Does Private Equity Really Have Long-Term Capital?

At a recent private equity conference, Stephen Schwarzman was asked why he thinks Blackstone’s share price has fared better than those of the investment banks (see Erin Griffith’s summary here). Schwarzman attributed Blackstone’s relative resilience to the fact that it has long-term capital and is not subject to the daily money-market pressures required to support trading operations. Indeed, a key benefit of the private equity business model is that you can afford to be patient with your portfolio companies. However, the long-term nature of private equity capital is often overstated. Private equity funds have commitments from investors to call capital as needed to make investments. Most funds hold just minimal cash or other assets that could be considered actual long-term capital.

While skeptics may wish to dismiss as semantics the distinction between commitments for and actual long-term capital, in periods of economic stress this difference can be highly problematic. Individual investors are often the first to default on capital calls. In the Internet boom, many of the founders and early employees of recently IPOed startups made commitments to venture capital funds with ten-year partnerships. When the market value of their stock options collapsed, many of these investors were unable to meet their capital calls—so much for long-term capital. My firm, VCFA Group, purchased many of these commitments on a secondary basis and assumed the investors’ capital calls. Our founder is fond of calling these individuals “the formerly rich.”

In today’s environment, the General Partners of private equity funds may be less concerned about individual investors and more concerned about financial institutions. Will funds that have commitments from Bear, Lehman or AIG be able to call down committed capital? While most financial institutions have segmented their private equity programs so that General Partners should be protected, there is indisputably increased risk for these once-solid institutions. Indeed, most secondary firms have seen increased activity from financial services firms (though few deals have closed to date).

Outside of financial services, the economic ripple effect of the credit crisis has had far reaching impact. Some of the world’s most conservative endowments and pension funds have suffered substantial losses in portions of their portfolio that were never intended to generate returns much more than basis points above treasuries. Private equity investors that had substantial investments in public equities and poorly performing hedge funds are suffering the “denominator effect”—private equity has become an increasing portion of the overall asset portfolio with the decline of the overall base. These institutions may suddenly find themselves over-allocated to private equity.  In many cases long-term capital from “blue-chip investors” suddenly seems less certain.

Even commitments from government institutions can be uncertain. Sovereign wealth funds from the Middle East and Asia are among today’s most coveted LPs. Some say that it is absurd to think that any of these state-sponsored funds would default. While an actual default is unlikely, there is precedence for governments wavering on their commitments. The United States Government established the SBIC program in the late 1950s to facilitate capital flows to small businesses. Through the program, the U.S. government became a special limited partner in many small private equity funds. When the program suffered massive losses in the late 1990s, many SBIC funds worried that the government would be unable or unwilling to meet its financing obligations. The resultant market disruption was a tremendous distraction for the operations of many SBIC funds and investing came to a halt. In recent years, VCFA has been the pioneer in purchasing the government interests in SBIC funds, helping these funds move to their next phase. Now suppose foreign governments begin to take massive losses on investments in U.S. private equity and other related assets (as may very well be the case). The mere notion that these funds might not fulfill their capital obligations could become tremendously destabilizing for GPs, likely paralyzing their activities. In the absence of a default, a sovereign wealth fund might ask for changes to the partnership agreement that the General Partner finds objectionable. A General Partner would be forced to hire a team of lawyers to be prepared for multiple scenarios.
  
As the global economy has been strong for many years, collecting capital calls has been a minimal problem for most General Partners. This may be changing. Over the last several months, I have been fielding calls from investors in private equity who do not believe they will not be able to meet their future capital calls. General Partners should proactively examine their LP base for potentially weak individuals or entities. While there are always legal procedures defined in the event of a capital call default, it is almost always better for all involved that the partnership interest be transferred before any default. Smart GPs will anticipate defaults and plan ahead to ensure minimal disruption. All General Partners want to avoid the nightmare scenario of having a great deal signed and ready to close only to find out that one of their “formerly rich” LPs cannot meet a capital call.

David Tom works with VCFA Group, where he focuses on the sourcing of secondary purchase opportunities. He can be reached at dtom@vcfa.com.