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Challenged Funds – Case Study #1

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Challenged Funds – Case Study #1 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.
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