The economic fiasco in which we now find ourselves is primarily the result of a collapse of trust. Lenders don't trust borrowers and vice versa. Buyers of debt products do not trust the ratings agencies whose risk assessments inflated asset values. Investors now doubt the magical powers claimed by fund wizards and the capital conduits that introduced them to said wizards. All forecasts are suspected to be wrong due to either incompetence or self-promotion. In such an environment, capital is rendered immobile and the quagmire retains its captives.
In private equity, the land of the 10-year limited partnership and blind-pool investing, counter-party trust remains comparatively healthy. It is unclear whether this is because private equity has conducted itself in a manner worthy of a higher degree of trust or because its very structure forces participants to remain bedmates and therefore more likely to simply love the one they're with.
But make no mistake – the potential for mistrust lurks in the hearts of all market participants. For example:
LP vs.GP: in private equity, GPs must first convince LPs that, as fiduciaries, they can be trusted to put capital to work in private companies over the long term, even though the specific opportunities are not yet known. Many LPs are now asking themselves two questions of certain GPs – “Was there a perverse incentive to put too much capital to work too quickly?” and “Did my GP really have the wherewithal to assess the risks of the investment in question?” GPs that last year put out money in debt purchases and PIPE deals will and should be forced to explain how this wasn't style drift. And they will and should be forced to explain how, “operating advisors” notwithstanding, they wound up in companies and industries that went so horribly awry, and which they now seem powerless to fix.
LP vs. adviser: think of this as the Bernie Mad off effect. Do professional GP pickers such as funds of funds and gatekeepers actually do the diligence work they advertise, or do they make a virtue of necessity by committing third-party capital to the funds to which they happen to gain access, given their resources? Have they ever said “no” to Kravis, Schwarzman, Bonderman or Black?
GP vs. lender: now here's a real mess, but it is one in which the value of trust may ultimately outweigh other aspects of the underwriting process. Those GPs that show themselves good stewards of their portfolio companies will be the first to secure financing from institutions that have profoundly lost faith in their own abilities to weigh risk in individual companies and industries. In the meantime, anxiety over under-skilled GPs is the least of the banks' problems.
LP vs. board of advisers: the faith that LPs have in the long-term prospects of private equity has been manifest in the desire among many to scramble for cash so as to “double down” in the current environment. These LPs are aware that good vintages grow from troubled soil. But getting their board members to keep faith in private equity is going to be challenging. This is an asset class that was supposed to bring out performance and stability to the portfolio, and instead it is bringing huge write-downs and draining cash from the coffers. Advocates for private equity within pensions, endowments and other institutional investors will find themselves facing a skeptical home crowd, the members of which are going to want to know when the upside of the J-curve is going to emerge.
GP vs. LP: you said you were in for $500 million, and now you want a partial refund? You promised to send in cash when requested, and now you say you may not have enough? You bundled together the funds of 400 high-net-worth investors and now you tell me that an undetermined number of these guys are getting cold feet and there's nothing you can do about it? You seemed so enthused at the closing dinner and now you're selling your interest in the fund at a 50 percent discount?
Private equity is a slow-motion asset class, and this means that industry players have the opportunity to view the carnage in the liquid world and take steps to avoid the same wreckingball swinging their way at a slow but steady pace. Those firms and investors that will survive and hopefully flourish through the unfolding cycle will need to address some or all of these trust issues.