15 Jun 2020
Are predictions of Limited Partner defaults being overstated?
A mature and sophisticated private equity industry is well-placed to weather any challenges ahead
The coronavirus pandemic continues to wreak human and economic devastation around the world. Even as lockdown restrictions are tentatively eased, news of second wave outbreaks and fresh hotspots mean the prospect of any return to business as usual remains uncertain.
It is perhaps unsurprising then that the rumour mill has gone into overdrive, as investors attempt to navigate this most unpredictable of crises. In particular, the prospect of mass limited partner (LP) defaults is being promulgated by some sections of the media, with anecdotal reports of some LPs already reneging on commitments.
But the reality is far less apocalyptic. On further inspection, it appears there may have been some misconstrued delays caused by the logistical challenges of working from home. There may have also been isolated incidents of high net worth individuals or small family offices unable to meet capital calls, in funds where no subscription facility was in place.
The majority of institutional investors, however, now have substantial and sophisticated private equity (PE) programmes and are cautiously optimistic that their liquidity position is sound. Meanwhile, a rebound in the public markets is keeping the denominator effect at bay. A recent survey conducted by the Institutional Limited Partners Association found that 52% of LPs were only “somewhat concerned”, and 37% were “not concerned”, that their policy allocation caps would be breached.
“I do think reports of widespread LP defaults have been overblown,” says Rune Munk, origination partner at Coller Capital. “Apart from anything else, defaulting is hugely punitive and will always be a last resort. With a secondaries market that reached $85bn last year, an investor is going to choose to sell and redeem some value, rather than damage their reputation and walk away with nothing.”
Indeed, the scaremongering that is currently taking place echoes that seen in 2008, when publications from the FT to the Wall Street Journal predicted a cascade of nine-figure defaults. But even though banks – which at the time, represented one of the most significant sources of private equity capital – were the catalyst for that crisis, actual defaults were rare.
A question of maturity
Furthermore, the asset class has matured significantly in the intervening years. LPs have learnt lessons about diversification and pacing, as well as the perils of knee-jerk reactions to turbulence. General partners (GPs), meanwhile, have learnt the importance of transparency and communication with their investors, according to Spencer Goss, director of institutional banking at RBS International. “Private equity firms put far more emphasis on investor relations today,” he explains. “Their approach to a crisis is a great deal more sophisticated.”
Adds Munk: “There are some similarities with the financial crisis in that this is a large, global shock. People are having to re-forecast their cash positions, re-evaluate portfolio compositions and reassess risk appetites. But the big difference is that investors remember last time round. LPs are far more proactive, internally writing down valuations, even before Q1 figures were released. In addition, this isn’t a single-sector squeeze. In the GFC [global financial crisis], a lot of banks and insurance companies were hit, both by the crisis and by regulation. This time we are looking at a fundamental, demand- and supply-led situation.”
In addition, the PE industry is not only far larger than it was in 2008, the nature of the business has changed as well, with the big buyout houses operating much broader platforms.
“During the current crisis, we saw a month of paralysis in March when everyone was focused on their existing portfolios,” adds Monk. "But, by April, certain groups were already trying to be opportunistic. Due to the nature of this crisis, there will be fundamental change. There may be terminal declines in some industries, but there will also be brand new growth elsewhere and investors are already looking closely these opportunities.”
With the prospect of a phenomenal buying opportunity on the horizon, defaulting LPs are in nobody’s best interests. “By keeping in regular contact with all parties, GPs can foresee any potential problems and either orchestrate a secondaries sale, or take other pre-emptive action,” says Goss.
One such possibility is to delay drawdowns. However, this can be fraught with conflict. Indeed, when some managers suggested delaying capital calls to support major LPs that found themselves in difficulty during the 2008 financial crisis, it caused widespread consternation.
“The reality is that nobody can predict what will happen over the next few months and so, for now, LPs and GPs are content to sit tight and work together to ensure the best possible outcome for all concerned”
Spencer Goss, director of institutional banking, RBS International
In the words of a partner at one of the world’s biggest fund of funds managers: “When a continental GP openly said to the LPAC [Limited Partner Advisory Committee] they would not be making any further drawdowns until the situation improved in order to assist a single investor, we almost choked on our coffee. Here we were, facing an incredible buying opportunity and the suggestion was we sat on our hands. We just weren’t that sympathetic.”
But there are alternatives.
A different approach
The fund finance industry has also changed dramatically in the past decade. In 2008, banks were largely providing subscription facilities for administrative purposes. These facilities would be drawn down for a short period of time, often a matter of weeks.
Furthermore, during that banking-led crisis, the priority for lenders was to work with their fund clients to ensure facilities were repaid on time, in order to manage their financial and regulatory position.
Goss observes: “This time round, banks are in far better shape and – with a long track record of stability and strong documentation – have grown increasingly comfortable with the risks of seeing their facilities drawn down for longer.
“This allows managers to offer greater flexibility to their investors, without missing out on the opportunity to support portfolio companies or to do deals.”
And, of course, the secondaries industry has grown exponentially. According to Rune, in 2008, it represented around $15bn of transactions but grew to between $85bn and $90bn last year.
“It has become a natural part of the ecosystem,” comments Monk. “LPs don’t need to be super-distressed or panicking to engage with secondaries buyers about sensible, tailored partnerships.
“That is a huge change. There is no stigma attached to proactive portfolio management. Before, it may have been seen as a sign of weakness. Now it is seen as a sign of sophistication.”
Of course, nothing is certain, particularly as this crisis is still being played out with no end yet in sight. March valuations came through too early for assets to be written down to any material degree. Much will depend on June valuations, which won’t become known until August.
It also remains to be seen if the public markets will see another leg down when central bank support runs out, furloughing starts to unwind and unemployment shoots up, in which case the denominator effect could be exacerbated.
Meanwhile, it is true that, while the consistent and outsized returns of the asset class’s most established PE houses are likely to mean those relationships are too valuable for investors to even think about not honouring a capital call, LPs may choose to strategically default on newer managers where they have less at stake.
“The reality is that nobody can predict what will happen over the next few months and so, for now, LPs, GPs and their lenders are working together in an attempt to ensure the best possible outcome for all concerned,” says Goss.
Every aspect of the private equity industry, from the secondaries market to investor relations and fund finance, have evolved beyond recognition since the dark days of 2008. There will be challenging times to come, but there is also a palpable sense of collaboration and good will in an asset class that has both size and sophistication on its side.
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