Winding down leads to in-kind conundrums

Alchemy Partners co-founder Jon Moulton, in a resignation letter sent earlier this month, boldly advised the firm’s LPs to push for a winding down its main fund and break up the portfolio. While such actions remain rare, firms that go this route may find themselves in possession of assets that they can’t sell, and this may cause friction with LPs.

London-based Alchemy’s investors have not made a decision on whether to liquidate the fund, referred as an “Investment Plan” by Moulton.

Fund wind-downs are rare in private equity, where assets tend to be illiquid, but common in today's hedge fund market, where assets tend to be more liquid (but not always). Other firms in similar positions include listed hedge fund Financial Risk Management, which told its investors this summer they should vote to shut down the $70.2 million Alpha fund and have their money returned. Meanwhile, Citigroup announced in April it was winding down its Citi Alternatives Distribution group, while Finvest Fund Management earlier said it has successfully wound down the US segment of its Finvest Yankee fund and returned cash to investors.

The process for Alchemy may be different due to its unusual funding structure – the firm raises a new pot of capital every year. Should the fund be liquidated and the portfolio broken up, the portfolio companies could get sold to a secondaries fund, in which case a solution would have to be found that worked for many different LPs who may have different investments across various years. 
Another issue would involve deciding who would manage any assets purchased.

For a standard fund with a 10-year term and fixed investment period, the first issue that comes up in a wind-down involves what happens when you have some investments that you cannot sell. “The first fallback is – and this is just the ordinary course – the fund hasn’t sold all its investments because the market is not good, it is not easy to exit, people may not want to be selling things they are holding,” said Michael Harrell, co-chair of the global private funds group of Debevoise & Plimpton. “They may need to get an extension, so sometimes the partnership agreement provides for an extension and then you just have to look at those provisions and see what consent is required and extend it.”

Firms that have already played out their extension may have to get another one, and the typical question then is what LP vote is needed. One conflict that can come up is over whether to charge a management fee during the extension period. “A lot of LPs worry about the term continually being extended because they think the GP is holding a crummy investment, but will just keep extending it rather than getting rid of the thing in order to keep collecting management fees,” Harrell said. “That in the real world is not a serious problem because the general partner wants to get rid of it if it is a dog unless he thinks it can really come back, and usually the fee is based on, at that point, invested capital, so they are not getting the big fees they got up front.”

If the LPs will not extend the term, then typically the GP has to wind down the fund and try to sell off all the assets in an orderly fashion, usually within a year or so. What most partnership agreements say is that GPs will use best efforts to reduce the holdings to cash. But if they can’t do that, then they’ll determine a value for their (often private) shares. With the LPs wanting to make sure it’s a fair value, this may require hiring a third-party to value it ahead of a distribution.

“The GP would like obviously to sell the remaining investments when the markets improve at a profit, and get some carry and the LPs get cash and everyone is happy,” Harrell said. “If that still doesn’t work out, and the term is over or, for example, the firm is out of business and they are just winding down the fund and can’t get rid of the asset, then they might need to distribute shares of the company in-kind to limited partners. That’s a problem for limited partners because they aren’t able to manage those usually.”

In those conditions, GPs either have to sell shares in a fire sale or distribute them to the limited partners. But LPs typically don’t want to be holding stock of the private company. “They just can’t deal with it, that’s why they hired the private equity firm in the first place, to manage these investments,” notes Harrell.

Such considerations are likely why in-kind distributions of private or public shares remain relatively rare, with GPs instead more often seeking an extension.

Harrell said the main task for GPs is to be up front in their communications with LPs. “Often the limited partners will say, 'I don’t want securities, just sell them at what you can get',” he said. “I think in general the GPs know the limited partners do not want securities typically, but when you’re getting to the end of the term of the fund, assuming the relationship is good and you’ve got some company left in the portfolio that you haven’t been able to sell, the most important thing with the limited partners is being straightforward and honest. Just talk with them about what they want and need and give them a warning and a heads up.”