Friday Letter The illiquid road ahead

GPs need to prepare now for a possible future uptick in LP default issues. The first step should be a simple, friendly, discreet outreach to the LP base.

The flood of LP defaults expected for many months never materialised for a variety of reasons – mainly because GPs have all but ceased capital calls, and also because they extended numerous means of relief to LPs, including slashing fund sizes.

So should LPs and GPs breathe easy now?

According to US industry players on both sides of the aisles, the answer is no. In fact, to sit back and relax now will only exacerbate the problem when the flood of LP liquidity issues does occur, which these people say is likely to happen over the next year or so as deal flow comes back and GPs suddenly need capital for transactions.

Short of proactive steps on the parts of GPs, according to industry sources, a resurgence in the deal market may find certain LPs with fingers still crossed they'll be able to honour commitments.

There are ways to head off this impending problem. At PEI Media’s Strategic Financial Management Conference in New York this week, panelists talked about the ways in which GPs are now assessing the state of their LPs. This informs how they might handle the possibility of defaults.

“If you’re a GP, get out there, don’t put your head in the sand,” said one speaker during a panel on managing potential LP defaults. “There will be a liquidity crisis down the road.”

Hold town meetings, and put your deal people on the road, since they’re probably not busy anyway, he joked.

Open, honest meetings between GPs and LPs give the two sides a chance to come up with constructive, cooperative solutions for possible future liquidity problems that could otherwise lead to harsh repercussions under default remedies in LPAs.

According to a survey of the conference audience, most US GPs have already been asked by at least one LP to assist in the sale of an interest on the secondaries market. In more extreme remedies, GPs have also cut fund sizes, put caps on capital calls and even allowed LPs to cut down the size of their commitments.

These gestures are all meant to keep strong the relationships that are vital to the life of a private equity fund. But they have to be carefully planned for, and a GP that avoids candid conversation with its LP base in advance won’t have as many options when the capital call surge happens.

Said one chief financial officer at a private equity firm: “We want to be seen as good guys and we want people to come back” for the next fund.