Gaining Room To Maneuver

When buyout shops generate windfall profits by moving outside their usual investment strategies, limited partners applaud their “flexibility and adaptability,” a buyout professional recently told me. Of course, when the strategy fails, limited partners have occasion to use another phrase: “style drift.”

In today’s somewhat depressed market, buyout firms have more time on their hands than usual to contemplate shifting gears in response to changing market conditions. Just to mention some of the ideas floating in the wind right now: investing in buyouts outside the United States where credit markets may be more accommodating; investing in the depressed real estate market; supplying mezzanine and other forms of debt financing to portfolio companies; buying hung bridges; investing in the securities of public companies that could become buyout targets; and investing in distressed companies. Just this month, Buyouts learned that Audax Group, a Boston mid-market buyout shop, has launched an effort to raise its first senior debt and distressed debt fund.

Those considering the diversification path have two main options. One is to chase such opportunities through their main limited partnerships. The other is to assemble a separate fund dedicated to the new strategy. I’ll talk mainly about the first option here, since that’s the more viable one in the short term for most firms. The primary obstacle to using a core fund to pursue a new strategy is the fine print in partnership agreements. Most include caps on how much of a fund can be deployed outside of the United States, and how much can be invested in public securities. Many have an outright prohibition on real estate investments (beyond the ancillary real estate holdings of portfolio companies) and on hostile takeover deals. So-called “purpose” clauses have also sprung up in partnership agreements to present another roadblock. Arising in response to egregious cases of style drift in the dot-com era, they in effect instruct the buyout firm to follow the investment strategy outlined in their PPMs.

That said, David Watson, a fund attorney at Goodwin Procter LLP, said that he’s seen a slow movement over the last few years toward allowing firms more flexibility. In many funds, outright prohibitions on real estate investments have given way to wording that lets firms buy property management companies, according to Watson, who works on some 30 to 35 buyout funds a year, mainly in the $1 billion to $5 billion size range. Some agreements go so far as to let firms buy property development companies, even though those companies may be taking risks associated with the rise and fall of the real estate market. Putting aside first-time funds, close to half of Watson’s clients can now invest in property management or development companies.

Some buyout firms also are being granted more leeway to invest in public securities. A typical partnership agreement a few years back would let a buyout shop invest up to 5 percent of its fund in public securities, but only in companies that are in the firm’s sights for a take-private. Today, Watson said, perhaps 20 percent of his clients (outside first-time funds) have the flexibility to invest a ratcheted-up 8 percent to 10 percent of their fund in public securities. Moreover, they often now have the green light to invest in companies that they don’t necessarily plan to bid on; in one sense this converts a portion of a buyout fund into a merger-arbitrage hedge fund.

On the international front, Watson has also seen some movement. Traditional partnership agreements place a cap of 5 percent or 10 percent on international investments, or investments in a particular region, Watson said. In perhaps one in 10 funds that Watson works on, he’s seen that cap get bumped up by 5 percentage points. Needless to say, not a lot of firms have the expertise to invest outside their favorite haunts, and very few press LPs on this issue.

Heather Stone, chair of the fund formation practice group at Edwards Angell Palmer & Dodge LLP hasn’t seen the same movement toward more investment flexibility—but then she works on smaller buyout funds than Watson does, mainly ones of $600 million to $1.5 billion. If anything, her clients tend to jettison investment strategies over time that don’t prove fruitful. As a result they become even more focused over time. Still, Stone said she wouldn’t be surprised to see her clients step up to do more debt investing through their core funds as pricing in that part of the market proves irresistible. Often buyout firms have the flexibility to do so given the way their investment strategies are typically worded in their PPMs. Stone also said she expects more small and mid-sized buyout firms to follow the lead of mega-firms by launching separate mezzanine, debt and distressed debt funds in the months ahead.