First Reserve revamp hits snag as LP sales come up short of target

First Reserve’s restructuring of its 11th fund has hit a roadblock.

Fund XI LPs recently approved the proposed revamp, which enables current LPs to either sell their stakes in the 2006 fund or roll their interests into a new vehicle that will house four portfolio companies.

But a key aspect of the deal was to get a certain amount of current LPs to sell their interests in the $7.8 billion fund, and that did not happen, according to two people with knowledge of the process.

LPs could sell their stakes for 96 percent of net asset value as of March 31, 2016, if they took full payment up front. They could also choose to take 60 percent of the payment up front and the rest in 18 months. Those LPs would make almost 102 percent of NAV as of that date.

Two buyers — Pantheon and Intermediate Capital Group — were set to buy existing LP stakes as part of the transaction. Those two buyers would also pay management fees and carried interest in the restructure vehicle. (Current LPs who rolled their stakes into the new fund would not pay fees or carry.)

To make the deal worthwhile, the buyers set a minimum of $175 million of existing-LP sales, with a ceiling of $400 million. The deal generated only about $88 million of existing-LP sales, the first person, an LP with knowledge of the deal, said.

So First Reserve must continue talks with the new investors and current LPs on how to move forward, the two people said. How the deal could change and how long that could take are unclear.

Sticking point

One point that may have caused some LPs not to sell was the reference date First Reserve used to price LP interests in the fund — March 31, 2016. Some LPs, including Real Desrochers, head of PE at California Public Employees’ Retirement System, felt that date represented the bottom of the cycle.

CalPERS is a member of the Fund XI limited-partner advisory committee and voted against the revamp in an LPAC vote earlier this summer.

“The fund is seeking to sell assets at valuations at the bottom of the cycle and at 3/31/2016 valuations that have already rebounded,” Desrochers wrote to First Reserve in June.

LPs “didn’t want to sell at a price that was struck at the market low,” the LP said. Both the public markets and oil prices have rebounded slightly since March 31, though oil prices have fallen back since peaking above $50 a barrel in May.

Part of this calculation is that the LPs believe the remaining portfolio companies will increase in value over time, and so they choose to sit on their fund stakes. It can be challenging to persuade an LP to sell fund interests and lock in at a price that might seem low in a few years, one secondary-market source said.

First Reserve proposed to restructure Fund XI to provide a four-year term and reset economics to finish selling off four remaining assets: FR Midstream Holdings LLC, Cobalt International Energy, Deep Gulf Energy LP II and Energy Credit Partners. (Certain other remaining investments in Fund XI are not being moved to the restructure vehicle.)

The goal of the restructuring was the return LPs’ principal, according to a letter First Reserve sent to LPs about the proposal earlier this year.

Fund XI was generating a negative 11.4 percent internal rate of return and a negative 0.63x multiple as of March 31, 2015, Oregon Public Employees Retirement Fund data shows.

Hitting the finish line

GP-led transactions like fund restructurings have become the hottest activity in the secondary market. Greenhill Cogent found GP-led transactions made up more than 30 percent of overall volume in the first half of 2016, more than twice the 15 percent of first-half volume last year. And Cogent says second-half volume will be led by GP-led deals, especially in challenged sectors like energy.

As activity around GP-led deals increases, so has the number of broken deals, or situations where GPs tested the market and then backed away, Cogent said.

These deals “require the right mix of motivations and underlying characteristics … to achieve a successful outcome. … [Some] GPs have experienced that this type of transaction is not a cure-all for every situation after exploring alternatives and receiving low interest or pricing,” Cogent said.

In a process like First Reserve, hitting a target amount of selling LPs is important for buyers to justify the expense of the deal, sources said.

Action Item: Greenhill Cogent’s secondary-market report:  http://www.greenhill.com/business/capital-advisory/secondary-advisory

William Macaulay,  chairman and chief executive of First Reserve, at his office in Greenwich, Connecticut. Photo courtesy of the firm.