Every year an increasing number of funds reach the end of their planned ten-year term. In 1997, 309 private equity funds were raised, meaning that all those that have not already been liquidated will reach the decade mark this year (source: VenturExpert).
At the end of a fund’s term, the General Partner has two basic options:
1. The GP can extend the life of the fund, usually for several years at its discretion without the need for LP approval. The GP can then proceed at its own pace in selling the remaining assets of the fund, possibly culminating with the creation of a liquidating trust.
2. Sell the entire remaining portfolio to a secondary fund such as my employer, VCFA Group. Despite the growing number of funds reaching their end of life and the increasing prevalence of the secondary market, each year there are relatively few transactions where a GP sells off its entire portfolio of an older fund.
Having spoken with many General Partners about end-of-life transactions, I believe that there are a number of common misconceptions about the topic. Here are what I consider to be the top five myths held by General Partners about end-of-life fund sales.
1. My LPs want me to get every last dollar
The most common myth that I have heard from GPs is that their LPs want every last dollar of value from the remaining assets in the fund. There will inevitably be some investors (generally individuals who made smaller investments) focused on incremental gains at the end of a ten year period. However, most institutional investors have already realized the vast majority of gains or losses before the fund enters the extension period. In many cases, GPs have subsequently raised substantially larger funds. Investors who have continually re-upped in funds typically will prefer the GP to focus attention on managing the newer funds where they have greater potential for gain. I recently met with a fund group that had an older fund of approximately $100mm. Given that their last fund exceeded $1 billion in size and many investors had continued, the older fund was increasingly recognized as a drag on operations.
2. There are no administrative costs to managing my older fund
Senior partners often underestimate the administrative costs of managing an older fund because much of the responsibility falls to their subordinates. Many fund CFOs have confided in me that they spend far too much time with older funds. This can be exceedingly frustrating since many older investors are no longer active in the GP’s funds. Most private equity firms, even those funds that focus on operational efficiency in their portfolio companies, spend remarkably little time on their own firm’s operations. Before dismissing the cost of managing an older fund, the GP should make certain that there is a clear understanding of the true process and procedures. Nordstrom had a policy whereby they would annually “fire” some of their least profitable customers. A similar vetting of a fund’s investor base could also improve fund operations.
3. Only my partners and I know how to extract the value from these companies
Many times the companies remaining in a fund past its ten-year mark have made substantial changes to their businesses. In such cases, the individual who led the investment (assuming he or she is still a fund employee) may no longer be the best person for the current operation. A fresh look at assets from a new party can often find new ways to create value. An end of life transaction also does not necessarily end the involvement of the former GP. A secondary firm may create a new management agreement with former members of the GP with a particular expertise managing the portfolio.
4. There is a stigma associated with the secondary market
Some GPs mistakenly believe that using the secondary market at the end of a fund’s life is an admission of failure to the LPs. We have found that, to the contrary, Limited Partners appreciate getting cash sooner rather than later. LPs have often already significantly discounted potential future fund cash flows and see any remaining distributions as a bonus. As the secondary market for LP interests has matured, GPs are beginning to understand how they can use this market to their benefit.
5. I have better things to focus on
GPs who have raised subsequent funds are often quick to dismiss an end-of-life sale on an older fund as a low priority. Indeed, there are other, more profitable activities for a GP to be engaging in. But isn’t that exactly the point? A sale to a secondary firm may take a little more time upfront than the status quo. However, in the long-term there will be a time savings as a sale frees whatever resources were previously devoted to the sold fund. If General Partners could aggregate the time they spend on older funds they would likely realize that a secondary transaction enables them to focus on better things.
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