Every firm wants returns, but sometimes getting them too early can cause unexpected complications. This is specifically true for a number of distressed debt firms, which earned returns on funds that were still in the process of being raised.
To illustrate, let’s take a look at a firm whose name I’ve promised not to share (sorry). It entered the market with a $1 billion-targeted fund last year and gathered commitments worth around $500 million. Seeing a strong opportunity as distressed debt trading levels rose, the firm held a number of closes on the capital and invested it.
The value of distressed debt improved so dramatically in 2009 that the firm’s invested capital generated an IRR of 60% in just six months. That’s great news, except those returns, which occurred during fundraising, create a tricky conflict for a manager of a closed-end fund.
If the firm continues to raise capital, it will dilute the performance of the existing investors, which includes a large commitment from the GPs themselves. Furthermore, new investors will need to support the carrying cost of their investments on their own balance sheets, which makes the fund less desirable.
So the firm is considering closing its fund, even though it’s only halfway to its target. Now that the distressed debt rally has largely subsided, investors will need to compete for LP money based on strategy and scale; strong performance during last year’s “rising tide” may be less impressive.
Generating returns while fundraising isn’t a conflict many traditional private equity firms face; their 10-year funds typically include a five year investment period and a five year hold period for investments. But as more distressed debt hedge funds convert to closed-end private equity funds to avoid redemptions, we could see this issue occurring up more often.
Take your pick!
- Buyouts delivers exclusive news and analysis about private equity deals, fundraising, top-quartile managers and more. Get your FREE trial or subscribe now.
- VC Journal provides exclusive news and analysis about venture capital deals, fundraising, top-quartile investors and more. Get your FREE trial or subscribe now.