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Friday Letter The spectre of defaults

The issue of LPs failing to meet margin calls is yet another thing concerning GPs at the moment. However for some professionals, LP defaults are a boon.

The fear of LPs (mainly banks) defaulting on capital calls has gripped mainstream private equity for sure, but recent comments by fund managers suggest concern has crept into the private equity real estate arena too.

The issue was highlighted yesterday at the IMN Real Estate Opportunity Fund conference in London with one panel saying established GPs were having to be selective about their investors. It is an amazing position to be in bearing in mind the usual balance of power between fund managers and investors.

Let’s not get carried away: Investor defaults are not something happening often and it certainly isn’t widespread, so there is no reason to panic.

However, the very fact that it is happening at all is sowing a seed of doubt in the minds of the already vexed GP in the middle of fundraising and, of course, those fund managers trying to tie up a deal. They are asking: “Will this investor really be able to meet my call in one month, six months, a year from now?”

Apart from presenting another thing for the private equity real estate fund manager to worry about at the moment, there are two other things to say about this.

It will certainly focus the minds of lawyers dealing with relevant terms in the fund agreement. One professional said at the conference that traditionally provisions had been drafted primarily to deal with an LP wanting to get a commitment back, not for when an LP can’t meet the commitment.

The second thing to say is that clearly LPs failing to meet calls is a godsend for dedicated buyers of secondary interests.

At the same conference in London, it was made clear that though the secondaries market makes up only 1 percent of private equity real estate transactions, the industry is set to grow. We all know the reasons for this; most notably the denominator effect, strategy shift and a desire among large investors to cut down the number of funds it invests in. It was also noted that the numerator effect might temper the denominator effect. Fair value write-downs of private equity real estate portfolios may well bring relief for property overweighted LPs.

However, LP defaults are cheering the secondaries industry along just as the numerator effect kicks in. LP defaults may be a headache for one set of GPs but they are a fillip for another, namely the secondary funds.