Pledge drive

Pledge funds are gaining steam among newer GP groups trying to make an impression with LPs. But the deal-by-deal funding model has some serious weaknesses that fund managers and LPs need to consider.

With private equity firms having greater difficulty fundraising than ever before, more managers – especially newer sponsors – are turning to “pledge funds” to deal with the current market challenges. And if LPs continue to have the upper hand in negotiations, it’s likely that such vehicles will gain further ground over traditional private equity funds.

Pledge funds are private equity investment platforms where, unlike in a traditional committed fund, investors provide no commitment to fund all the manager’s deals, but only agree to consider providing capital on a deal-by-deal basis. Such vehicles are especially well suited to firms that have not yet established a track record to secure a traditional fund close.

“I think it’s a good thing for all the new sponsors that are starting up, the guys who have come out of Lehman or Goldman or whoever, or who have been affected by the credit crunch, who are looking around to try and raise funds or who are finding it very difficult to get commitments,” said Adam Levin, partner at law firm Dechert. “The people who are in that position have great contacts in the industry, great opportunities through their prior employment to do deals but who don’t have the track record. And with the natural reluctance of LPs to make commitments particularly at a time when they’ve got all these other commitments that potentially are going to go unhonoured, this is a way for LPs to stay open to deal flow opportunities.”

However, Levin says recent franchise-imperiling developments at firms such as PAI Partners may even make more established funds start to consider the pledge fund model going forward. LPs have been gaining ground in negotiations with PAI and there’s now a deal to reduce outstanding commitments by 50 percent in the French firm's latest buyout fund.

“Essentially PAI kept coming up with deal after deal, with the last one saying ‘Let’s chop the size of the fund in half as long as you all come up with your commitments and honour it’, which shows you the pressures out there in the marketplace on the managers,” Levin said. “So they are really stuck between being able to do the deals and keeping the relationships that they’ve got with their LPs. If they start to enforce the provisions in their fund documentation as to what happens when an LP defaults, does anyone seriously think they will stand a chance of getting any future commitments from those investors? No.”

It may make sense, then, that a platform which offers investors improved control over the choice of investments might prove popular. But there are several pros and cons for managers who use such vehicles.

“There is potential for a big shakeup in the industry if this catches on,” Levin said. “There are a number of significant ramifications for the whole of the industry and people had better be alive to that fact and go into this with open eyes before they start doing it. And if they do start doing it in a routine way, private equity fund managers are going to have a totally different perception in the marketplace as regards how they can do deals.”

One such ramification concerns when a private equity fund manager shows up for an auction. “The first thing that a seller is going to say is ‘how can you commit to this auction process if you haven’t got a committed fund behind you?’” Levin said. “The manager may be forced to either give a separate confirmation or have a confirmation from their LPs that they would be committed to fund the deal if the deal goes ahead. So essentially you may well find a private equity manager needs more consensus than they would have before from LPs on their choice of deals, and that may well put them at a disadvantage in a highly competitive, fast-moving situation.”

Issues around confidentiality will raise their heads when the deal is shown to LPs, and that will have an impact on an auction situation where the seller wants to keep a low profile, but if the manager is showing it to the investors as a condition for them effectively funding the deal, it may get out to a wider circle than normal. This is even more of a concern for public deals.

Another ramification would be felt in the leverage market. “Because when the deal comes out, usually the banks are making the assumption that when the private equity fund said they were putting down 50 percent or 60 percent or 70 percent, that that was a done deal,” Levin said. “Now they may feel more cautious about those statements for a pledge fund and they may need to seek assurances from the LPs directly, and do GPs really want their LPs to be talking to the banks?  They will probably have to come up with some sort of process to evolve for that to occur.”

Finally, questions remain about how the carry is going to work in situations where a LP goes into one deal but not the next. “Let’s say the first deal is a loss situation, and the equity is wiped out,” Levin said. “If you are in a fund and you funded both deals, the home run you hit on the second deal would sort of take care of the first deal in part or in full.

But if you don’t have an exposure to all the investments you could find yourself in the position that the fund manager is seeing that he’s got a home run on deal number 2 but on deal number 1, which needs a lot of time and attention because otherwise it is looking disastrous, the manager says ‘well I’m going to make no carry on that, so why should I spend a lot of time on that, I’d rather focus on the area where I’m going to get a lot of carry’. But the fact is that the investors in deal number 1 who had no exposure to deal number 2 have no benefit of that.”

Such considerations mean that, for all the flexibility that accrues from going without a fixed fund agreement, managers should not go the pledge fund route lightly.