Dry powder is a nice thing to have these days. Most GPs have portfolio companies that could use some support. This could mean rescue cash for weak investments and opportunistic bolt-on acquisitions for the strong ones.
But for funds that have drawn down all their capital, finding access to additional funds is going to come at a price.
There are four options for GPs looking for a bit more cash to improve the portfolio. They can raise an annex fund; they can take out a loan from a bank or other third party lender; they can convince their LPs to allow them to recycle some of the proceeds from exits; or they can use capital from a follow-on fund to support an old portfolio company.
Annex fund: It’s a tough market for GPs to raise any kind of fund, let alone an annex fund, a type of vehicle which historically hasn’t shown encouraging returns. Those looking to do this should expect LPs to ask for a cut in the management fee, or a cut in the GP’s portion of the carried interest, says Raj Marphatia, a partner at law firm Ropes & Gray. A GP might also have to offer to integrate the old fund and the new fund, ensuring that investors get back their capital and preferred return from both funds before the GP takes carry.
GPs need to be aware that an annex fund will create a conflict of interest for the GP when pricing an investment, as it owes a fiduciary duty to both investor groups. Even if all the LPs in the original fund choose to re-up for the annex fund, it’s unlikely that they will own the same proportions of the new fund. A GP would benefit from having a consulting firm price the investment, or asking a third party to coinvest alongside it.
Third party loan: If the LPs won’t cough up new dough, GPs can go elsewhere for capital. Getting a bank loan in the current credit markets could be just as difficult, however. Banks are used to giving loans secured by the value of the undrawn commitments in the fund. But by the time a GP needs capital for follow-on investing, there are no more undrawn commitments to collateralise the line of credit. In this case the bank would need to secure the loan with the assets in the portfolio. But portfolio companies are fairly illiquid – the bank would have to sell them if it wanted to recover capital – making those types of loans too risky for most institutions to take on right now. For these reasons, banks want a large cushion, so loan-to-value ratios are hovering down around 10 to 15 percent, Marphatia says. GPs also might also be subject to contractual limits in the LPA on the amount of debt they can take on at the fund level.
Crossover investments: In some circumstances a GP can use capital from one fund to support the portfolio companies in an earlier fund. Usually, this is not prohibited in the LPA, but it does tend to require the approval of the investment committee. Turnaround firm Sun Capital executed a variation on this strategy this April when it reinvested $75 million from its $6 billion fifth buyout fund in the portfolio companies of its $1.5 billion fourth fund.
“A normal reaction might be, ‘I wanted you to find new investments, not make investments in your predecessor fund’,” Marphatia cautions. “That’s the hurdle that the GP has to overcome when it seeks to make that kind of investment.”
Recycle capital: Many LPAs prohibit GPs from recycling the proceeds of an exit back into the portfolio, so GPs who wish to do this may have to go back to their LPs for permission. Getting the LPs to agree to this type of amendment is very difficult, especially at a time when many LPs are suffering from a liquidity crisis of their own and are thirsty for distributions. If a GP obtains approval, he may only be allowed to recycle a small percentage of the proceeds, and he will probably have a limited time horizon, perhaps 12 to 18 months after exit, in which he can reinvest the proceeds.
“Obviously it’s really hard to get LPs in this climate to open up their wallets in that manner,” Marphatia says. “At that point you may as well set up an annex fund, because that’s what it is. You’re asking people to give you more money.”
Marphatia adds that there is uncertainty over what sort of consent is required to make this sort of fund terms amendment. Because in a sense, allowing the fund to recycle a portion of the proceeds is equivalent to increasing the size of every LP’s commitment, it may require unanimous consent rather than a simple majority.
Of course, generating proceeds in this environment may be the most challenging task of all.