Notes from the frontline

Professional departures, investor defaults and some LPs pressuring GPs not to issue capital calls are among a host of changes in the fundraising sphere suggesting a more regulated marketplace in the future, write Marco Masotti and Ellen Ching.

The global financial crisis is having a profound impact on private equity fundraising by altering the focus of the marketplace from the establishment of new funds to protecting and nurturing existing funds. For many firms, any intentions to raise new capital have temporarily been abandoned in favor of addressing problems in their portfolios and waiting out the market. The crisis is progressively freezing fundraising activities and changing the stresses and routines of industry participants. The following are some discernible trends from the front lines:

Limited new commitments. The pace of new commitments to private equity funds has dramatically slowed. Although some investors remain willing to invest in standout funds, the crisis makes routine interactions difficult with investors who are distracted by problems elsewhere in the marketplace. Fund closings involve a protracted herding of cats with more frequent closings as GPs seek to close on any investor willing to commit as soon as possible.

Institutional fund group displacements. Troubled or failing financial institutions have severely impacted the private equity groups that they house. Entire management teams and funds are in the process of spinning out from these sponsors – to establish independent businesses or to join other firms. These complicated processes require legal versatility and diplomacy in managing the various role players and interests including the original institutional sponsor, professionals, investors and purchasers (if applicable).

Marco Masotti

Departures of professionals. The financial crisis and underperforming investments are taking a significant toll on the investment professionals in private equity firms themselves. As a consequence, many firms are experiencing internal pressures and tensions and, in some cases, the departure of important professionals.

Defaults. The GPs in private equity funds are increasingly seeking counsel on available remedies for investor defaults, which have emerged as a modest trend. The need for (or lack of) liquidity has forced defaults and the ensuing draconian remedies (in some cases, forfeiture of as much as 50 percent of capital). In the case of private equity funds that are not substantially invested, there are murmurings of limited partners pressuring GPs not to issue capital calls and expressing concerns about the GPs’ ability to fulfill their stated strategies.

Secondary sales. The secondary market for limited partner interests and underlying investments appears to be gaining momentum. As the need for liquidity drives large and small sales across the marketplace, a number of commitment flush secondary buyers – individually or as part of syndicates – are bargain hunting and closing quickly on opportunities.

Valuations. The liquidity crisis is creating renewed pressure on GP valuations. Significant challenges in valuing portfolios amid the financial crisis and accounting rule changes may have consequences for investor reports, write-downs (for purposes of distributions) and track records for future offerings.

These emerging trends suggest a more consolidated and regulated marketplace in the coming months and years. Although new commitments may remain limited for the coming months, the long-term and patient outlook of private equity firms may serve them well when investors look beyond Treasuries and return to the market (hopefully sometime in 2009!).

Marco Masotti is a partner and co-head of the private equity group at international law firm Paul Weiss Rifkind Wharton & Garrison. Ellen Ching is an associate.