At the heart of private equity is a relationship of trust between the private equity firm and the institutional investors, such as public pension funds and charitable endowments, which back the firm and its key investment professionals. The limited partnership structure commonly used for private equity funds is based on certain fiduciary and other duties that partners owe to one another due to the position of trust that they enjoy.
In the current market, general partners are considering innovative contractual changes to their funds in order to ensure that limited partners receive the returns on their investments that they require for their own ultimate beneficiaries. Capital Contributions
Fundraising and investing are relatively straightforward: investors that want to participate in the fund join the fund partnership as limited partners and make capital contributions that are used to acquire the fund's investments. The contributions are not made immediately, as general partners have traditionally chosen not to manage excess commitments before deploying them, thereby avoiding a potentially negative impact on the fund's performance. Limited partners contribute their capital immediately before a proposed investment, upon receipt of a draw-down notice from the general partner. Usually, a limited partner must provide the requested liquidity within 10 business days. Investors in Trouble
In general, investors trying to unburden themselves of uncalled commitments must also sell their invested fund interest, often at significantly below the net asset value. However, even if an investor finds a buyer, the interest is generally not assignable or transferable without the general partner's prior written consent. Alternatively, the general partner may forfeit the investor's future participation in the fund, with the investor retaining a right to repayment of its draw-down commitment (subject to cash being available in the limited partnership). However, under default provisions in the partnership agreement, this repayment would occur only after the liquidation of the fund and after all other investors received full repayment of their draw-down commitments. This approach proved satisfactory in an earlier economic climate - largely because it was rarely invoked. However, a growing number of investors are unwilling or unable to fulfil their original funding commitments. Some investors simply lack the liquidity to contribute further capital, whereas others (eg, endowments and pension funds) are suffering from the denominator destruction effect. With stock indices hit heavily by broad sell-offs, institutional investors' public equity holdings (ie, the denominators) have fallen in value, while the percentage of overall assets devoted to private equity (ie, the numerator) has risen, leading to a potential breach of portfolio allocation rules. Cash-strapped and overcommitted private equity investors try to reduce their exposure, but in some circumstances even general partners can no longer afford their initial cornerstone commitments to their fund. Possible Solutions
One option for a concerned investor is to transfer outstanding uncalled commitments to a new investor while keeping the stake in the invested portion of the fund. The benefit for the investor is access to a fund in a climate in which relatively few new funds are raised and prices are beginning to look attractive at the threshold of a relatively promising year. In some cases limited partners and the general partner may choose to reduce the size of the fund, thereby retaining their prospects for attractive investment opportunities in the coming months. Buy-out firms recorded a 31% fall in the value of their holdings in 2008, which is thought to be the biggest drop since the 1980s. In one recent transaction the reduction was initiated by the departure of senior fund executives, which triggered a 'key man' clause and allowed the limited partners to renegotiate their commitments. A third option for the general partner is to release the investors from their commitments to the fund, leaving the general partner with no capital to invest, but also free from funding commitments. Comment
Limited partners in private equity funds are rightly concerned about the value and liquidity of investments. However, many general partners have legitimate reasons to consider contractual adaptations to their funds in order to maximize the ultimate returns delivered to limited partners. As the terms of these innovative solutions become more familiar to limited partners, such options may be more frequently employed. In light of the unprecedented challenges that the financial markets have faced recently, investors in private equity owe it to their ultimate beneficiaries to consider reasonable solutions that seek to bridge the funding and expectations gap that has arisen - or may yet arise - in many funds' partnership structures.
For further information on this topic please contact Timothy A Spangler at Kaye Scholer LLP's New York office by telephone (+1 212 836 8000), fax (+1 212 836 8689) or email (firstname.lastname@example.org). Alternatively, please contact Thomas A Jesch at Kaye Scholer LLP's Frankfurt office by telephone (+49 6925 4940), fax (+49 6925 4944 44) or email (email@example.com).
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