When Good Performance Is A Bad Thing (Part 2)

Last week we discussed the perils of earning returns too early. It’s happening in the distressed debt world, where firms have earned returns on funds that are still in the process of being raised. If the firm continues to raise capital, it will dilute the performance of the existing investors. Furthermore, new investors will need to support the carrying cost of their investments on their own balance sheets, which makes the fund less desirable.

The phenomenon has apparently infected private equity funds as well. This week Private Equity Insider reported that Avista Capital’s LPs aren’t too excited about the fact that the firm used the strong early performance of its second fund as a way to lure investors into it, pitching a sort of “J-curve-free” fund. Avista Capital allowed new investors to buy into the old investments for only a small buy-in fee, diluting existing investors and making them feel they weren’t properly valued for their early commitment to the fund. Existing investors approved the move, yet they’re not happy about it, PE Insider reported. Seems those investors had a choice in the matter and made the wrong decision…

Regardless, it’s a situation that may arise more frequently with firms taking longer and longer to raise their funds. By the time many of these funds hold a final close-Madison Dearborn’s two-plus year fundraise which closed last month is a good example, some of them are halfway into their investment period. It’s important that the funds raised over long periods invest the money along the way, otherwise their investment period is greatly diminished at the final close. Typically new investors don’t get to take part in the old investments without paying a premium. Avista allowed new investors to get a piece of already written-up investments for a small interest rate.

Maybe it’s not the greatest move in the world, but desperate fundraising times call for desperate GPs. Considering the initial investors voted to approve of the allowance and of Avista’s fundraising extension, it sounds like sour grapes to me.