The equivalent of a panda attack

Journalists are often accused of seeking out negative news stories. But the reality is they have a responsibility to write and report on things viewed as both good and bad news, it's just the latter often attracts more attention. Faced with a headline choice of “New panda born at zoo” and “Panda attacks zoo visitor”, for example, most readers will click on the second, more shocking story. For the private equity set, this might translate to a “New fund closed” headline garnering less attention than a story proclaiming, “Fund falls short of target”. This is probably truer today, as market participants absorb as much information as possible to help make sense of a changing industry and macroeconomic landscape.

PEO readers last month were understandably attracted to stories that detailed problems being confronted by private equity firms; stories with headlines that, until quite recently, would have seemed absurd.

Very few people expected 29-year-old UK buyout firm Candover to be so suddenly and severely affected by the liquidity problems of Candover Investments, the London-listed investment trust that is a cornerstone investor in its buyout funds. The steep decline of its share price in past months has been linked to concern about its over-commitment strategy. Indeed, the listed entity not only slashed its portfolio value in half recently, but said it couldn't meet future calls for Candover's 2008 fund, which has only done one deal. Given that it committed €1 billion of the fund's €3 billion raised, Candover was forced to temporarily cease investing to negotiate with LPs on the fund's investment strategy going forward. It quickly began cutting staff to diminish costs, told its Asian and Central Europe teams to raise their own funds or face closure, and began discussions with “selected parties” on measures including a potential takeover of Candover Investments.

The delicate relationships between liquidity-starved LPs and their GPs resurfaced throughout the month, with Terra Firma's unprecedented interactions with investors attracting much attention. The UK-headquartered firm avoided both LP defaults and shrinking its €5.4 billion Fund III by having its management company buy out three cash-strapped LPs at a “small premium”. Days later, at the same time as it emerged that the Guy Hands-led firm had written down its EMI investment by 50 percent, Terra Firma revealed its decision to return €80 million in carried interest accrued since 2004 to limited partners. “Our investors have suffered and therefore our rewards should suffer at the same time,” Hands wrote in the firm's annual report.

The difference between “hard” and “soft” LP commitments – those approved by an institution's board and contractually agreed with the GP, versus those simply recommended by investment staff – was catapulted into the spotlight when the $45 billion Pennsylvania Public School Employees' Retirement System cancelled hundreds of millions of dollars in planned private equity commitments to firms including Cerberus, HgCapital, Apollo and Gold Hill. The US public pension is one of many limited partners struggling with the denominator effect – its actual allocation to private equity stands at 24 percent, while its target is 14 percent.

LPs cancelling commitments would have been unheard of even as recently as six months ago. Equally shocking would have been the suggestion that GPs would return carry, de-list vehicles or shrink the size of already-closed funds. But these issues – and the ways in which they're confronted by LPs and GPs – are part of a new reality facing the private equity industry today.