Firms use ‘annex’, ‘supplemental’ funds to bolster investments

Delegates at PEI Media’s Strategic Financial Management Conference Wednesday outlined the various ways private equity firms are generating additional capital outside their funds to make new investments or re-invest in oftentimes struggling portfolios.

Firms should keep some portion of capital left over through the end of the investment period of a fund in case of portfolio company emergencies or investment opportunities, according to delegates at PEI Media’s Strategic Financial Management Conference Wednesday in New York.

“You need to have some dry powder at the end of the investment period,” said Stephen Hoey, partner, administration and chief financial officer at New York-based KPS Capital Partners, who spoke at the conference.

Hoey described situations in which KPS identified lucrative investment opportunities but did not have equity to deploy because the firm was at the end of its investment period.

Hoey noted that many other firms find themselves in similar situations today, including lacking the funds to prop up struggling portfolio companies.

Without reserves, firms are finding other ways to gather capital at the end of the life of their funds. The panelists discussed several ways that private equity firms are collecting additional money in today’s environment – in some case even after their equity has run out. Firms are raising annex funds to prop up struggling portfolio companies; supplemental funds to expand the size of funds that have already closed and using capital from fresh funds to re-invest back into the portfolio companies of prior funds that need support.

All these options are in use today, delegates said, but could be avoided by diligent forecasting throughout the life of the fund. “We forecast what each portfolio company will need for acquisitions and working capital,” Mark Lessing, chief financial officer with Insight Venture Partners, said. “Regular forecasting is really important.”

Some of the options can cause conflicts with LPs. For example, “cross-pollination”, or using money from a new fund to re-invest in an older fund, can come with legal issues because of different sets of LPs that exist in the funds.

“If you’ve gotten a new round of financing for a portfolio company, how do you price that? If it’s an LBO shop, how do you price that new round to be fair to Fund III and Fund IV,” according to Raj Marphatia, a partner at law firm Ropes & Gray.

For example, Florida-based turnaround firm Sun Capital Partners has caught flak from some of its LPs for using $150 million to reinvest in the firm’s $1.5 billion fourth fund, half of which is coming from the firm’s $6 billion fifth fund.

On the other hand, LPs are generally happy to increase commitments to expand funds that have already closed for new investments if they are happy with the performance of the fund manager. KPS recently began asking existing LPs in its third fund for additional commitments, seeking to raise an additional $800 million to the $1.2 billion fund, which closed in 2007. KPS closed the fund after receiving more than $4 billion of commitment requests.

The firm has been active investing the fund, including creating a brewery platform North American Breweries with the acquisitions of Labatt USA from Anheuser-Busch; the High Falls Brewing Company, which makes Genesee and Dundee brands and the licenses for the Seagram’s Cooler Escapes and Seagram’s Smooth malt beverages from the US arm of French company Pernod Ricard.

Raising any kind of add-on fund to a prior fund can be tricky, as LPs have grown more sophisticated in the current environment, and want to know more than ever, “exactly where is my money going”, according to Erick Bronner, managing director, Bank of America Merrill Lynch.