Restructurings can be a minefield for investors

Private equity fund restructurings in some cases might be a get-out-of-jail-free card for the general partner and a big source of business for alternative investment secondary market players, but for the funds' limited partners, such as pension funds and other institutional investors, it can be a minefield.

As restructurings of older private equity funds are growing so, too, are questions about fairness and potential conflicts of interests. Limited partners are being asked to make quick decisions — often within 45 to 60 days — on deals for which they are receiving little information and have no access to any competing offers the general partner might have received, industry insiders say.

“Some of the deals we are seeing in the energy sector require new money to salvage the portfolio because either the bank loans are being pulled or portfolio companies have run out of money,” said David Fann, New York-based president and CEO of private equity consulting firm TorreyCove Capital Partners LLC.

“Usually the LPs are presented with one deal that the GP has selected. Usually LPs don't have the benefit of seeing multiple offers,” Mr. Fann said. “There are a lot of competent secondary firms out there willing to transact and LPs are presented with one solution without knowing if there could have been a better deal. The GP could have selected the deal that was best for the GP and not the LPs.”

Limited partners are starting to take issue with some of these restructurings.

The $303.3 billion California Public Employees' Retirement Association, Sacramento, in a June letter balked at a proposed restructuring — led by Pantheon Ventures LLP and Intermediate Capital Group PLC — of an underperforming energy fund, the $7.8 billion First Reserve Fund XI.

CalPERS objected to the recapitalization of the 2006 fund because of “inherent conflicts of interest” in selling a select group of the fund's assets — which included publicly traded securities — with reset carried interest terms for a fund in which “the original investors are not expected to receive a return on their investment,” the letter stated.

Real Desrochers, managing investment director, private equity, at CalPERS contended in the letter that investment manager First Reserve Corp. had plenty of money to run the firm and keep firm executives happy. Not only had First Reserve Fund XI already collected $500 million in fees, but also First Reserve was collecting fees on three subsequent funds. As part of the terms of the restructuring, First Reserve executives and the secondary buyers wanted to buy the limited partnership interests at the bottom of the cycle prices, before energy markets had rebounded this year, CalPERS letter stated.

The deal gave little economic benefit to existing limited partners other than a small reduction in management fees and provided “inordinate economic gain for First Reserve and the secondary buyers,” Mr. Desrochers wrote.

Instead of restructuring the fund, Mr. Desrochers suggested extending the fund terms with limited recycling of the remaining assets. The publicly traded securities could be distributed to the existing LPs.

For its part, First Reserve shortened the duration of the new fund that would have held the restructured portfolio and removed all fees for existing limited partners that remained and decided to invest alongside new investors in the portfolio, according to an undated letter to Mr. Desrochers from William E. McCauley, CEO and chairman of First Reserve, Greenwich, Conn.

In that letter, Mr. McCauley noted the deal would only go forward if it had the support of 66 2/3% of all the limited partners in interest.

Members of the fund's advisory committee that had seen the deal first, gave approval for First Reserve executives to market the transaction to the rest of the LPs. The recapitalization since was terminated because not enough limited partners agreed to sell their partnership interests to meet the secondary managers' minimum, said Helen Gustard, ICG spokeswoman in an e-mail.

“ICG and Pantheon have decided together with the FR (First Reserve) team not to move forward with the fund restructuring transaction,” Ms. Gustard wrote.

First Reserve and Pantheon executives declined comment.

“The letter that was sent to First Reserve is another example of CalPERS' efforts to hold private equity firms accountable,” said Joe DeAnda, spokesman, in an e-mail in response to questions about the current status of the First Reserve matter. “We believed a decision (by the advisory committee) was made lacking the full picture.”

Mr. DeAnda declined further comment.

The California State Teachers' Retirement System, West Sacramento, has a seat on the fund's advisory committee. Officials at the $188.7 billion pension fund declined comment.

“We are still in early innings of the restructurings and the quality of disclosure has been mixed,” Mr. Fann said. “Some GPs have done a better job than others regarding disclosure. If a public company or even a private company engages in a restructuring, investors get a much more detailed information package than what LPs are getting from their GPs.”

Frank Morgan, partner and president of Coller Capital-U.S., who is based in New York, said that restructuring transactions in general have to be fair to the restructured funds' existing limited partners.

Funds can be restructured in different ways. Sometimes, the manager will get additional commitments to make new investments as well as work out the existing portfolio, he explained. “This additional capital is of great value to the GP, but does nothing for existing LPs,” Mr. Morgan said.

Limited partners that want to stay have to make an additional commitment alongside new LPs that are providing capital to work out the old portfolio and make new investments, he said.

“The whole issue is: Are you treating your existing LPs fairly,” Mr. Morgan said. “Our view is that you need to provide a fair opportunity for LPs that want to stay in place … an option that doesn't involve new money.”

There are “substantial issues” of conflicts especially in the areas of valuations and fiduciary duties, said Paul Verbesey, partner, in the Washington office of Goodwin Procter LLC.

“In situations like this, the same GPs are often representing the sellers and the new fund buying the assets,” Mr. Verbesey said. “As a result, it is very important, and the (Securities and Exchange Commission) is focused on there being full disclosure to existing investors and new investors about what the portfolio looks like and how it is being valued. It is crucially important to provide full and fair information and to have an outside third party providing the valuation process.”

Conflicts also crop up among limited partners in a restructuring process, said Kishore Kansal, managing partner of London-based secondary market broker PEFOX.

In some fund restructurings, limited partners — faced with the choice of rolling over their investments into a new fund with fresh capital, selling their limited partnership interests or doing nothing — often take no action, Mr. Kansal said in an e-mail.

“LPs find themselves with differing economic terms and potentially conflicting interests," he said.

"PEFOX's view is that often the only clear winner in these more substantial restructurings is the GP and the main (secondary) buyer who is backing them.”