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Editor’s Letter: Weighing restructuring against millions in fees

Here’s an eye-catching number that helps explain why many LPs hold their noses as they approve fund restructurings and give GPs more time to harvest investments in funds that may not earn a return for existing investors:

First Reserve has collected more than $500 million in fees in Fund XI, which closed on $7.8 billion in 2006, according to CalPERS private equity chief Real Desrochers in a letter to First Reserve.

This, along with fee streams from subsequent funds, should be more than enough for the firm to manage down assets in Fund XI during its natural term, which ends this year but comes with two one-year extensions.

Desrochers, in a letter obtained by Buyouts from outside sources, argued that the restructuring proposal primarily benefits First Reserve and the secondary buyers in the deal, and not existing investors, who are not expected to get a return on Fund XI.

Desrochers’s point is that with all the fees the firm has collected over the years, the restructuring should not be necessary to keep the investment team motivated to manage down the fund in its natural course.

His argument makes sense, but the other side of this is that Fund XI has remaining value, which needs to be managed out to maximize value for investors. The firm shouldn’t be rushed to exit remaining investments, especially into today’s market, which many believe is at or near the bottom.

The term on the restructuring would give First Reserve another four years to manage out Fund XI, ample time to find the best value for the remaining investments.

For LPs, this is a tough situation: Do you force the GP to find exits for older investments perhaps prematurely, considering the tough energy environment? Or do you give the manager more time as well as reset management fees and a chance for carried interest despite failing to earn a return on the fund after 10 years?

To be clear, this deal proposes to enable existing LPs to roll their interests into the restructured fund on a no-fee, no-carried-interest basis. Only the new investors, which include Pantheon and Intermediate Capital Group, would pay management fees and carry. Existing LPs could also choose to sell, and it’s not clear at what price they could exit their holdings.

It’s a situation many LPs have encountered, and will continue to deal with as long as PE managers promise to invest a fund in 10 years and fail to live up to their promises. And let’s be honest: LPs to some extent have only themselves to blame in situations like this. They agreed to the terms, they chose the manager, and they failed to secure some sort of end-of-fund-life protection to force the GP to close the fund at the end of the 10- or 12-year life.

Restructurings are here to stay, and the problem of long-lived funds, even zombie funds — run by managers with no hope of raising a new fund — is not going away. They have been a much more significant part of the secondary market, and in fact have helped drive overall volume. Several big-name firms, including Lee Equity and Irving Place Capital, have been through restructurings. JC Flowers & Co  also recently completed a restructuring of its second fund, which has underperformed.

Several more firms are considering restructuring or some other form of liquidity option for limited partners looking for exits in funds that are living beyond their contractual terms, sources have said in recent interviews.

It’s a solution to a problem — the problem of funds that just won’t close down, despite living for 10 or more years. It’s just a choice many LPs have to make while holding their noses.

Photo: Private Equity Editor Chris Witkowsky reflects at home. Photo by Wendy Witkowsky