The concept of a ‘bad fund’ could be coming to PE

GP-led processes were used to isolate top performing assets during the bull market, so why not the opposite now?

GP-led deals have in many ways become a bull-market play, allowing general partners to hold on to prize assets and captive investment teams to open up to third-party capital. The role they will play at a time of crisis is far from clear but there are some new and interesting avenues to explore.

In January, sister publication Secondaries Investor caught wind of a proposed deal which involved an asset that no longer made it past the ESG filters of some LPs being removed from a buyout fund and placed in a separate vehicle backed by investors with less stringent requirements. Could a similar mechanism be used to isolate assets badly affected by the coronavirus crisis from the rest of the portfolio?

Let’s say a fund has 10 investments, three of which are in a sector disproportionately affected by the covid-19 crisis. These assets could be spun out into a separate vehicle backed by new, probably distressed investors, allowing LPs to quickly cut their exposure to failing assets and the GP to focus its remaining capital on what is salvageable.

“Think of the analogy ‘good bank and bad bank’ but ‘good fund and bad fund,’” said Eamon Devlin, a partner with law firm and asset management consultancy MJ Hudson, who expects to see an uptick in such deals as the crisis progresses.

What does the market make of such a deal? If it’s the right GP and the right assets, why not, one New York-based secondaries buyer with an appetite for difficult situations told Secondaries Investor. 

Others are much more circumspect. One London-based secondaries buyer believes such deals can work if you ring-fence the right assets, which isn’t necessarily easy in this environment: “This time around the negative economic impact is so all-pervasive. You could try and segregate one part of your portfolio and it’s a completely different part that causes you real trouble.”

It could also be difficult to attract distressed investors to back such deals for the same reason it is hard to get investors with their own co-investment and direct-investment capabilities to back single-asset secondaries deals: control.

“I would expect most distressed investors to struggle with having the old GP in place, as they are used to calling the shots for their own investments,” said Ted Cardos, a partner with law firm Kirkland & Ellis.

Such deals would invariably involve spinning out the assets at a steep discount and crystallizing that loss. The net, long-term outcome might be positive for the fund; the good assets get more investment, survive and exit for a healthy multiple.

The question is: are LPs willing to take that chance? With the coronavirus-induced downturn rolling on and GPs’ liquidity problems likely to become more severe, we may soon know the answer.

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