It's not over yet

The over-commitment strategy used by many listed private equity vehicles has gone from being a virtue to a vice, but it will survive

Two recent events have highlighted the delicately balanced predicament of listed private equity vehicles in the UK. Drastic action from both SVG Capital and Candover Investments – two Londonlisted investment vehicles feeding capital into buyout houses Permira and Candover respectively – showed that when the over-commitment strategies they employ come unstuck, the consequences can be serious.

Put simply, an over-commitment strategy involves a fund making capital commitments in excess of its asset base and relying on cash distributions to meet capital calls as they come in. This lets the fund put as much capital to work as possible and minimises the negative impact of cash drag on returns. This works, provided the distributions keep rolling in.

When distributions dry up, however, as they have done as a result of the market meltdown, the strategy hits a wall.

Candover Investments, the London-listed entity that owns Candover and invests in its funds, recently had to slash its €1 billion commitment to the firm's €3 billion 2008 buyout fund.

A couple of months earlier SVG Capital, a listed vehicle that invests most of its capital in funds managed by Permira, confirmed it had taken several steps to shore up its balance sheet, one of which involved cutting its €2.8 billion commitment to Permira IV by 40 percent.

Over-stretched over-commitment strategies have been cited by industry analysts as a cause for concern for several London-listed private equity investment trusts (PEITs), including F&C Private Equity, Standard Life European Private Equity and Partners Group's Princess Private Equity. “Funding calls could become a challenge and we have already seen some companies effectively forced to sell fund interests at discounts in order to improve their balance sheets,” said JPMorgan Cazenove analyst Chris Brown in a research note back in November.

Combined with other analyst bugbears, such as high leverage at both company or portfolio level and scepticism about the real value of underlying portfolio companies, the over-commitment issue has led to record-breaking discounting among listed PEITs. At the time of writing Candover was trading at a discount to net asset value of over 81 percent. F&C Private Equity Trust – a PEIT with a net asset value of £178 million – was trading at a 79 percent discount, while Pantheon International Participations – a trust managed by fund of funds manager Pantheon Ventures – was 83 percent down. These examples are at the larger end of the scale: the average discount to NAV is nearer 64 percent.

With the unprecedented slowdown in distributions last year, the vulnerability of over-commitment strategies has been exposed and what was previously accepted as a fundamental element of private equity fund of funds management has become a dirty word. “It has gone from being a virtue to a vice,” says one PEIT manager.

But before critics inside and outside the industry round on this latest “vice”, it is worth considering why it has for a long time been considered essential. Managers with a given pool of uninvested cash are obliged to use it as efficiently as possible. Sitting on a pile of cash is not efficient: the cash drag will kill returns.

Even if a manager immediately commits 100 percent of his capital to underlying funds, it will still take up to five years to get the money ‘into the ground’, and even then the GPs probably won't draw down the full 100 percent. Then there are the cash distributions: they can't just sit on the balance sheet either, they need reinvesting. Over-commitment, if employed wisely, is the right tool to deal with these issues.

So has the strategy now been exposed as bunk? No. Recently the parameters of over-commitment have been shown to be out of line with reality. They were formulated in better times, based on assumptions of future cash distributions. If managers before the credit crunch foresaw distributions continuing apace – and unless they were Nostradamus or NassimTaleb (of Black Swan fame) they probably would have done – they would have upped their commitment levels or risked sitting on unused capital.

As a result, the ebbing tide has exposed a few bathers with no trunks on. Like many strategies in all lines of business, over-commitment in private equity will have to be adjusted in light of the Black Swan events of the past 18 months. It will not, however, be scrapped altogether. Investors in private equity funds, whose aim is to manage their capital efficiently, will continue to rely on it.