The Challenged Fund: Toolkit for Dealing with Zombie Funds, Legacy Assets, GP Restructurings and Other Difficult Situations Tom Bratkovich, Founder/Managing Director Longview Investment Partners Introduction This workshop will explore issues and solution paths for relationships that LPs no longer desire going forward, from the most simple to the most complex. The pros/cons and degree-of-difficulty of each solution path will be explored. Multiple real-life case studies will be presented (non- attributable summaries of which will be distributed in each session) to promote interactive discussion and determine whether the actual desired outcome was achieved. Participants will have a framework for recognizing, evaluating, and acting on these situations in the future Learning Objectives: • Determine the root causes and evolution of challenged funds and how relationships can deteriorate over time • Provide a playbook of options for dealing with these situations and explore the nuances of pursuing various solution paths • Assess who initiates action in these situations, and why; assess whether and when an LP should initiate action and the potential benefits and consequences • Explore which of the following options might be a good fit for specific situations: pre-commitment legal terms, fee-reductions, suspension/commitment reductions, GP replacement, position secondary sale, fund restructuring, legacy asset management, and do nothing/business as usual 2 Description – Which Funds are “Challenged”? • Anyone you have excluded from re-up, even if for non-controversial reasons: • Performance • Strategy drift • Team issues • LP allocation issues • More complicated – GPs stretching (or out-right breaking) the LPA • Waterfall manipulation • Cross-fund investing • Capital account manipulation • Conflicts of interest • Fee offsets • Didn’t read own LPA (!) • Early fundraising • Case Study #1 • More nuanced – LP belief that there is some way to improve likely outcome through “proactive management” 3 Case Study #1 – Situation 1.1 • Large, institutional RE GP with > $15 B of AUM, mostly in public REITs • You, the LP, are in one of the only commingled, private equity funds that the GP manages • Capital calls as expected for 3 years; then the LP detects a small overage on the capital calls versus committed amount and stops funding capital calls for 6 months • A reach out to the GP for clarification yields assurances from the CFO and fund accountants that there is no discrepancy and the calls should be funded 4 Options 1.1 – Should you, the LP: • 1.1A – Fund the capital calls – GP is large with decades in the industry, a great track record, and likely the LP’s fund accountants are in error, not the GP. The next fund is going to be raised soon, will likely be over- subscribed • 1.1B – Refuse to fund the capital calls, ask GP for full accounting –Buy some time, give the GP the benefit of the doubt and time to come back with a full accounting/explanation of the situation • 1.1C – 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 assessment 5 Case Study #1 – Situation 1.2 • The LP decides to hire an outside advisor to assess the situation (Option 1.1C) . 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 GP failed to pay the LP for an early exit during fundraising; instead the proceeds were distributed to other LPs that committed 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 . Still a high performance fund with 2.5x MOIC • The GP has been lending the fund capital to “make up” for the unfunded capital calls . Loans have first position over the LPs’ equity, 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 6 Options 1.2 – Should you, the LP: • 1.2A. – 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”. • 1.2B. – 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. • 1.2C. – 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 7 Case Study 1: Outcome • The LP decides to confront the GP and the other LPs with the reality of the situation, threatens Option 1.2C, but ends up privately asking the CEO of the GP for Option 1.2B • 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 8 Case Study 1: Lessons • Even large, storied, high-performance investors can make mistakes and end up as a challenged fund relationship • Assessing probability-weighted cost-to-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) 9 Who seeks the change? • LPs with large commitments, voting power, and/or long-term relationship with GP seeking actions . Rest of LPs may be “along for the ride” • May not be the relationship manager (PM, etc.) forcing the issue . CIO(s), allocation studies, risk/correlation managers, Boards, etc. • GPs (or factions) seeking something in return . Extensions of fund term (and fees), staple to next fund, release of concentration or cross-fund investment limits, etc. Next gen team “fed up” or leaving • Advisors – acting for one LP client, pushing for others to support 10 Should you seek change? • Do the probability-weighted benefits outweigh the likely costs? Benefits Costs Upside potential of action – increased NAV at exit, Your time – how long will it take? What other value minimize NAV degradation/downside creation in your portfolio could you be doing? Securing allocation to future funds with GP Hard costs - advisor cost (legal, accounting, consultants) Your brand as a trusted advisor to GPs (if you care…) Reputational issues (GPs and LPs talk) Your brand as an “active investor” (if you care…) Headline Risk – anonymous leaks to the press both while “in process” and after • Assess the probability of each option coming to pass. Reality checks: • Do you have influence? • Do you have the $ to fund advisors to assist? • Do you have the votes? • Are the LPs/GP generally in agreement on the right path? • Do you have the time/patience to see it through? 11 Solutions - Overview • Pre-emptive Measures – Pre-commitment • Fee reductions, etc. • Suspension/commitment reductions • Nuclear option: GP replacement/fund termination • Sell in secondary (GP may be buyer) • Restructuring transaction • Legacy asset management • Do nothing 12 Pre-emptive Measures – Pre-commitment (I) • Knowledge gained during diligence can be instrumental to figuring out what to ask for and how to mitigate risk . These days, “How could I know?” replaced with “I should have asked” . LPs (and advisors) need to be as sophisticated as the GPs • Common important knowledge points: . Assessing gen succession plan, incentives/compensation, commitment of team, attribution, potential conflicts of interest . Assessing decision-making power (formal and informal) within the GP (IC, management company, overall firm, etc.) . Assessing culture of openness/transparency – reference checks with existing LPs and LPAC members, partners that may have left, etc. Assessing commitment to governance – presence and power of Board (if any), LPAC, etc. 13 Pre-emptive Measures – Pre-Commitment (II) • Ultimately the LPA (plus side letter(s)) will govern in any situation • Difficulty in starting relationship on a “down note” and pushing for “downside protection” terms . Balance is important, knowledge and support of advisors on “market” terms • Terms to pay attention to: • Key man • Waterfall • Suspension • Fee offsets • Voting/governance rights • Fund-level debt restrictions • LPAC/Board composition • Strategy definitions • GP removal • Cross-investing • Conflicts of interest • Investment restrictions/concentration limits 14 Fee reductions (I) • Fairly common at extension periods (e.g., Y10+); rare at all other times • Forces GP to begin making portfolio and personnel decisions heading to wind down • Seek to avoid “blunt instrument” decisions; seek a thoughtful approach • Firesales generally are value killers • LPs should be proactive approaching this time period • GPs are happy to send out an extension consent for signature without discussion 15 Fee reductions (II) • What is the right number/structure? . Usually, already baked into the LPA – fee basis is net invested capital . However, portfolio companies can have large NIC but low NAV – value based approached (now and at exit) usually better .