FINspeak

In the current market conditions, it becomes harder to find a safe haven for any investment. One particular investment segment that has come under scrutiny is placements into Private Equity buyout firms. As a diversification strategy for large portfolios, some money managers have chased outsized returns with Private Equity to balance other less risky (less rewarding) investments. Acting as a Limited Partner (LP) for a Private Equity Buyout fund has historically been one way to aggressively put your money to work and generate returns that significantly outpace the overall market.

However, being a Limited Partner, just as the name implies, makes you are a true partner of the buyout firm. LPs often times invest in multiple fund vintages from the same Private Equity firm with the assumption that some disbursements from previous funds would roll forward to fund future obligations in addition to providing liquidity back to the money manager. This riskier partnership and the Private Equity investment class in general has rewarded those investors with outsized returns in the past, but has flat lined in this current market. Regardless of the fund return, LPs are still legally bound to fulfill their full capital funding obligations (often putting 20% or more upfront) during the life of the fund with capital being drawn down to make acquisitions or buyouts (sometimes those obligations can be sold to a secondary buyer at a discount, just like any other asset). Unfortunately for LPs, many are experiencing interrupted disbursement cycles due to fund losses or an inability to divest fund holdings. This puts significant stress on the LP as they will continually be required to place money into these funds without planned payback.

This may sound like a bad deal as there has been an uptick in the number of articles written about the stress that these Private Equity relationships have put on LPs from this capital call arrangement. I have even seen quotes to saying that they [LPs] would rather not see any new buyouts so those capital calls would not have to be funded. While it may be an interesting human angle and generate some sympathy for LPs, I am a bit confused as to the problem. Risk is rewarded by higher returns. An indefinite higher return is free money and nothing is for free so I don’t understand the worry about these LPs since they should have modeled downsides into their investment strategy. If they have not, then we may see a period of underfunding for buyout firms (in addition to LP portfolio strategy changing) which could limit buyouts in a 1-3 year window if a number of LPs take a haircut via forced liquidation to secondary firms which reduces their appetite during future fund raising. Interestingly enough, I really feel this is much ado about nothing and don’t believe it will have a drastic impact on most buyout firms. I am basing my assumption on the fact that there is still a significant amount of uncommitted capital or “dry powder” and deal sizes will be smaller since banks will not be backing mega-buyouts so that capital will go farther. While I can’t appreciate these LP concerns over losses, my bigger worry is that some LPs are also state retirement funds which becomes a completely different story…