Between bad and worse

It is the single most important question facing limited partners when considering the recapitalisation of struggling funds and investments: are they simply throwing good money after bad?

LPs all over the private equity universe have been confronted with this choice.

Fortress Investment Group, for example, has approached its LPs at least twice in the past two years looking for additional capital. Last year, the Wes Edens-led firm requested more money from LPs in its $2 billion third fund to help the vehicle reduce its debt load. Fortress was back earlier this year looking for more capital to shore up existing investments in companies from a co-investment fund raised in 2007.

Last month, another LP, the Los Angeles Fire and Police Pensions, received a request from one of its private equity real estate managers that appeared to give the institution a choice between a bad situation and a worse one.

LAFPP is an investor in the $1 billion Stockbridge Real Estate Partners II fund, which closed in July 2006.
San Francisco-based Stockbridge spent much of the first half of 2010 urging LPs in its second opportunity fund, which also include the California Public Employees’ Retirement System, the California State Teachers’ Retirement System and New York State Common Retirement Fund, to support its recapitalisation plans. “Several” proposals were rejected by LPs, LAFPP said in a report from its August investment committee meeting.

Also unable to attract outside investors, Stockbridge proposed a new final plan following negotiations with LPs. That plan addressed five keys issue of concern to LPs including priority payments for recapitalisation capital; fewer loan pay-downs; the restructuring and recapitalisation of assets and a lowering and subordination of management fees. After winning the backing of one major pension, which invested $125 million into the recapitalisation, smaller investors, such as LAFPP, also agreed to the deal.

The proposal, though, is not without its pitfalls. According to Stockbridge’s estimates, LPs taking part in the recapitalisation will achieve a return of 69 cents on the dollar. Yet projections by LAFPP’s consultant, The Townsend Group, suggest just 31 cents. Under the more conservative estimate, that means following an initial $30 million commitment, and an extra $3.75 million of capital under the recapitalisation plan, LAFPP might recover $10.5 million of its $33.75 million investment. Had the pension done nothing, Townsend predicted recovery of just $3 million of the original $30 million.

Of course, there is a caveat in all this – the word might. LAFPP might recover $10.5 million. Even given the priority repayment status of rescue capital, there are no guarantees for anyone taking part in this – and other – recapitalisation plans. Townsend warned LAFPP in the report that the $3.75 million was “also subject to loss”.

Stockbridge was unavailable for comment at press time. Townsend declined to comment.
This uncertainty is the crux of the problem facing limited partners. In deciding whether to invest additional capital to rescue original commitments, are they in fact throwing good money after bad? Is recapitalising a fund actually worth the financial investment, time and energy involved or is allowing liquidation the best option for all?

In the Fortress example mentioned above, it seems the additional capital committed by LPs to support investments in the 2004 Fund III may be paying off. In September, 2009, Fund III was generating a -1.21 percent internal rate of return. By 31 March 2010, the fund was being held at a return multiple of 1.03x and producing a 1.24 percent IRR.

Caught between choked debt markets and a fluctuating economic environment, many GPs have been forced to confront several unpleasant truths about their portfolios; mainly that they paid too much and employed too much leverage. In order to salvage some value from their funds and deals – and with it their reputations – GPs need additional capital to help persuade banks to restructure loans, to pay down debt or reposition an asset so that some equity can be extracted.

Too often though there’s simply no money left in the fund, with GPs having little option but to turn to their limited partners for help.

For LAFPP, Stockbridge’s last-in, first-out subordination structure, its ability to have extended loan maturities by two to six years and promise of a 33 percent fee reduction, were key reasons for backing the recapitalisation plan. Despite that though, they – and other LPs considering recapitalisation plans – will continue to question whether rescue capital kick-starts a turnaround for a fund today, or merely postpones inherent problems until tomorrow.