Default anxiety

A problem that many thought would be confined to financial institutions has cast a pall over the limited partner universe: default risk.

Ultimately, few LPs will actually fail to honour capital calls, but in the meantime there has been an explosion of activity in the secondaries market from LPs of all stripes which, in extreme cases, are worried that their current commitments to private equity will cause them to run out of cash. More often, they are simply eager to dump existing general partners so they have enough cash for favoured managers.

In addition, some state pensions have told intermediaries that they would be relieved if certain managers allowed them to reduce the size of their commitments, according to a source in the secondaries market.

It is a situation that brings to mind the aftermath of the tech implosion of 2001, during which many major venture capital firms slashed fund sizes. At the time GPs explained they were right-sizing to address the smaller venture opportunity. Today, many buyout GPs insist that their funds and fund targets remain the right size. And therein lies the problem – many LPs recently made hugely increased bets on the private equity asset class under the assumption that these allocations would continue to be self-funded. In the absence of exits, they wonder if they will have enough cash to fund ongoing capital calls.

“This is going to be a huge issue,”says a source in the secondaries market. “We're at the top of the first inning in this problem.”

For some LPs, of course, the problems are more severe than mere over-allocation. Some LPs played a leading role in the credit meltdown, and at least one is already informing its GPs that it may not be able to respond to capital calls. According to a source in the fundraising market, executives with responsibility for the balance sheet commitments of Lehman Brothers (not to be confused with the Lehman Brothers fund of funds group) have begun contacting GPs to tell them the bankrupt investment bank will “struggle to meet its capital commitments”.

A separate source says that anyone with a commitment from a regional US bank is worried. Many of these are in dire need of new capital.

But liquidity concerns are being directed even at “the most pristine investors in private equity”the source says, including state pension funds and university endowments. He explains that the strong performance of private equity funds in recent years persuaded these LPs to not only increase allocations, but to assume that distributions from previous investments would help fund newer ones.

But the credit crisis has brought exits to a halt, thereby also halting the self-funding mechanics of many private equity allocations.

This wouldn't be as much of a problem if GPs weren't still determined to put capital to work amid the economic ruin. “Some [LPs] have gone back to the GPs saying, ‘Hey, do you plan on calling any capital in the future?’ And they've been shocked at how much capital is going to be called,”says the secondaries market source. “The GPs have said this is a great environment, there's no leverage but they can still call capital and do all-equity deals. It has people scared.”

Most LPs agree that the best time to invest is during bad times. Their fear is that they simply won't have the capital to do so. The source notes that some LPs have resorted to selling stock in order to fund capital calls to private equity – a technique that throws target allocations further out of whack.

A better, if more laborious, solution is a sale in the private equity secondaries market, which is “absolutely crazy busy”, the source says. As with stocks, LPs are “willing to sell crap at a steep, steep discount”in order to double down in a better vintage with better managers, he says.

It is unclear if any GPs would actually consent to reducing existing LP commitments. Allowing one LP to downsize by 40 percent would mean allowing all the other LPs to do the same. But buyout GPs should remember an important motivation of the venture capital fund downsizings – it allowed VCs to pull the plug on funds with no hope of generating carry and, a year later, go back to market with more promising new offerings.