Last year had the feel of a witch-hunt, with the spectre of LP defaults looming and with GPs going to great lengths to search out any LPs showing signs of weakness. But while there were few distributions last year, there also weren’t many capital calls, so defaults remained more of a threat than a reality, aside from a few high profile cases.
Among those cases, CapGen Capital Advisers sued two of its LPs, Grail Partners and WK CG, in the Delaware Chancery Court last March for missing an $800,000 payment and a $200,000 payment, respectively. According to the Wall Street Journal, a managing partner at Grail said the firm missed the payment because of a liquidity squeeze. A partner at WKCG, memorably, said the payment was “on my list of things to get around to”.
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David Scherl |
“What you may end up seeing because of that increased M&A activity is an increase in LP defaults,” said David Scherl, chairman and managing partner at law firm Morrison Cohen. He notes that the second half of the year may see even more deal activity as sellers try to take advantage of the current 15 percent capital gains tax rate in the US – a Bush-era tax cut that expires in 2011.
Of course, the coming tax hike also means that GPs will look to sell off the winners in their portfolios this year, which will lead to more distributions to LPs. It’s impossible to know which effect will be more prominent though.
“There is a certain concern that what didn’t happen in 2009 might happen in 2010, said Jérémie Le Febvre, a partner a placement agent Triago. “Many investors were able to make it through the year last year because nothing happened. It’s quite hard to identify where [defaults] are going to come from and from whom, but it is a legitimate concern.”
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Jérémie Le Febvre |
“The investors who were on the edge went over it, and the rest certainly are no worse off now than they were 12 to 18 months ago,” said Craig Miller of Manatt, Phelps & Phillips. “The ones who made it through last year will likely find a way to fund their commitments, whether they are borrowing money or disposing of other assets to meet their capital calls.”
Rising denominators
The recovery of the public markets does help. The denominator of the last two years, where an LP’s public equities declined in value so much that the LP found itself significantly overweighted in private equity.
Increased value in LPs’ public equities portfolios also means that LPs will simply have more resources to fund capital commitments.
“You have to think of LPs as having diversified investments in a lot of different areas of the economy,” said David Winter, a partner at Hogan Lovells. “And as the economy improves – recognising that unemployment will lag that – but as the economy improves, the stock market goes up, people just see the value of their portfolios go up, they’ll have a lot more resources to draw on to fund their commitments.”
Recovery in the public markets also means that the value of the public comparables GPs use to mark their portfolio companies to market has increased, pulling portfolio valuations up.
“I think that market has stabilised obviously and what comes with that is increased valuations, certain LPs might feel more bullish about their overall portfolios,” Scherl said. “Or valuations in public holdings have gone up so they have more liquidity to fund their capital calls.”
But it’s important not to overstate how much the denominator affected LPs’ ability to meet capital calls in the first place, says Le Febvre.
“It’s true that the fact that stock markets have picked up in the last few months has reduced the denominator effect, which was most concerning for the public entities and the institutions,” he said. “But that said, the denominator effect is purely technical. It doesn’t imply anything about the balance sheet. It just meant that your exposure to the public markets versus your exposure to the private markets was much lower.”
But Le Febvre did concede that those LPs that were in distressed situations last year mainly because they had incurred severe losses on their public market portfolios may be better off and less likely to default on commitments today.
“If you do have default events, the renewed strength in the economy and people feeling good about liquidity events in process or in the future, may allow other LPs to pick up that defaulting LP’s interest,” Winter said.
Second chances
Another factor that may reduce the number of LP defaults this year is the fact that the secondary market for limited partnership interests is more efficient now, and sellers are getting prices that are closer to NAV now.
“Purchase prices are much more suitable to sellers, so those that see a risk of not being able to meet their obligations are much more inclined to use the secondary market to solve that problem,” said Le Febvre. “They don’t have to give crazy discounts to sell their assets anymore.”
After huge growth in the secondary market last year, which enormous funds raised to pursue secondary opportunities, LPs are more aware of how to use this tool to avoid defaulting on their commitments, Le Febvre said. The current pricing conditions also allow them to use those tools.
Certain vintages are more likely to be sold off on the secondary market than others, he adds.
“Many investors will try to avoid defaulting on the deals that are coming now because everyone is agreeing that this is going to be a great vintage,” he said. “From a pure portfolio standpoint, the current deals are deals that you don’t want to miss. You might try to get rid of or sell on the secondary market some of your 2006, 2007 exposure, where some of the deals might never be exited because they were purchased at such high multiples that there is no way they’re going to return the capital.”
Scherl warns that while it may now be easy for large institutional investors to access the secondary markets, family offices or high net worth individuals might have a tougher time.
“Some of the individual LPs don’t necessarily have the same access to the secondary markets, so that’s where you may see greater defaults,” he said.
Careful monitoring
The danger of defaults is also mitigated because GPs are better equipped to manage the risk, as compared to the start of the crisis.
“Many more GPs are in alert mode or are aware of the problem and are doing their best to manage it,” said Le Febvre. “It seemed like every large GP we had contact with last year had hired a dedicated person to monitor their LP base to identify which LPs were most likely to default. In reality, it didn’t happen in most situations. But we’ve seen defaulting situations here and there, and because GPs were so proactive, very few were messy.”
And once an investor has defaulted on a commitment, “word gets around”, he said, so all GPs in the system know who to watch out for, and in some cases don’t let that investor come back to invest in their next fund.
“When you get into a default situation, you become a less desired investor from a GP standpoint,” Le Febvre said. “And in most situations when that happened it was really symptomatic of LPs who were not suitable investors for this asset class. I’ve not seen any LPs default and come back afterwards to pursue their private equity programme. It’s generally a very strong signal about what they intend to do.”
By 2011, most market sources believe that exits will have picked up again, bringing the threat of LP defaults down. So the main concern for GPs should be 2010.
“It’s quite hard to identify where [defaults] are going to come from and from whom, but it is a legitimate concern,” Le Febvre said.
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