LPs face challenge of GPs who come back to market early

Perhaps the biggest challenge LPs face in today’s bullish fundraising market is dealing with their preferred GPs coming back with new, larger funds earlier than expected, with scant realizations in prior funds to prove out a track record.

The GP, without much proof of concept in the prior fund because of few or no exits, now claims to be adept at navigating even larger deals. But at some point the GP’s skillset and networks are less relevant for the increasing size of deals, one LP source told Buyouts in a recent interview.

LPs are increasingly scrutinizing this issue in a fundraising environment that shows signs of reaching near-record levels. Preqin reported recently that 206 private equity funds held final closes in the second quarter, collecting $121 billion — $21 billion more than was raised in the first quarter.

Sam Green, who recently left the Oregon State Treasurer’s office where he worked as a senior private equity investment official, said GPs are scrambling to raise as much money as possible in this  environment, in part because of fears the economy could turn down, drying up investor appetite for new funds.

“It seems we are late in the economic cycle, and one never knows when it is going to turn south. So GPs are motivated to raise a fund while the raising is good,” Green said.

The big issue is exactly how deployed the prior fund is; LPs like to see around 75 percent of the capital in the prior fund invested. But that deployment total usually includes some amount in reserve for fees, add-ons and other things. Ideally, LPs like to see fee reserves around 15 percent of the fund, but LPs who talked to Buyouts said they’ve seen GPs come back to market with 50 percent or 60 percent of the fund in the ground.

GPs also use subscription lines of credit to fund acquisitions, which can distort the capital called percentage, Green said.

“While a fund may only be 45 percent called, it may be 75 percent committed due to outstanding credit lines,” Green said. “The capital calls to the LPs will be coming; they are only delayed while using the lenders’ lower-cost capital.”

A second LP said coming back early with a larger fund is “indicative of a manager that has migrated to become an asset gatherer. The management fee becomes the annuity stream and the [carried interest] a free call option. The AUM becomes more important than the MOIC.”

The second LP conceded: “We get it, as business people, they’d rather have steady streams of cash and less volatility. … They’d love to diversify their product offerings to target the small end of the market, the middle market, and then add a debt fund. More AUM, less risk to the overall platform if one fund stumbles.”

While LPs may find this dynamic a challenging aspect of the fundraising environment, it is not preventing them from committing to new funds in the market.

Action Item: Read Preqin’s research here: http://bit.ly/2tf3QYT

Photo: Female hands with money. Solar panels in the background. Photo courtesy of vencavolrab/iStock/Getty Images.