Private equity general partners have spent the last two years slogging through a deal wasteland. It should come as no surprise that some of the money they had originally hoped to invest was never called down from investors.
Now the deal market appears to be coming back to life, but some GPs face a problem – the investment period of their fund is over or reaching and end, and they haven’t deployed all the capital committed to their funds.
This article is one of two that will explore the phenomenon of the “stale unfunded” commitment, and what GPs can do to change this from a challenge into an opportunity.
It should be noted that the issue of unused capital commitments is not confined to recent times. Limited partnerships have always allowed for the reservation of undrawn commitments to pay fees and support portfolio companies beyond the initial investment period.
However, in today’s market, fund are more likely than ever to have capital reserves far in excess of what is needed to support the portfolio going forward. In more liquid times, LPs were unconcerned about stale unfunded commitments. But in today’s market, some investors are concerned that precious capital is tied up in funds that have no need for the money, but are failing to communicate this to LPs.
Responsive and reactive
Today stale unfunded commitments are often found in private equity funds that are well beyond their investment periods. A significant portion of these commitments are unlikely ever to be called. Canceling or cutting such undrawn commitments should be a relatively easy give for GPs since they usually will have switched to charging fees on invested equity at this point.
Bob Long, president and CEO of Conversus Asset Management, the investment management arm of Conversus Capital, has been tracking the stale unfunded commitments in his large, mature portfolio of LP interest held in a public company format. In an interview with PEM, he said, “A responsive GP would do LPs a favour and right-size the remaining unfunded to the circumstances of the fund. For an early stage venture fund one year beyond the investment period, the LPs should expect very substantial calls for several more years.”
Long noted that GPs would score major points with LPs in the process. The reverse is also true – failure to address an outsized stale unfunded number may not play well with the investor base. “Consider the perspective of CIOs and investment committees,” said Long. “When the head of private equity proposes to begin committing to new funds, the natural reaction is to question the exposure to all the program's unfunded commitments. Explaining why certain unfunded is very stale and never going to be called could be a difficult and unnecessary conversation.”
Conversus is one of a few firms that track stale unfunded, said Long. At the end of the first quarter, Conversus had $685 million in unfunded commitments, $187 million of that of which is stale unfunded, or 27 percent. Long estimates that a significant percentage of the stale portion will never be called, although he would certainly like to have better guidance on this from his GPs.
The overhang grows old.
The private equity industry has roughly $445 billion in uninvested capital poised for deals, with about half of the untapped money in the hands of large firms with $5 billion or more in commitments.
According to research from Cambridge Associates, much of the overhang, or about 75 percent, is housed within funds raised in the period from 2007 to 2009. On average, funds raised in 2007 are about 25 percent called, those raised in 2008 are about 15 percent called and funds raised in 2009 are less than 5 percent called, Cambridge said.
In projecting cash flows for a mature program, analysing stale funds is critical, said Long. “In the typical LBO fund, we have found that the stale portion that's a year old could very well be called-think of it as 'day old bread'. At three or four years past the investment period, the probability decreases dramatically,” he said.
If GPs addressed the amount of stale unfunded, private equity fund managers may well have an easier time inthe next round of fundraising. “LPs are starting to wake up to the magnitude of the overhang that has not been invested,” said Long. “When the fundraising wave starts again, it will be interesting to see if LPs push back.”
How and when to communicate stale funds continues to be a gray area. It is notable that issues pertaining to stale unfunded were not included in the Institutional Limited Partners Association (ILPA) principles.
Framing the stale unfunded issue is the broader issue of GPs trying to figure out how best to support their portfolio companies with whatever capital resources are available. “Private equity firms have really been in the middle of this [downturn], working with portfolio companies, trying to determine the best use of capital,” said Andrea Auerbach, a managing director with Cambridge. “Their investors have really had a chance to see what their managers are like under significant pressure.”