Licence to be bad

Public relations experts will tell you (for a fee) that the best way to deal with bad news is to spill it all at once. Tell the full truth, blush and stammer, say how you've grown from the mistake, and then move on. Think Hugh Grant.

Of course, most doers of bad or stupid deeds never take this advice. Instead they pursue a communications strategy that gradually drags them down into the sludge, from which they find it hard to emerge. They stall and deny. They admit to a fraction of the mistakes and then watch in horror as the whole awful truth comes dribbling out with the aid of innuendo and rumour and in a manner that is beyond their control. A story that could have been a one-day headline becomes a monthslong feeding frenzy. Think Bill Clinton.

What better time to disclose bad news than the present? We are in the midst of a recession so bad thatWall Street veterans in their 60s claim to have seen nothing like it in their lives. People understand that bad news is supposed to happen in bad recessions. In this environment, they are willing to forgive most failures if the story is delivered with apparent candour and alacrity. But they will not forgive a cover-up.

In private equity, this expectation of the ugly truth applies most directly to reporting. Today GPs have what amounts to a get-out-of-jail-free card in their hands – they get to write down the value of their portfolio investments to sickening levels and not be blamed for incompetence by their limited partners. GPs that maintain Pollyanna views on their unrealised performance, meanwhile, will appear to be bluffing or worse.

But valuations are only a formalised piece of the overall LP-GP relationship. A number of LPs and their advisers have noticed a disconcerting “everything's fine” reflex from some GPs, especially those managing the largest funds. It is one thing to express confidence in the future. It is quite another thing to appear to be in denial, as if decisions taken under your leadership in better times can't possibly have gone sour. After all, those with preternatural faith in their own abilities eventually make disastrous investment decisions, exposed when the facts on the ground do not conform to the assumptions baked in the mind of the hubristic investor. The ongoing crisis allows PR cover for more proactive manouevres than telling bad news. Strategic GPs and LPs are asking partners for unusual changes or concessions that in any other environment would be considered embarrassing, even reputationdestroying. Take the phenomenon of the cash-constrained LP, for example. It is well known that certain LPs are going to GPs and asking that commitments be reduced, or that capital calls be kept to a minimum. Less known is the degree to which cash-constrained LPs are favouring some GPs over others. After all, if you have a finite amount of cash to invest, rather than tell all your GPs that you need a 10 percent commitment downsizing, it is wise to instead tell your least-favourite GPs that you need a 50 percent downsizing, while maintaining full liquidity for the managers in whom you have the most confidence.

Likewise, GPs now have an opportunity to valiantly change economic terms that appear to be huge concessions to LPs, while in fact they keep the franchise alive. In particular, GPs are offering (or insisting on) fee-free life support to existing portfolio companies.

If history repeats itself, a major buyout firm will eventually announce that its current fund will free LPs of the remainder of their commitments, citing unfavorable market conditions. This is what venture capital firms did in the aftermath of the technology implosion. It was on the face of it an exercise in high-touch investor relations. But in most cases it made economic sense for the GP. These were funds that were never going to generate carry. Better to give back the remainder of the dry powder and start afresh with a new, smaller fund than to continue investing from a hopeless pool of capital.

The bad news is that we're in a severe recession. The good news is that bad news is easier to digest, and can often cloak changes that you wanted to make anyway.