A week ago, news broke of how Permira was prepared to let investors reduce their commitments to its latest fund. An unprecedented move for a buyout group, it delivered proof that there really are LPs out there who cannot keep their funding promises to general partners.
At the heart of the issue Permira is seeking to address is SVG Capital, its largest investor. SVG’s investment model relies on an over-commitment strategy that has come unstuck as distributions from previous investments have dried up. Given the size of SVG’s commitment to Permira’s latest fund (€2.8 billion), as well as the unusually close relationship between the two organisations (Permira has a 4 percent equity stake in SVG), this is quite an extraordinary situation.
However, SVG is hardly the only investor in the world today struggling with its private equity obligations. At a recent seminar hosted in London by law firm SJ Berwin, LP default was cited as one of the key risks facing private equity firms in 2009, alongside under performance, style drift and LP activism.
Nigel van Zyl, a partner at SJ Berwin, confirmed there haven’t been many defaults yet. But he warned that more will come, and he also reported that many GPs are now busy reading those sections in their limited partnership agreements (LPAs) spelling out what happens if LPs balk at capital calls.
You couldn’t help thinking that most of these GPs must be reading these default provisions for the very first time. Until now, there was no need. Now there is, and because defaults are the worst case scenario for all concerned, GPs are advised to attend to problems in their investor base before they become acute.
Central to any proactive approach to the issue is, once again, for GPs to communicate early with LPs. Provided there is enough time to deal with a limited partner’s cash flow problem, there is a catalogue of measures that can be taken to minimise pain. These include deferrals of capital calls; transfers of limited partnership interests to a new owner; or a partial resizing of the fund à la Permira.
GPs also need to think through the various conflict of interest problems vis-à-vis the non-defaulting LPs in the fund, as well as their fiduciary obligations towards them. Suffice it to say that this part of it gets complicated, too.
The bottom line, as van Zyl explained it to the many fund managers present at the seminar, is this: GPs need a strategy for dealing with defaults before they actually happen. A year ago, they would have dismissed this as a waste of time. But now, in the midst of the market meltdown, it is sensible advice. It is still highly unlikely that LPs will start breaking their funding commitments in droves. But in today’s environment, LP default has become an eventuality worth preparing for.