Merely trading LP positions won’t address the deep problems of funds whose managers haven’t raised additional capital for at least eight years. LPs should be more proactive, explains Joncarlo Mark, founder of Upwelling Capital Group.
The evolution of private equity is in full swing. As new investors emerge and new regions develop into investable markets for private institutional capital, private equity is truly a global industry. Pooled private equity returns to institutional investors on a 5, 10 and 15 year basis continue to outpace public markets, adding alpha to investment portfolios held by pensions, sovereign wealth funds, endowments, foundations, family offices and corporate investors.
There is another side of private equity and, broadly speaking, of all alternative investments, which is following this wave of evolution – the resolution of stranded funds.
Or is it? With estimates of the global private equity market at roughly $3 trillion, a significant pool of capital is held in funds whose managers have not raised additional capital for at least eight years, reflective of the natural metering of the industry.
Upwelling Capital Group has evaluated all funds raised since 1999 and developed some staggering statistics. We have found almost 3,000 stranded funds and can measure well in excess of $140 billion of current net asset value (NAV) locked in these vehicles. This NAV is, however, based on only a quarter of all stranded funds that we have identified as most funds do not report their information publicly. In addition, almost $800 billion of NAV exists in funds that are third and fourth quartile over a similar time period.
Although the private equity secondary market has grown tenfold over the last 10 years (another sign of the progress of private equity as an asset class), there are so many funds that need to be resolved in a different fashion. Unfortunately, merely trading limited partner positions is not a complete solution. As the fees roll off for the GPs and the prospect of carried interest becomes negligible, the normal “strategy” of allowing legacy funds to “wind down” is problematic from a capital preservation standpoint.
Yet for many LPs, when a GP is deemed non-core, the manager is essentially ignored. This scenario has been amplified in the recent “electric” fundraising market where many institutions have almost exclusively focused on new commitments and have allocated a vast majority of their investment team resources to this endeavour.
There is no doubt that doing an appropriate level of due diligence and negotiations with prospective new and existing GP relationships is paramount to generating acceptable returns. However, in a world where the spread between private and public equity returns is narrowing as the private market becomes more efficient, it is important to explore ways to maximise value in one’s existing portfolio, particularly with those funds deemed non-core. This effort could result in the difference between an LP clearing their performance benchmark or going into the holidays with a can of spam instead of a cash bonus.
Unfortunately, unless there is a crisis with a manager, at which point it may be too late for the LPs to utilise a wider array of value-creation options, most stranded funds languish.
Potential steps that could be taken to resolve stranded funds include establishing a more definitive life of the partnership, allowing for new capital to be invested in the portfolio winners and providing new incentives to the GP to monetise the assets in the most prudent yet expeditious manner. Of course, taking a close look and adjusting for an appropriate level of fees and expenses is also important. Although re-cutting an LP agreement is a somewhat painful activity, GPs reset agreements with their management teams on a regular occurrence to realign interests and maximise value of their underperforming companies.
With a proactive approach, many of these situations can be mitigated and result in a win-win outcome for both the LPs and the GPs. No doubt these activities take time and attention but it is clear that with uncertain capital markets (not to mention real pain in the emerging markets), one should expect more stranded fund situations to emerge. It is time that LPs allocate more attention – whether internally or through external resources – to address these situations before they cause irreparable harm to their portfolios.
Upwelling Capital Group is an advisory and investment management firm that specialises in helping LPs maximise value their non-core portfolios and providing capital solutions in certain fund secondaries and direct secondaries situations.