep a company alive. We expect most of this defensive capital to be called in 2010.
Add On Acquisitions: Long a staple of the middle market buyout business, we would expect add on acquisition activity (where existing portfolio companies are buying competitors or complementary businesses) to pick up across the buyout spectrum. These deals are highly accretive if done correctly, and are not generally restricted by the investment period of a partnership as capital is being called to invest in an existing portfolio company. Funds with eighteen months or less left in their investment period may become very focused on this strategy, although it is best executed by firms with a long history and culture of doing these types of deals. A number equal to 50% to 100% of the equity capital already invested in companies pursuing add on acquisition strategies would reasonably be reserved for this activity. A reasonable estimate would be that this type of capital would go out evenly over the next three years as individual transactions take time to be agreed to, closed, and integrated.
New Transactions: Last but not least, everyone would like to do new deals. They are diligenced and priced in the current environment, and add company, industry, and time diversification to a fund. Operating performance at many target companies, however, remains weak and difficult to project in many sectors, leverage is still scarce, and given the run up in the public markets – prices are not as cheap as many thought they would be six months ago. We would expect any capital not allocated to fees & expenses, defensive investments, or add on acquisitions, to be called for new deals on a straight-line basis over the remaining investment period for a fund. Certain General Partners that have rock solid franchises and are booking recent gains in a private equity world that has few (i.e. they have scarcity value around which to raise a new fund) will move more quickly, but most will not. A series of new sub $1 billion transactions has been announced in the first quarter, indicating that new deal activity is accelerating.
Impact on Secondary Value
For those holding all of their private equity assets until realization, the utilization of unfunded capital will have a significant impact on liquidity timeframes and realized returns. For those interested in secondary transactions, unfunded commitments have been a “boat anchor” dragging valuations to historic lows. Next month we will review the models used to project the returns on unfunded commitments, and the resulting discount to a Limited Partner’s capital account to facilitate a transaction.
