Challenged Funds – Case Study #1
Situation 1.1
A large, institutional real assets manager (“the GP”) has over $15 B in AUM, with a broadly diverse strategy/product set (approximately 7 different categories of investments, including North American opportunistic multifamily, gateway market core commercial, opportunistic commercial, value-add hospitality/leisure, value-add industrial, etc.). The firm is public, with most strategies operated as REITs and other publicly accessible vehicles, with a few private, commingled funds with institutional LPs
The GP calls capital over a 3 year period as expected, yet seems to call more than a certain large LP’s total commitment amount. The LP detects this situation after a small overage, and stops funding future capital calls for a period of 6 months, and reaches out to the GP for clarification. The GP’s fund manager and CFO assure the LP that everything is correct and the capital calls should be funded
Options: Should the LP…?
A. Fund the capital calls – This is a large institutional GP with decades in the industry, many personnel, a great track record, and likely the LP’s fund accountants are in error, not the GP. Besides, the next fund is going to be raised soon, will likely be over-subscribed, and the LP wants full allocation B. Refuse to fund the capital calls, ask GP for full accounting – Can buy some time, give the GP the benefit of the doubt and allow them some time to come back with a full accounting/explanation of the situation C. Refuse to fund the capital calls, hire an outside advisor for a full accounting – Will take even more time, will cost additional expenses, but may get an independent view
Contact – Tom Bratkovich [email protected] 916-747-1746 1
Situation 1.2
The LP decides to hire an outside advisor to assess the situation. The advisor reviews the LPA, capital call notices, capital accounts, and fund financial statements. The advisor engages in discussions with the GP’s CFO, fund accounting staff, and fund legal counsel. The advisor purports to find a complex situation where:
The GP failed to pay the LP for an early exit while the fund was still being raised; instead the proceeds were distributed pro-rata to other LPs that committed just before the final close. The difference is about $10 M on a $30 M commitment underpaid to the LP and overpaid to the other LPs (assume for the sake of discussion that the overall total unrealized plus realized is 2.5x) The GP has been lending the fund capital to “make up” for the unfunded capital calls. These loans have first position over the LPs equity in the fund, have a high interest rate, and have not been properly disclosed to the LPAC to vet for conflicts of interest The other LPs take a dim view of this line of inquiry, and hire their own advisors to make their own assessments
Options: Should the LP…?
A. Don’t believe the advisor, believe the GP and fund the capital calls – The advisor is new to the situation, doesn’t know the history of the relationship, the accounting really can’t be that “off” B. Believe the advisor, ask the GP privately for a secondary exit for the LP from the fund – Will take even more time, may not get a fair bid/valuation, may be “stuck” with no resolution C. Believe the advisor, ask the GP for a full repatriation of owed amounts, restatement of the capital accounts, and a suspension of further fund activities – Sure to anger the GP and other LPs, but may achieve the right solution over time, likely additional expenses incurred and even litigation
Contact – Tom Bratkovich [email protected] 916-747-1746 2
Outcome:
The LP decides confront the GP and the other LPs with the reality of the situation, threatens Option C, but ends up privately asking the CEO of the GP for Option B:
The GP, Fund Counsel, and CFO had not read the LPA, did not understand the accounting rules for new fund entrants. The GP had been illicitly loaning the fund amounts from its own balance sheet without recognition of the implications. The GP admitted to not understanding how to manage private, commingled funds – not a large part of the overall business and fund accounting and conflict of interest controls lax. The auditor (Big Four!) failed to identify the discrepancies. The CEO of the firm gets involved, recognizes the risk to rest of the public platform if the news gets out, and agrees to buy the LP’s stake for the full value plus the discrepancy. The LP never re-ups with this GP again.
Lesson(s):
Even large, storied, high-performance investors can make mistakes and end up as a challenged fund relationship. Assessing cost to weighted probability benefit of potential outcomes is important in decisions on whether to pursue a situation. Not all LPs will be on your side (or care) about your situation. Rarely are these situations “all of us” (LPs) versus “them” (GP)
Contact – Tom Bratkovich [email protected] 916-747-1746 3
Challenged Funds – Case Study #2
Situation 2:
A lower mid-market control buyout firm is on Fund II of $350 M, in year 2 of its investment period, with 3 investments made and several others in diligence and near completion. The LPs of the fund are a mix of larger public pension plans, fund of funds, and other sophisticated investors; many of them have made commitments through their emerging manager programs. Fund I has $200 M of commitments, is past its investment period, is partially realized, and is currently bottom quartile at -24% net IRR.
When the LPs were evaluating their investment/commitment into Fund II, Fund I was marked at positive net IRR of 12% and the GP had largely met its goals as outlined in its strategy for deploying the fund. However, soon after the final close of Fund II, Fund I was marked down by the GP consistently every quarter until it was in the bottom quartile.
At the current time in the middle of Fund II’s investment period, the second most senior investment professional leaves the firm, triggering a keyman event. The rest of the team of 5 investment professionals remains otherwise intact. The LPs begin to have conversations with the GP and amongst themselves on the proper next steps. The GP aggressively pushes to make two investments that have been wholly diligenced and will be made (pending capital call approval by the LPs).
You are the largest LP in this fund, but not a majority.
Options: Should you, the LP...?
A. Vote to place the fund into suspension per the Keyman terms (6 months), attempt to organize the LPs into a voting block to remove the GP and wind down the fund – The GP wasn’t forthcoming during the raise of Fund II and sand- bagged the Fund I true performance, and let’s face it, you are never going to re-up with this manager. Better to cut bait early and save time/cost/heartache and the remaining commitment. An advisor and counsel will likely need to be retained to assist in driving out this solution. B. Vote to place the fund into suspension and provide the GP time to put together a go-forward plan and find another investment professional to augment the team (i.e., cure the keyman) – The remaining deals in Fund II and some those left in Fund I are early in their life, and could be interesting. It will take time and cost to truly diligence these portfolio companies as an advisor will likely need to be hired along with counsel to determine options. C. Vote to not place the fund into suspension, allow the GP to continue their investment program – The GP is a darling of your emerging program, is known to and has the strong support of your Board, and has reasonable portfolio companies that could be developing winners. This is an emerging manager after all, and some hiccups are to be expected, and there is no need to incur the extra costs of advisors in this case.
Contact – Tom Bratkovich [email protected] 916-747-1746 4
Outcome:
The LP decides to pursue Option A, placing the fund in suspension and organizing the other LPs to suspend and then wind down the fund
The first vote to place the Fund into suspension passes. However, after this, the LPs discover (as does the GP) that there is a great split among the LPs for the proper / desired outcome. Approximately 40% of the voting interests want to remove the GP and wind down the fund, 30% want to give the GP extended time to complete the investment period under a partial suspension, and the other 30% want to remove the suspension immediately and allow the GP to continue on un-encumbered. Six months of heated (and sometime acrimonious) discussions ensue among and between the LPs and the GPs, with much additional cost incurred from advisors and lawyers. The LPs struggle to find a solution that can carry a majority vote of LP interests. The suspension period must be extended, and another six months of similar activity ensues. Eventually, the LPs vote to permanently suspend Fund II (no more investments), to leave the GP in place to manage out the existing portfolios of Fund II and I, and to formally reduce Fund II commitments. Subsequently: o Most of the remaining investment professionals (other than the founder) leave the firm soon after this solution is implemented o Fund I remains bottom quartile o Fund II experiences a loss of 1/3 of the invested capital when the GP reports that one of the portfolio companies is being utilized by organized crime elements to launder money. Fund II never recovers, and the GP never raises another fund.
Lesson(s):
The solution that may seem infinitely correct to you may seem infinitely incorrect to the other LPs. Vote counting matters. There are thousands of GPs in the world; once you detect poor performance and likely poor continued future performance an decide to not re-up with a GP, the remaining capital might be better deployed elsewhere. LPs have numerous structural constraints in implementing solutions such as this, including keeping legal separation as an LP from the business of the GP (operating the fund, making fund level decisions). One could argue that situations like this highlight why most of the market has moved to GP-led solutions for fund restructurings.
Contact – Tom Bratkovich [email protected] 916-747-1746 5
Challenged Funds – Case Study #3
Situation 3.1:
A lower mid-market emerging market focused firm is on Fund I of $100 M, in year 4 of its investment period, with only 1 investment made and one other in diligence and near completion. You are the sole institutional LP of this fund representing over 80% of the LP interests (and have full voting control); the remaining LPs are HNWIs and friends of the GP.
This fund has been off the radar and nearly silent from a relationship perspective for the last couple of years; in fact the relationship is not yours but was formed years ago with the prior private equity portfolio manager (who has now left your institution) – i.e., you have inherited this relationship. Quarterly reporting from the GP has been scant, but recently the GP reached out regarding a pending investment that could have a co-investment opportunity. A new advisor is available to you and after a cursory review they have highlighted that this relationship requires attention.
After picking up the file, you see that the GP’s only investment to date was made 4 years ago, is in a convertible note in a foreign casino, and is held at cost at $50 M. The financial statements of the firm have been filed (annually), but the latest financials are late. Further, there is some reference in past quarterly reports that various team members have left, however a review of the GP’s website shows that those members are still posted as active within the firm. The GP has a pending capital call for full management fee and has been collecting full management fees since inception based on the full commitment amount. The GP seems to have a strong pedigree (Harvard Law School) and some experience operating in this emerging market.
Options: Should you, the LP...?
A. Review the pending transaction, get to know the GP through in-person meetings, figure out/learn some details about the casino investment – This is a new situation for you, best to do some research with fresh eyes before making any decisions. In the meantime, fund the management fee capital call(s) to ensure that your capital account is fully protected, as your predecessor has done. B. Immediately put the fund into suspension with the view that you are going to push to remove the GP, and hire advisors to assist in building the removal case – Questions on the lack of an investment program (only one investment in 4 years), lack of a team, and not adhering to ASC 820 fair value principals, requests for additional full management fee… plus this is not your relationship and you can probably save ~$40 M of undrawn commitments and put toward another pending interesting fund relationship.
Contact – Tom Bratkovich [email protected] 916-747-1746 6
Situation 3.2:
The LP decides to pursue Option B, placing the fund into immediate suspension, engaging the advisor to conduct a deep forensic drill of the situation to build a case for GP removal, and in the meantime withholding capital calls for management fees.
You and the advisor find a whole host of issues that would qualify for removal of the GP for cause: o The “team” doesn’t exist – while they were “ready” to be hired at the beginning of the fund, they mostly never were or left within the first year. o The single investment is a real legitimate investment in a tranche of securities that other prominent private equity firms also invested in. However, the investment wasn’t proprietary, wasn’t necessarily on-strategy for the fund, and was “widely shopped” and available to the PE community and thus took little effort by the GP from a sourcing / diligence perspective. The convertible notes can be converted into publically traded stock and could have been exited at any time in the last 2 years (most of the other PE firms did indeed exit their positions in years past). o The management fees have been collected by the manager and mostly been used to set up the founding GP “in-country” with an expensive lifestyle (lavish apartment, first class flights back and forth to the US, etc.) to develop a “deal network” and relationships, which the GP claims has now resulted in a possible deal which he wants to fund. o Your advisor recommends further forensic legal and fund accounting activity; the legal and fund accounting support available is bolstered and further forensic reviews of the books and records are conducted. . They find that the GP has been inappropriately charging the fund for GP-related expenses of approximately $2 M and also not using the management fees for proper fund-related expenses. . The reporting provided is incomplete and violates the reporting clauses in the LPA. . The fund auditor claims no knowledge of any of the above (nor of the need to value/mark-to-market the security position) and a legal case begins to be built additionally against the fund auditor, as well as the GP. o The advisor finds and negotiates deals with two potential qualified replacement GPs that will take on the fund if the GP is removed
However…! o Your advisor does a deep look at the investment security with the support of legal counsel and determines that there is a strong case that the security has a complex ratchet clause that could make the security worth 10x its cost basis (i.e., $500 M). o The GP is unaware of this (he had not read the convertible note documentation), and once made aware, fully agrees with the LP that there could be massive value in the security and he will pursue it. He subsequently displays some value by organizing a call with the CEO & CFO of the casino and their counsel to discuss the issue. The casino management team acknowledges the presence of the ratchet term, but denies that it is applicable in this fashion, but does agree that it should result in a valuation of $100 M for the security (i.e., 2x). o The GP hires high-powered security lawyers to review and potentially litigate the situation. The GP positions that he is the best person to go after the full $500 M (carry incentive strong, knows the players, and is willing to fight/litigate the situation and pay back the mis-allocated management fees).
Options: Should you, the LP...?
A. Remove the GP, hire a replacement GP, litigate for the $500 M – That’s a lot of money, better to have the outcome in the hands of someone competent! It might take $1 M+ in legal fees and 3+ years, but it is worth it. B. Remove the GP, hire a replacement GP, accept the $100 M from the casino operator and wind up the fund – Get someone competent involved, but don’t waste additional time/money to wrap this up. The legal case is uncertain. C. Keep the GP, litigate the $500 M – He seems to be willing/able to go after this, the incentives for him are clear...plus he has made vague insinuations that if he is removed and the LP pursues the case that the LP will be piercing the limited partnership veil and could be open to being sued by the GP for interference in the operation of the fund.
Contact – Tom Bratkovich [email protected] 916-747-1746 7
Outcome:
The LP decides to pursue Option C, keeping the existing GP and funding the litigation for the full $500 M, paying a negotiated reduced management fee along the way in return for the GP repaying the fund the past owed amounts:
The legal team researches and files the case in New York, the judge agrees that the case has merit and agrees to take it to trial. Trial commences and the case is pending final decision from the judge. It has been a 5 year journey…
Lesson(s):
GPs (rarely) are completely out of their element managing a fund, but it does happen. Your time is valuable and experts are helpful and probably worth the cost… without the support of the advisors in this case the true and deeper details of the situation would likely have not been uncovered given the relatively small size/importance of the relationship. Even when the case to remove a GP for cause is a slam dunk and malfeasance/ gross negligence are blatant, the GP is still likely the one that knows more about the portfolio than anyone else, and may be in a position to achieve maximum (or best) value from disposing the assets. Withholding capital calls generally not recommended, but once it gets to this stage, this tactic can provide leverage in negotiations with GPs… with some risk to the LP’s capital account over time.
Contact – Tom Bratkovich [email protected] 916-747-1746 8
Challenged Funds – Case Study #4
Situation:
A lower mid-market healthcare focused firm is on Fund III of $300 M (year 3 of investment period), and has two aged prior funds (Fund I $500 M of commitments, 9 years old, Fund II $600 M of commitments 6 years old). The LP base is a diverse mix of institutions and HNWIs. The table below shows the approximate status for the 3 funds:
Fund Size Age (yrs) DPI TVPI Net IRR Number of Remaining Remaining NAV Investments I $500 M 9 1.6x 1.8x 8% 2* $100 M II $600 M 6 0.4x 0.9x -4% 3 $300 M III $300 M 3 0.2x 1.8x 20% 4 $480 M * The two remaining investments in Fund I overlap with those of Fund II (i.e., they earlier positions in the same portfolio companies
The GP approaches the LPs with concept of executing a GP restructuring deal focused on Funds I and II. The GP proposes to hire an advisor who is experienced in this space. You are on the LPAC, and the GP brings the advisor to the LPAC meeting where you meet them and agree that they are competent and fairly neutral. During this meeting, you learn the following: The main purpose is to achieve a liquidity option for the LPs (i.e., a bid for the LP interests) for Funds I/II The GP is amenable to including a portion of Fund III if the bids are high enough and this helps to get a good blended deal for the LPs that want to exit The GP would like to reset the carry in Funds I/II to provide some on-going incentive, and also achieve some additional management fee to manage out Funds I/II as part of the transaction. Fund II will receive an extension The GP is hopeful that it can achieve a staple to Fund IV and kick start the fundraise for that vehicle The advisor believes that a buyer can be found that can satisfy most of the above, and that LPs will be given a choice to exit or roll, with roll options including “status quo” capability
A few other salient facts: One of the portfolio companies in Funds I/II is public, and has been so for nearly 2 years (no restrictions). The company is a trailer in its segment and while cash flow positive, has had a wealth of management issues and intellectual property disputes. Another of the portfolio companies in Funds I/II is private, barely cash flow positive, and needs a strategic partner or otherwise it will also subside into “also-ran” status. This company also has substantial management team turnover. The final portfolio company is a winner, a leader in its space, and has already been majority purchased by a strategic. The Funds can exit the deal free and clear in two years at a pre-agreed to multiple of EBITDA. EBITDA is increasing 18% per year. The team is intact and thinks that they can raise Fund IV and continue on, however the two founders are in their late 60s.
Options: Should you, the LP...?
A. Nip this in the bud – advocate to kill the process – The GP should focus on exiting the portfolio companies through normal means and investing Fund III. Plus, the potential conflicts are significant what with the reset of the carry/mgmt fee and the staple option. Plus the advisor will cost all of the funds some expenses. B. Stay silent, but in the background inform the GP that you would be interested in seeing this pursued and getting a bid – no one needs to know what you think, but privately you are done with this GP and would like an exit option, even if at reduced NAV. C. Speak up! Strongly advocate in the LPAC meeting that this be pursued – The GP most likely has inflated the NAVs of all of these companies (even Fund III), and Fund I/II look like they are headed for a train-wreck. This might be the best last hope to recoup some value…which you can put to work in a better opportunity in a few quarters.
Contact – Tom Bratkovich [email protected] 916-747-1746 9
Outcome:
The GP receives some (but not an overwhelming amount of) vocal support to launch the process and this is bolstered by some additional private support in the background. The GP decides to launch the process:
The advisor packages the deal quietly moves it into the market, two bids are obtained: o Both are around 0.65x of NAV for the LP positions in Funds I/II (structured as an LP tender offer). Both offer an extension of Fund I and a reset of management fee and carry to market levels. One offers a small staple to Fund IV. o Neither make a bid on Fund III o The advisor believes that the bidders can be pushed up in the 0.70x-0.75x range. The advisor learns during the process that the two founders have fundamental differences of opinions, and do not have a good working relationship. One of the bidders observes/determines this dynamic on their own yet still bids. The LPs do not appear to be wholly aware of the depth of this dynamic. The GP privately reviews these bids and the team disagrees on what to do. A majority of the GP team (including the next generation) wants to submit the bids to the LPs and negotiate a final option, but one of the founders is embarrassed by the bid valuations and does not want to “lose face” with the LPs. This GP does not respect silent LPs’ wishes and the process is killed by that founder, and the bids are never submitted to the LPs. Subsequently: o The GP holds onto the positions for too long (note lack of carry/hurdle issues in Funds I/II). The public company share price tanks, the other struggling private company is sold for a deep discount, and the winner ends up exiting at about current NAV. Overall, Funds I/II return 0.4x of the NAV at process launch. o During the following two years, the GP fragments with the team splitting into three groups. Fund III achieves 1.0x DPI before this happens, but the LPs are left with a dilemma on who should manage out the fund.
Lesson(s):
Whatever your position, advocate for it. In group situations, the “silent majority” is often not enough to drive a GP to the right solution. GPs need to know what you think early and often in situations like this. The cost for getting a bid on tail-end fund assets or a restructuring deal is not significant (~$100K to pay an advisor) relative to the potential savings. There is no obligation typically to take a bid, might as well learn what the market thinks about the portfolio. What if a bid is received? Should you take it? o Often, the GP’s advisor can give you insight on the valuation (the good ones will have done their own with an independent valuation firm), but note that the advisor is has an incentive for LPs to take the deal. That can mean that they fight for a higher price, and/or tell you that the price is fair. o Hiring your own advisor to work through the alternatives, structure, and valuation can be quite useful. Especially if you share the cost and work product with several LPs.
Contact – Tom Bratkovich [email protected] 916-747-1746 10
Challenged Funds – Case Study #5
Situation:
A mid-market control buyout firm is on Fund IV ($800 M of commitments and is in year 8). There are two portfolio companies left in the portfolio, one in the waste management space and the other in the healthcare services sector.
The GP has tried to sell both companies using one of the better known sell-side M&A boutique investment banks witinh the last two years. The healthcare services firm is in a fairly positive situation – the firm is growing, has proven its platform build model, and is busy acquiring smaller competitors to construct a regional winner. On the first sale attempt 2 years ago, the GP received multiple bids, but they were not compelling to the GP. The GP informed the LPAC of the bids and the LPs tended to agree. The GP waited a year and tried again, and once again both the GP and LPs believed that the bids were not compelling. The waste management firm is in a more difficult situation. This firm is barely cash flow breakeven, has a set of business areas that are not complementary, is asset heavy, and has had management turnover. The GP bought this firm out of receivership 5 years ago – the prior owners had ties to organized crime and the original investment thesis was a turn-around at a rock-bottom price. While there have been no inklings of further malfeasance in the company, the turn-around has taken longer than expected. The GP took this firm to market in hopes of achieving liquidity with an M&A broker, and received no bids.
The GP has hired a fund restructuring advisor who believes that the two companies can be sold as a package to a secondary buyer, whereby they will be set up in a Newco with the GP paid a small fee until ultimate liquidity for the positions can be found.
A few other salient facts: The GP has informed the LPs that they will not raise another fund, i.e., that they are retiring. The GP’s prior funds have all been 1st or 2nd quartile. The GP’s management fees have decreased substantially, and a skeleton crew remains. The fund has cleared hurdle so carry should be available if the companies are sold for something near NAV. Privately, the GP has told several of the larger LPs that if a tail-end fund solution/buyer can be found, perhaps the LPs can get liquidity and the buyer can provide some follow-on capital for the healthcare company to continue the rollup. The GP would be willing to stick around to manage that investment with the option for the LPs to participate.
Options: Should you, the LP...?
A. Nip this in the bud – advocate to kill the process – The GP should focus building the companies until they can be sold. If it takes more than a year, the LPs can just extend the fund until ultimately liquidity is achieved. B. Stay silent, but in the background inform the GP that you would be interested in seeing this pursued and getting a bid – no one needs to know what you think, but the GP has already held these investments for 5+ years and any liquidity offer would be at least considered. C. Speak up! Strongly advocate in the LPAC meeting that this be pursued – What are the chances that traditional sales processes can be run again and again and achieve a different result? Time to seek a buyer with potentially a lower cost of capital (i.e., the secondary funds) and if the bid is good, remove the burden of continuing to pay fees to the GP.
Contact – Tom Bratkovich [email protected] 916-747-1746 11
Outcome:
The GP presents the case to an LPAC consisting of 5 of the largest LPs:
Four of the five LPs are enthusiastic about running a process (approximately 70% of the voting interests). The fifth and largest is adamantly against running a process (30% of the voting interests). This LP argues that the companies should be sold in normal individual M&A processes (i.e., try again) and that it is not fair for the GP to attempt to find follow-on capital and continue to manage the assets for a fee. The LP makes vague threats that it will lobby the other LPs to replace the GP if he does not agree with this course of action, noting that they are retiring anyway. The LP has a large fund of funds practice and a secondary and co-investment practice. The LP introduces his secondary team to the GP with the thought that maybe they can bid on/buy the assets outside of a process. The GP considers whether this LP is acting inappropriately and whether to discuss this with the other LPs. The GP also wonders if this LP has pierced the GP/LP veil and could legally liable for interfering with the operation of the fund. Ultimately, the GP decides to kill the process and try again to sell the companies through traditional means: o The healthcare company goes to market and after 9 months, a buyer is found for a moderate gain above the carrying NAV. o The waste management company cannot be sold once again. The fund has to be extended, and two years later the company receives an offer at 0.7x the carrying NAV, the GP accepts the offer. It is unclear if the traditional method results in significant benefits. On one hand, a small improvement over the carrying NAV is obtained. On the other hand, small management fees and fund expenses are paid for an extended period, advisory fees are still paid to the M&A bankers, and some potentially liquid capital remains locked into the waste management company for an extended time.
Lesson(s):
LPs have a diverse set of opinions when presented with the same facts. No opinion is right/wrong, but it does complicate solutions for funds at the end of life. Collegial working relationships developed over the years among the LPs themselves and with the GP can be quite helpful in working through issues such as this. Remember who manages the fund by LPA – the GP. Decisions should be made by the GP; GPs (if they value their reputation and customers) should solicit input but ultimately they have to make the call. GPs generally want to do the right thing but incentives can become unhinged near the end of a fund’s life, and the best path to maximizing value is not always clear. Focusing on incentives can often get to a good solution, if not the best solution.
Contact – Tom Bratkovich [email protected] 916-747-1746 12