The return of the annex

For GPs that have recently raised new funds, weathering the financial crisis might not seem too daunting a prospect. It might just be a matter of supporting companies for longer than expected through tougher times, or of taking advantage of bolt-on opportunities at bargain prices. But it's a problem if you've already invested the majority of your original fund – and there's just not enough money left to take the necessary measures.

“A lot of GPs have been working with about 10 percent reserves and that's just not adequate,” says Mounir Guen, chief executive of London-based placement agent MVision. “What we're finding is that some of the best performers which have exceptional un-realised valuations actually have an underlying problem in accessing equity to hold their companies and develop them for longer.”

Increasingly, the word's going out from fund managers to their investors – we need more money to preserve the value of what you've already invested in.

The idea first emerged following the dotcom crash at the turn of the millennium, as technology-focused venture capitalists tried to maintain the growth of cash-hungry portfolio companies in a hostile market.

VCs are again leading the way in the current crash. In February, veteran US investor Bessemer Venture Partners announced it had raised a $350 million annex fund to its $1.1 billion BVP VII fund. Kleiner Perkins Caulfield & Byers has also reopened its $700 million fund XIII and its $500 million Green Growth fund for extra commitments. Other US and European VCs are also understood to be taking similar steps.

No buyout funds have, so far, officially announced their intention to do the same. That's possibly not surprising, as buyout companies are less cash-hungry than early-stage ventures so there's less demand for add-on financing.

But although no one's yet naming names, a number of mid-market buyout funds are known to be looking to secure extra capital for their existing funds. Demand is led by funds raised around 2002 to 2004 which invested heavily during the good times. Some large LBO funds are also believed to be going down the same route.

The new fundraising may be structured as a kind of rights issue to expand the existing fund, or it might involve the creation of a new annex or add-on fund. Either way, going cap-inhand to your LPs is probably not anyone's first choice at present.

There are alternatives. Some funds are looking to reinvest the proceeds from early exits, although that also needs the agreement of LPs and isn't always an option. Others are preserving management fees to eke out a little extra capital. If the GP has raised a subsequent fund, co-investment may be more appealing.

But annex funds are being raised. It's a slow process, partly because this is unexplored territory. The newness of the concept is reflected in the array of different names being used – the new vehicles are variously referred to as annex, add-on, build-up, or top-up funds.

MIXED RECEPTION
The annex funds are new territory for many LPs as well as GPs. Ralph Aerni, head of private equity at Swiss gatekeeper SCM, says he has not yet seen any requests for annex funds but believes it will become an issue for established funds without adequate reserves.

There is, however, a question mark about appetite from investors for follow-on funding. Listed investor SVG Capital had a lacklustre response from shareholders to its recent rights issue, intended to meet future capital calls from Permira.

The willingness and ability of LPs to invest in add-ons will vary, notes Guen. “Some of them have cash, some of them don't. Some like the idea, some don't,” he says. “It's quite a mixed bag.” LPs are likely to remain receptive so long as they don't feel there's any dilution of value to their existing investment, and that the add-on is not being raised just to prop up an ailing portfolio. One of the main challenges for GPs is to persuade them that the additional funds will be invested in the existing portfolio at a fair price.

“So long as investors are comfortable with that and accept there are cash constraints in some funds in terms of supporting deals, this is a practical way of dealing with things,” says Jason Glover, global head of private funds at law firm Clifford Chance.

So far, the additional money is generally being structured as a new annex fund rather than as a rights issue. Most LP agreements feature a standard clause saying that additional funds can only be raised within 12 months of close. “If you do need to get additional commitments, a GP can't increase the commitment of an LP without their approval,” notes John Gripton, head of investment management Europe for Swiss investment manager and adviser Capital Dynamics. “You do need to get 100 percent approval for anything that can dilute the investment of any one investor.”

LPs unwilling or unable to commit further funds will have to decide whether the potential gains will offset the dilution of their original investment. “You do have to take a practical view on this, because it could be in your interest to allow the fund to have the rights issue that you might not participate in,” Gripton says.

If the extra money is raised as a separate add-on fund, the GP will need to take care to retain the goodwill of existing LPs.

Issues around exclusivity and keyman provision may also have to be addressed. “It's not always strictly required that you get approval in advance, but everyone is taking pains to be completely up front with investors beforehand and ask LPs what their view should be,” says Duncan Woollard, partner in the funds team at law firm SJ Berwin.

The annex funds currently being raised are being offered initially to existing investors at pro rata. Any spare capacity is then offered to those who have come in, and any remaining after that will be offered to new investors.

ANNEX, COMPLEX
The terms and conditions of any new annex fund are likely to be very different to those on the original fund.

“The terms are significantly more beneficial because the equity is significantly more important than additional management fees,” says Guen. “When VCs did annex funds, it was often just a way of getting extra management fees, but now it's a completely different story.”

Annex funds in the pipeline are typically being offered at reduced or no management fees and reduced carry. Standard terms may emerge once a few such funds have closed.

Investing from the annex fund also raises some serious concerns. Perhaps the biggest is potential conflict of interest when deciding the valuation at which the new fund invests.

“Conflicts of interest have generally been dealt with by going to advisory committees, but it may be your committee for the annex fund has the same members as that of your main fund,” notes Woollard. “They may want to see a third-party valuation before they decide, but third-party valuations are pretty difficult at the moment.”

Calculating returns will also be an issue. The earlier generation of annex funds generally under-performed their primary funds. But performance is not clear-cut, as the performance of those primary funds will have been boosted by the involvement of the add-ons, and the add-on in turn rides off the back of the original. For existing investors, add-on investment can seem attractive even if the headline numbers on the new commitment are disappointing.

Generally, returns will be calculated separately for the annex fund. Returns may be blended if all LPs commit to a rights issue at pro rata, but there would be no strong reason for doing so.

When exit opportunities do reappear, the annex fund should sell at the same time as the main. “It should come in very much as an entity that has to follow whatever the main fund does,” says Glover.

Inevitably, many of the technical issues will be resolved only when more such funds have been raised and invested. Annex or add-on funds seem set to become a growing feature of the buyout market place, but they will remain a matter of necessity rather than fashion. “I don't think any fund manager would do these add-on funds out of choice,” Glover concludes.