Professor Glenn A. Okun
Things are tough in the land of private equity. Limited partners are using their newly-found bargaining power to demand that general partners make substantially larger capital commitments to their new funds. In addition to illustrating the shift in power between the parties, it reveals an inconvenient reality: in many cases, general partners are not as wealthy as they claim.
The disappointing performance of existing private equity funds accounts for limited partners’ diminished demand for new funds and their increased negotiating strength. Limited partners are able to require concessions, including an increase in the general partners’ capital investment in a fund.
Historically, general partners made a one percent capital commitment to a fund. Now, limited partners are demanding that the general partner pledge between five and twenty percent.
The problem, in many cases, is that they lack the wealth required for their commitment to be viewed as reliable. It has been reported that general partners are second mortgaging homes, pledging personal assets and taking loans in order to meet this demand.
Lenders, including large banks, private credit investors and business development companies, are willing to make these loans only on their preferred terms. Borrowers pay interest rates in the fifteen to twenty percent range and pledge the bulk of their assets as collateral in order to raise the required capital.
How could these individuals lack the liquid wealth necessary for their pledge to be considered reliable? According to popular belief, general partners make a lot of money and are really rich. Also, the capital commitment is small relative to the cumulative management fees generated over a fund’s ten-year life, typically requiring limited partners to pay two percent annually.
A general partner’s compensation is contingent, to a large extent, on the realized value of their carried interest, the twenty percent participation in the profits of the fund. Several executive search firms that specialize in the industry have estimated that half of a partner’s compensation is carried interest participation.
While it may impress the neighbors to brag about their wealth, estimated portfolio value and portfolio profits, or carried interest, cannot be spent or saved. In other words, the realized value, if any, of the carried interest on existing funds will be a fraction of the estimate due to the change for the worst in lending, initial public offering and mergers and acquisitions markets. Portfolio companies have suffered a significant diminution in value as a result, collapsing a general partner’s net worth.
The general partner’s marked to market balance sheet may not inspire the confidence required for limited partners to rely on their personal guarantee. Ironically, once the appropriate loans are in place, the general partner personally resembles the firms in their private equity fund: a highly levered, high risk, illiquid investment.
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