When bundles collapse

When the topic of limited partner defaults comes up, the term “high-net-worth individual” is usually not far behind.

Funds of funds are widely assumed to have the greatest exposure to capital from wealthy people, who are attracted to multi-manager funds due to their diversification and lower minimum commitments. But there is a distinct breed of limited partner built exclusively with high-net-worth and family money – the feeder fund.

The term “feeder fund” is an indistinct bit of jargon referring to the hugely diverse set of investment vehicles affiliated with private banks and wealth management boutiques. In general, feeder funds bundle high-networth individual commitments into compelling blocks of capital dedicated to single private equity funds. Especially in cases where the “bundler” is a major private bank, some feeder funds are today among the largest single LPs within the investor bases of major private equity funds.

If individuals are indeed the first among LPs to seek liquidity for their private equity fund interests, and also among the first to default or threaten to default, feeder funds could see a disproportionate amount of this activity, say fundraising and fund formation experts.

The decline of individual net worth levels, as well as the decline in prestige of alternative investment strategies in the eyes of the broader public, has also meant a drying up of capital that once flowed strongly from private banking clients to private equity funds. It also doesn't help that much of the capital in the collapsed Ponzi scheme run by Bernard Madoff came through feeder funds. All this will further impact private equity fundraising, especially for wellknown firms. According to a New York-based fund formation lawyer with major private equity GP clients, big private banks such as those controlled by UBS, Credit Suisse, JPMorgan, Citi and Morgan Stanley were, until a year ago, “pretty significant in the fundraising market”. Today these groups have seen a “significant drop-off” in the amount of capital they can contribute to private equity fundraisings. The lawyer attributes this decline to the fact that “one of the most stressed out categories of investors is the individual. They are struggling to meet existing capital calls and [are] savaging their private equity portfolios.”

The lawyer says he has seen an “uptick” in defaults coming out of feeder funds. However, on a capitalweighted basis, he expects a few key institutional liquidity constraints to have a greater impact on the industry. But individual and feederfund liquidity issues will cause headaches thanks to their sheer numbers, he says.

Most clients of private banks would only get excited about a fund they'd heard of,” says a New York placement agent. “They'd be teeing off at the country club and saying, “I'm in Bain VII,” and their golfing companion is saying, ‘Wow, you must be a big hitter.’

Feeder funds grew and proliferated along with all other aspects of the private equity industry, in part because of huge demand for access to famous private equity names, and – according to several private equity fundraising market insiders – in part because the fees associated with feeder funds were very good business for the private banks. Clients were willing to pay hefty fees for access to the firms they read about in the financial headlines.

During the boom years of the financial markets in general and private equity in particular, feeder funds met a need for private clients, who wanted access to private equity funds, and for general partners, who wanted large capital commitments. Being the middle man between such twin demand usually spells a fine opportunity to make money. While private clients are always charged to varying degrees for access to feeder funds, some private banks “were just happy to be able to access quality product and wouldn't ask GPs for fees”, says an independent European placement agent.

PLACEMENT-STYLE FEES
Some notable Wall Street banks, however, saw an opportunity to charge placement-style fees to GPs for large bundles of high-net-worth capital. For example, one European placement agent says that JPMorgan's private banking unit, among the largest feeder fund bundlers in the private equity market, will charge upwards of 2 percent of capital “placed”. JP Morgan has been known to often place between $500 million and $750 million in large private equity funds, the placement agent said. JP Morgan did not return multiple calls on the subject.

Given the huge diversity of fees and terms within the feeder fund market, GPs will experience an equally diverse range of issues when dealing with defaults from within feeder funds. In today's uncertain market, the feeder fund term of greatest interest to GPs has to do with who is on the hook in the event of an underlying individual default – the private bank or the individual? General partners would prefer an arrangement whereby the “bundler” is responsible for the full amount of the capital call, whether or not the underlying investors are sending in the cash. However, according to the fund formation lawyer, the largest feeder fund bundlers are usually able to negotiate pass-through treatment with regard to the default clauses, effectively meaning that GPs must chase down delinquent individual LPs within the feeder fund and, if necessary, enforce default provisions against them. “If you don't get the pass-through, that would show that you're not a significant amount of capital,” says the lawyer, commenting on a feeder fund's ability to secure this term.

“Most clients of private banks would only get excited about a fund they'd heard of. They'd be teeing off at the country club and saying, “I'm in Bain VII,” and their golfing companion is saying, “Wow, you must be a big hitter””

Where the pass-through treatment is not agreed to, the feeder fund managers must cover for a defaulter, or allocate any punitive action down to the offending client capital accounts.

More frequently, however, private banks can use their significant resources to offer liquidity tools to private clients in a feeder fund, offering to buy out or transfer interests for clients who no longer wish to participate in given funds (the prices paid for these interests are of course set by the bank).

According to the New York placement agent, some feeder funds have managed the capital call issues sometimes faced by private clients by calling a large amount of capital up front in anticipation of actual GP draw-downs.

The European placement agent says that when he secures feeder fund capital for a GP client, he requires the private bank to verify that certain client account management procedures are firmly in place. “We ask them, do they meet a quality test? Do they meet accredited investor rules? Are they labeled in the bank system as sophisticated? Do you hold their assets? How much of the assets? Does the bank have the authority to make the capital call on behalf of the client?”

The placement agent put this rather stringent set of requirements in place after being shouted at by a GP who had called capital from a feeder fund only to have some of the capital come in late – two of the major participants in the feeder fund were on extended vacations and unreachable by the private bank. “My GP was furious,” says the agent, who had placed the feeder fund in the partnership.

Over the next year or two, defaults from within feeder funds are more likely to be the result of individual net worth collapses than of misplaced holiday Blackberrys. In these situations, general partners may find themselves with plenty of better things to do than chase down an errant private bank client.