By John Carter, Managing Partner at Hollyport Capital
Any investor with an established Private Equity Fund programme will understand the inexorable growth in the number of Funds within a balanced Private Equity portfolio. Additional Funds are added on a periodic basis to provide coverage of new geographies and strategies, while the mature Funds within the portfolio seem to take on a life of their own. While the intended life of a standard Private Equity limited partnership is ten years, often with the option of two one year extensions, the average life, as reported recently by Preqin, is now over 17 years. Why is the Private Equity industry so bad at managing the life of its investment vehicles, what are the consequences for longstanding investors in the asset class, and what can be done about it?
The implicit contract between the General Partner (“GP”) and the Limited Partner (“LP”) at the outset of a Private Equity Fund is that the GP will draw and invest commitments over the initial five years of the Fund, deploy their skills and expertise to increase the value of the companies in which they have invested, and crystalise this value growth over the last 5 years of the Fund. In practice, it is never this straightforward. Companies rarely manage to deliver precisely their original business plans. There are often delays in achieving desired results, and times when businesses suffer significant set backs, requiring plans to be re‑written and timescales to be reset. Even when the business delivers on the original strategic plan, exit markets may not be favourable, and consequently the GP may decide to continue to hold the investment until they perceive that they can get a better price. The situation can be further complicated when the Fund only holds a minority position, in which case the objectives of other shareholders have to be in alignment. An additional factor that should also not be overlooked is the alignment (or not) of interests between the GP and LP. The prospect of carry is a powerful incentive for the GP to grow and crystalise value, returning cash to LPs. However, if there is little prospect of carry being paid due to the underperformance of the Fund, it may be in the GP’s interest to continue to hold the remaining investments, particularly if the management fee is linked to remaining asset value, and there is little prospect of raising a successor Fund.
This combination of factors helps to explain why the average life of a Private Equity Fund is now over 17 years, and the aggregate value of assets in Private Equity Funds over 10 years old (as reported by Cogent) has increased from $16bn in 2006 to $120bn in 2014.
With a steadily increasing value of assets in these legacy Funds, there is a growing incentive to focus on how this value can be enhanced and turned into cash. In some cases this is driven by the GP, who may, for example, see considerable potential for growth in a company which has been in a Fund for ten years, but where additional capital is required to deliver this strategy. This could potentially be supplied by a new co‑investor, by selling the interest in the company into a new vehicle with new investors, or by restructuring the Fund incorporating additional capital from some of the existing LPs. LPs may then be faced with the choice of accepting dilution in this asset, the asset being sold by the Fund at a substantial discount to its potential worth, or participating in a restructuring which can enable them to participate in potential upside. Such restructurings are typically time consuming and resource intensive.
There have recently been a number of relatively high profile Fund restructurings, which have involved the introduction of new capital, existing LPs being given a liquidity option, and the GP having carry reset. The latter point can be controversial, particularly for original LPs who see this as a ‘heads you win, tails I lose’ scenario. Negotiating a package that is acceptable to the GP, LPs and new investors is often a resource intensive challenge.
The consequence of these Fund dynamics for longstanding investors in the asset class is an ever increasing number of legacy Funds. Historically the value of these assets was a relatively small part of the overall portfolio, and therefore could be consigned to the bottom drawer. However, with the value of these legacy assets steadily increasing, and greater numbers of Funds engaging in some element of restructuring activity, benign neglect is becoming an increasingly untenable option for LPs.
For LPs who do not have the resource or inclination to become actively involved in these situations, there is an increasingly attractive alternative, which is to sell to specialist secondary Funds. These are managed by GPs who are actively involved in this sector of the market, and view Fund restructurings as a tool of value creation. These secondary Funds can purchase entire portfolios of such legacy assets, which in turn can enable the vending LP to both redeploy capital to invest in strategic Funds, and free resource for core activities. The development of this secondary market is an example of the ongoing evolution of the Private Equity industry as it matures as an asset class, turning the challenge of dealing with tail-end Funds into a number of new opportunities.
Managing Partner, Hollyport Capital
T: +44 (0)20 7478 3971
You can read the other article from Ipes' Private Equity update (edition 16) at the following link: