Friday Letter Renewing the vows

GPs who need a little more time to find deals are asking for extensions. LPs should use these requests as a chance to ‘re-underwrite’ the relationship.

More GPs than ever are approaching limited partners asking for extensions of investment periods, as PEO recently reported.

MatlinPatterson, BC Partners and Montagu have all been granted extensions this year by their LPs, to name a few. The reasoning behind the requests has generally been that the landscape has not been ripe for investments over the past few years and GPs need more time to find quality deals. Some fund managers may also be loath to return dry powder to investors, given the challenge of raising fresh commitments in the current market

Should LPs feel obliged to grant these extension requests? No way. LPs should look at investment period extension requests like this: If the GP asking for an extension was instead approaching you about a new fund, would you commit?

The extension request is a chance for the LP to “re-underwrite” its commitment to the GP, in the words of Andrea Auerbach, managing director at private equity consultancy firm Cambridge Associates.

These requests allow or force LPs to essentially perform due diligence anew. They are prompted to review the relationship; to look at how past investments are performing; to analyse how the GP has adapted and positioned the fund for the downturn. One principal with a family office told PEO that granting extensions is viewed in his organisation as committing fresh capital.

Despite the powerful position in which investors currently find themselves, LPs have been handling these requests in various ways. Some are prepared to automatically grant the extensions, explaining they've already put their faith in the manager. Some even say the extensions are necessary to prevent the GP from having a perverse incentive to wildly invest capital prior to a deadline (though the LP should probably end a relationship with a GP if he/she thinks that fund manager has the propensity for perversion).

If an extended relationship is agreed, LPs may want to amend the terms and conditions. Some LPs are indeed using extension requests to ask for concessions – mostly management fee reductions – sources have told PEO.

It’s unlikely these requests are going away any time soon. LPs and their consultants are expecting to see many more GPs coming to the door asking for extension amendments. The cold reality is that our industry is burdened with $425 billion of unspent capital. In other words, a mountain of dry powder has yet to be drawn down. And the overhang is global. A flood of extension requests are expected to come in from European firms in 2011, a public pension source said. Many US GPs are already approaching investors, while Asian LPs are also beginning to discuss the matter in advance of expected appeals from fund managers.

With all these extension requests, LPs are in a strong position to take a look at GPs with fresh eyes, see how they have performed and behaved, and make a new determination about the legitimacy of the relationship going forward.