Opinion

The Great Debate

Investors stuck in a private equity annex

September 4, 2009

wwwreuterscom– Neil Unmack is a Reuters columnist. The views expressed are his own —

It’s a sign of how bad things are in the private equity industry that some buyout funds are asking their investors for additional capital to prop up ailing portfolio companies.

But such moves can be messy. Investors should be wary of throwing good money after bad, and even more careful of rewarding failed managers.

Private equity portfolio companies will soon have to start refinancing a wall of maturing bank debt. Unless the leveraged loan markets recover, new equity capital will be needed.

The first port of call will be existing investors in the buyout funds. The argument is that raising cash early would allow a troubled portfolio company to tackle the problem early, for example by buying back debt at a discount.

Kohlberg Kravis Roberts & Company has already closed one such vehicle, called annex or top-up funds. Others may follow suit.

But these kinds of funds are laden with tension for both investors and managers. Small wonder then that, according to the Financial Times, the latest attempt to launch one, by Apollo, has failed.

It’s a grim prospect for investors who have to pony up more cash or see their existing investment suffer. They also need to do a lot of work, analyzing each company closely to make sure they are not just throwing good money after bad.

Even if they want to, not all investors will be able to reinvest, which means that existing investments will be diluted by the new equity. That causes friction between private equity investors, something any manager will want to avoid.

The more contentious issue, however, is fees.

Some managers will have precious little to show for their existing deals other than overleveraged companies bought at too high a price. They will probably struggle to raise new funds, and face declining fees on their existing ones as deals go sour or returns dwindle.

The danger is the manager simply uses the annex fund as a way to preserve its own business rather than protect investors’ capital. After all, with an annex fund, you don’t even need to go out and find new companies to buy.

Also, by keeping the original investments alive, the new fund will help managers earn performance fees which they wouldn’t be entitled to otherwise.

There’s a simpler way round this, which is for limited partners to invest directly in ailing companies, rather than buying into an annex fund.

That helps solve the need for new capital more quickly, eliminates additional fees, and ensures fresh capital is targeted at companies with a chance of survival. The downside is that this could require investors get involved in multiple capital raisings. An annex fund might be more flexible.

But in that case investors should push for managers to waive the base management fee for the annex fund, and lower their performance fees. Then again, that’s not really part of the private equity model.

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