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Things default apart
When GPs make capital calls, some LPs now turn a deaf ear. In a market littered with nonperforming funds, the threat of default – even by respected institutional investors – looms larger. David Snow explores the allure and hazards of defaulting.

In a classic sketch by comedian Jack Benny, the famous cheapskate is accosted in a dark alley by a couple of thugs who give him two choices: “Your money or your life!” The victim is silent, and after a long pause, one mugger says, “Well?” Benny replies, “I'm thinking about it…”

Were this sketch modified to reflect the ongoing tragicomedy of today's private equity market, it might feature a GP demanding of a recalcitrant LP, “your money or your reputation!”

Some LPs are thinking about it.

The bedrock of US private equity investing is the limited partnership, a legal structure that requires investors to provide capital whenever general partners need it. Failure to comply with a “capital call” is considered a very serious breach of contract. As such, defaulting LPs are made to suffer harm to their pocketbooks as well as their reputations as punishment for defaulting. The trouble is, some private equity partnerships are now in such dire straights, it makes financial sense for LPs to default. The major consideration that prevents them from doing so is the damage this might do to their reputations as investors. But in cases where LPs are actually forced to choose between their money and their reputation, more and more may chose the former.

Cold calculus
In order to discourage defaults, most partnership agreements include provisions that allow GPs to impose various penalties on LPs who cannot, or will not, honour a capital call. These penalties run the gamut from a slap on the wrist to more draconian punishments. A common penalty involves attacking an LP's capital account. For example, an LP that won't join the other LPs in providing capital for a new deal may see the value of its stakes in preceding deals cut in half, with the severed value redistributed to the obedient LPs.

To be sure, private equity defaults are still so rare that most lawyers have never even seen one. Few can predict how a default case might play out were it taken to court. Defaults only began to bubble forth in the aftermath of the tech market collapse, when erstwhile high-net-worth individuals with commitments to venture capital funds found themselves strapped for cash. The choice between paying rent and throwing money at goofy tech deals, one would imagine, is not a difficult one to make.

“What I have seen out there, particularly in the case of venture funds, is people defaulting who never should have been LPs at all,” says one attorney, who represents a major private equity firm. “You find these dotcom millionaires who had $30m in net worth when they committed $1m, but now they can't meet a $50,000 capital call.”

Meanwhile the default phenomenon is burgeoning. Until recently it had been confined entirely to individual investors. Most market observers predicted that investing institutions would never dream of backing away from a capital commitment, a move that might get them blacklisted among private equity firms. But the cold calculus that has prompted individuals to take the default route is beginning to find purchase among some institutional investors.

Consider the following “perfect storm” scenario: A private equity fund is raised just as market valuations peak, and all of its early investments are in overpriced, ill-conceived companies. Said companies go over like led balloons. If they aren't already dead, they appear on quarterly reports as the “walking dead” – portfolio zombies in need of a blow to the head. Ominously, the fund in question still has hundreds of millions left in dry powder to draw down. Knowing that his capital account is essentially worth zero, and fearing that the GP group will continue to invest his money in losing ventures or – worse – in “Hail Mary” deals, the LP decides that defaulting makes the most fiduciary sense.

Some partnerships are in such dire straights, defaulting makes financial sense for LPs

Industry sources now say that GE Equity, the private investment arm of General Electric, is facing this dilemma with regard to a number of its private equity fund investments. GE, which is in the process of winding down its private equity program, is invested in a number of venture capital funds that resemble the perfect storm described above. Rather than ride out the tenure of its commitments to these funds, GE Equity is searching for ways out. In some cases, according to sources, the firm has threatened to default if GPs do not relieve GE Equity of its capital commitments.

A number of other legal sources report an increase in LP clients searching for ways to walk away from certain funds.

Murky legal waters
The default option is made all the more alluring by the lack of better alternatives. LPs have been discouraged from simply selling their partnership interests in the secondary market for a number of reasons, among them: No one wants to buy; when they do, the bid is pennies on the dollar; and sometimes, the risk of taking over a fund commitment is so great that the seller is required to pay the buyer.

In cases where an LP's capital account is worth zero, and when that LP in question is in the process of exiting the private equity market altogether, the twin penalties of a slashed capital account and a damaged investor reputation are not as scary. The threat of default brings all parties into murky legal waters. In Delaware, where most private partnerships are created, section 502c of the state's Revised Limited Partnership Statute explicitly authorises a reduction or elimination of a partner's interest in the partnership in the event of a default. Clearly, GPs are on solid legal ground in their right to penalise a defaulting LP.

But the real-world application of this rule is more complicated. Many GPs are loath to enforce default penalties, which are time consuming, not to mention embarrassing when brought to the attention of other LPs and outside parties. In addition, one legal expert points out that even the most seasoned private equity attorneys have no idea how sympathetic a judge would be toward a defaulting LP. “Most lawyers don't know how these deals work in practice,” says an attorney.

Many market observers believe that incidents of defaulting LPs will go away once the private equity market returns to health. But legal experts are already pondering a number of changes to the traditional partnership agreement that would make the default an even rarer event.

For one, part of the incentive to default is due to the discretionary nature of the penalty provisions. Some legal experts believe GPs should, through “selfexecuting” provisions, be automatically required to enact draconian penalties in the event of an LP default. “The best mechanism should provide that on each occasion that an LP defaults, it will loose some high percentage of the capital account to the non-defaulting LPs, while remaining liable for future capital calls,” says one attorney.

Reputation appears to be the main consideration now preventing the dissolution of many private equity partnerships

Forcing a GP's hand would convince LPs that the only way out of a partnership is through a quick secondary sale – no matter what the price.

As for reputation, this appears to be the main consideration now preventing the dissolution of many private equity partnerships.

A commitment to a private equity fund is, after all, a legally binding agreement among partners. Few institutions want to be known as investors that, when times get rough, asked for their money back, a request that serious long-term investors do not regard with any degree of good humour.

David Snow is the editor in chief of PrivateEquityCentral.net, a New York-based website providing news and information on the private equity industry.

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News

Pomona's fifth secondaries exceeds target
Pomona Capital, the global private equity manager, has closed its fifth secondaries fund on $582m in investor commitments, $182m above the original target. The fund, which was launched a year ago and in the course of the past six months has already committed $140m to investments in limited partnership interests, aims to proactively select investment opportunities away from the auction process.

Commenting on the fundraising, Michael Granoff, president and CEO of Pomona, said: “We've always believed in raising relatively modest amounts for our secondaries funds, which enables us to avoid competing for deal flow with the very large funds that are in the market place.” He added

that the fundraising benefited from substantial limited partner interest in secondaries products generally: “Investors are keen to take advantage of some of the problems that have been created in the market over the past couple of years, not just be victims of them.”

Pomona, which now has $1.3bn of capital under management, is aiming to invest the fund over the course of the next two to three years. Said Granoff: “We tend to be very cautious with regards to asset quality and pricing. It's taken us twice as long to invest Fund IV than its predecessors. Now conditions are improving, but we are not in hurry.”

Darby, Stratus launch Brazilian mezzanine fund
US private equity firm Darby Overseas Investments and Stratus Investimentos of Brazil have formed a partnership and are establishing a Brazilian joint venture to sponsor Brazil's first local currency mezzanine fund.

No target has yet been set for the fund, but according to Darby managing director they will be looking to raise over $100m. The joint venture will be operated by a dedicated full time team of at least three people, in addition to drawing on the resources of its parents. In terms of making investments, Darby will control the decision making process.

“Creating a mezzanine fund denominated in Brazilian Real will enable domestic investors, mostly local pension funds, to diversify their portfolios by allocating their resources in long-term assets,” Darby chairman Nicholas Brady said in a statement. “We are confident about the investment climate in Brazil and our research, together with that of Stratus, indicates strong interest on the parts of investors and borrowers alike in a Real denominated mezzanine fund.”

Graffam said the Brazilfocused fund could be the first in a string of country specific mezzanine vehicles set up with local partners in Latin America. “It would make a lot of sense. Plus, it would be very complementary for any off shore vehicles that we have, because frequently we find situations where borrowers need more money than we can provide through one vehicle.”

Paul Capital grows medical royalties franchise
Paul Capital, the US private equity house more commonly associated with its activity in the secondaries market, is currently fundraising for its second medical royalty acquisition fund. The firm plans to hold a first close on its latest fund, which has already received significant commitments, before the New Year. The firm is looking to raise $750m for the fund, having raised $300m for its predecessor in 1998.

To date, Paul Capital Partners and its affiliated entities have invested in or structured more than $190m worth of royalty transactions. Through co-investment arrangements with its limited partners, the Paul Capital Royalty Acquisition Funds have access to more than $1bn in additional funds to complete larger transactions. The firm hopes to hold a final close in early 2003. UBS Warburg is acting as placement agent.

Sunrise Capital launches second distressed fund
Sunrise Capital Partners, a US-based private equity firm specialising in distressed and turnaround investments, is to launch a $400m to $600m fund targeting opportunities in North America and Europe. The fund, which is managed by Sunrise Capital, an affiliate of US privatelyowned investment bank Houlihan Lokey Howard & Zukin (HLHZ), will receive commitments of at least $20m from the two companies and their management.

Sunrise Capital Partners II will follow the same strategy as the 1998 fund which raised $192m. The new fund, which will look to make investments of between $20m and $50m per company, will invest primarily in North American investments, although around 25 per cent of the fund's capital will be available for European opportunities. HLHZ has recently established European headquarters in the UK which will serve as the base for European investments.

“When we raised the initial fund in 1998, people asked if there was a need for a distressed fund in what was then a buoyant market. The previous fund's performance proves that the demand was there and there is an even greater need in the current environment,” said Larry Coben, senior principal of Sunrise.

US private equity pay down 70 per cent
Senior executives in the private equity industry have seen their total compensation shrink almost 70 per cent, according to a survey released by Mercer Human Resource Consulting, a subsidiary of Marsh & McLennan Companies. Managing general partners/chief executive officers saw their total compensation, which includes base salary, annual incentive and carried interest value, fall to $1.847m in 2001 from $6.081m in 2000.

Most positions saw their total compensation decline as well. For senior partners and executive vice presidents, the fall was a dramatic 80 per cent to $940,500 from more than $5m. Mid-level partners and senior vice presidents saw a 40 per cent decrease to $576,600 from $964,900. Lower-level investment executives saw their overall compensation increase, however. Junior partners and vice presidents actually saw an increase of slightly less than 2 per cent to about $299,000 and senior associates saw a 5.3 per cent jump to $172,000.

The survey was conducted with data from 84 firms representing more than 1,000 employees. The survey reflected salary trends as of early 2002 for 11 positions in the private equity industry.

Blackstone buys TRW Automotive
New York-based private equity firm The Blackstone Group has agreed to acquire the automotive systems and components manufacturer TRW Automotive from defence conglomerate Northrop Grumman in a deal that values the division at $4.725bn. Northrop Grumman is selling the division as part of its $7.8bn acquisition of manufacturing conglomerate TRW, which was originally announced in July.

Blackstone is committing $500m in equity to the deal. Northrop Grumman will receive $3.75bn in cash, $600m in debt securities, and an initial equity stake valued at $368m. This equity stake will be reduced when the deal is completed. All debt financing has been provided by JP Morgan, Deutsche Bank, Credit Suisse First Boston and Lehman Brothers. TRW Automotive makes and markets automotive systems components, such as steering, suspension, seat belts, braking, and steering. The division had $10bn in sales in 2001, down from $11bn in 2000.

HarbourVest exceeds target for Fund IV
US private equity investor HarbourVest Partners has held a final close of its fourth fund, HarbourVest International Private Equity Partners IV, raising $2.8bn. The fund is split into two offerings, fund of funds and direct investments. The fund of funds raised $2.425bn with the direct investment pool making up the remainder ($375m). Investors were able to invest in any combination of the two funds.

The fund, which will target investments around the world, has committed just under 25 per cent of its capital since investing commenced in February 2001. “We have a global remit although around 90 per cent of the total capital committed to date has gone to Western European funds,” said George Anson, partner at the firm's UK office.

The firm has not disclosed the identity of the fund's investors, although over 50 per cent of the capital was committed by previous investors. “We have a good cross-section of investors,” added Anson. “Around 50 per cent came from European pension funds and financial institutions, with the remainder coming from the US.”

The new fund exceeds the total raised for HarbourVest's third fund, which raised $2.1bn. “I think investors are aware of the increased opportunity in the current market which is reflected in the fact that we exceeded our target,” said Anson.