Spotlight 2011: Capital calls and the 'overhang'

Going into 2011, GPs will increasingly issue capital calls for deals, especially as more than $70bn in dry powder is set to expire in less than 24 months, writes Ian Charles.

“It’s tough to make predictions, especially about the future.”  – Yogi Berra. 

With tremendous market uncertainty, I’m confident that predictions for 2011 will be inaccurate. That being said, if equity markets appreciate modestly during 2011, the following trends should emerge.

Capital calls will increase materially, starting this quarter. The “unfunded overhang” is creating massive short-term deployment pressure with more than $70 billion in leverage buyout dry powder expiring in less than 24 months. At current debt levels, this represents $300 billion to $350 billion in new deals over the next two years for just the 2006 and 2007 vintages. The unfunded – a free call option – will be deployed because this “option” expires with a negative value because of lost future fee revenue.

Ian Charles

LBO entry multiples will remain elevated. This year, entry multiples were almost 10 percent above the 10 year average and the overhang pressure is creating multiple distortions where mid-market transactions cost more than large buyouts for only the second time in a decade.  Therefore, 2011 should be good for LPs whose net asset value is weighted toward small and mid-market US and European LBOs, but disappointing for LPs with significant unfunded commitments to mid to large-market LBO funds.

Next year will be challenging for the GP community as many managers will not be able to hold off fundraising if they hope to sustain their franchise.  Entering 2011, the $500 billion that GPs are trying to raise represents an unprecedented 333 percent of what LPs were willing to commit in 2010. Many GPs will fall short of expectations or outright fail.  The resulting organisational operating improvements and cost-cutting efforts will be painful. 

Finally, the re-up rate by LPs will be 30 to 50 percent for mature programs. If capital calls accelerate or maintain their fourth quarter 2010 pace, additional stress will be created in the LP community, where allocation, liquidity and resource constraints are ubiquitous.

More flexible and nimble investors who have capital will cycle into smaller, specialised funds, while large institutional investors look for alternatives to mega-LBO funds and fill the void by overfunding firms in the mid-market. 

Ian Charles is a principal with Landmark Partners.