‘There is a degree of hostility towards annex funds’

Do you anticipate fund restructuring being a significant part of your business in coming months and years?
Yes, we are already quite active in this area and see it as having the potential to rival even our secondaries advisory practice over the short and medium term. We have not had this level of activity since 2002/3.

In retrospect too many investments were made at too high prices with too much leverage. Many portfolio companies are now underperforming, leading to a requirement for new money and many funds having insufficient reserves.

What types of restructuring do you anticipate?
Some funds will have to raise further capital to support portfolio companies which may require equity cures or funding in restructurings. In many ways it's reminiscent of the problems we saw in the venture market back in 2002-03; funds couldn't support their portfolio companies and therefore raised annex or top-up funds or re-opened funds. In the case of closed-end vehicles, leverage or over-commitment strategies need restructuring. Other restructurings will involve the renegotiations of terms and conditions of existing funds to realign interests or deal with a change in the market.

What about more recent funds that aren't fully invested?
Some funds raised over the last couple of years, if anything, might now be deemed too large for current market conditions and deal activity levels. Combine this with the fact that many investors are under significant pressure in terms of allocations and you may see pressure increasing on GPs to release a proportion of the undrawn commitments, seen at firms such as Permira and TPG. The extent to which this pressure increases or decreases clearly will depend on what happens in the wider world. If deal activity remains very low, institutions are going to become very sensitive about the ongoing level of management fees on undrawn commitments.

What else might be renegotiated?
While it has been very rare for GPs to be replaced since the last downturn, most funds now have nofault divorce clauses, and many new forhire GPs and direct secondary managers have been established and are now available. So there's a real alternative for LPs who've historically been very nervous of jeopardising management agreements and being left with the assets. The question is: will LPs take a more activist approach when performance is really poor?

Aren't some of these restructuring measures seen negatively by LPs?
The requirement for restructurings is in most cases the result of underperformance or other problems, which investors may in part blame on the GP. Investors don't like being forced to put up new money in negative circumstances. For example, and maybe not surprisingly, there is a degree of hostility from LPs towards annex funds. Institutions, however, will want to be a little bit careful they don't cut their nose off to spite their face if money is needed to support and protect the value of portfolio companies.

One LP recently told me that annex funds simply don't force GPs to ‘share the pain’.
Annex funds are typically done without management fees and sometimes without carried interest and many LPs are requiring an increased GP commitment, so GPs are not benefiting. LPs in some cases do believe though that the GP should in some way be penalised. This may in part be due to the misalignment of interests that have in some cases developed over the last few years between GPs and LPs, particularly at the large end of the buyout market, where managers could become very wealthy on the back of management and other fees alone. Part of the need for restructuring is to bring back that alignment. In others cases, it is about right-sizing or unwinding some of the last few years' excess.