Most private equity pros believe that if you do right by your LPs today, then they’ll do right by you when it comes time to raise the next fund. It’s a sensible equation, but is also subject to a giant sinkhole: What if there isn’t going to be a next fund?
That seems to be the dilemma facing Cypress Group, a New York-based buyout firm that is basically running out the string. Cypress raised $2.35 billion for its second fund in 1999 — a very heady number for its time – but has not successfully returned to market since. Most of the firm’s troubles have been lousy returns for both Funds I and II, and it’s been additionally stung by a series of high-profile personnel defections (including co-founder James Singleton and former president William Spiegel).
Cypress also had some troubles investing all of its Fund II capital in the allotted time period. Early last year, the firm asked LPs for an investment period extension. Such amendments are usually majority-rules, but Cypress allowed dissenters to stop funding – with the understanding that they couldn’t participate in new deals, and would be diluted if existing portfolio companies raised follow-on rounds. This was doing right by LPs, and most agreed to the extension.
Fast forward to this past September, and Cypress called down around $120 million in new capital. It was designated for a series of follow-on investments, and came shortly before the extended investment period was set to expire (which happened last week). Cypress invested about half the money, but held off on two final deals because of what a source refers to as “timing issues.”
This is where we get to a buyout firm behaving badly. Most firms in this situation would either return to un-invested capital to LPs, or request yet another investment period extension. Cypress, however, has given LPs the following choice: (a) Let us hold onto the money until we choose to invest it; or (b) We’ll return the money to LPs, but only with a new agreement that we can recall it at will.
I’m not arguing that any of this violates Cypress’ limited partnership agreements (which I have not seen), but rather that it’s an egregious example of bad faith. It’s almost as if Cypress is holding the money hostage, and is only willing to lend it back to its rightful owners.
So why would Cypress do this? CEO Jim Stern declined to be interviewed, but here is the prevailing theory from multiple LP sources: Cypress so far has collected approximately $50 million in carried interest on Fund II, but currently is far enough underwater that it can’t even see its hurdles. That would mean a brutal clawback, and a make-good on its promise to track down former partners for their share of the cash.
The only way around it – save for negotiation – would be to throw extra cash at existing portfolio companies, in the hopes that one of them becomes an unexpected floatation device.
It’s a strategy that makes sense as economic theory, but wouldn’t pass muster in most pragmatic biz school classrooms. Unless, of course, everyone acknowledges that the business in question doesn’t have a future…