News and Insights

Introduction

 

“Private markets” encapsulates investments in debt and equity of privately owned companies. It covers the full range of related asset classes such as private equity, venture capital, private credit, distressed, real estate, real assets and infrastructure investing. Of particular note are the dominant sectors of private equity and venture capital (often collectively referred to as private equity) since their valuations closely track those observable in public markets.

 

Recent stock-market volatility and the subsequent cooling of the IPO market that often serves as an exit for private equity investments, coupled with rising interest rates causing stress in such a structurally indebted industry, is giving rise to increased tension between investors and managers within private markets.

 

In this asset class, institutional investors (Limited Partners or “LPs”) invest in funds which are controlled by managers (General Partners or “GPs”). The LPs are comprised of pension funds, sovereign wealth companies, insurance companies, high net worth families, endowments and foundations. The GPs use those funds to invest directly into a portfolio of companies with the aim of growing them over an average period of four years and then exiting via M&A or an IPO.

 

The asset class has experienced a frenetic period of growth over the last 10 years, with institutional investors chasing the premium returns that the sector has delivered consistently over the last 30 years, which have become hard to find in other markets.

 

Litigation instigated by GPs arising from their investment activities is relatively common. For instance, it may become apparent that the due diligence reports ordered as part of the investment process did not bring to light certain materially adverse information, or the management team selling the business to the GP may not have disclosed, or even conspired to hide, certain significant issues.

 

Litigation is less common arising from the LP-GP relationship. In part, this is because both parties are considered to be sophisticated investors who would rather avoid airing difficulties in public.

 

Access to the best funds is excruciatingly difficult to arrange, being singularly relationship-based. Thus, resorting to litigation also risks destroying a valuable relationship. The more sophisticated investors will therefore go a long way to avoid litigation and will usually seek a negotiated solution.

 

However, in current market circumstances LP-GP litigation is more likely to arise. These disputes could be material, since the parties are in most cases are well-known organisations and the volume of invested funds in the industry is huge. The sector now manages something in excess of $9.0 trillion.

 

Increasing LP-GP Litigation?

 

The value of private equity investments is around 0.7 correlated with public markets, meaning that we would expect a 10% fall in stock markets to see a corresponding fall in the private markets of 7% (for an investment in the same sector). Thus, the large drops seen in public markets during 2022, will lead to significant reductions in private equity valuations, though fund managers have some flexibility as to timing and the extent of adjustments.

 

A complication to bear in mind is that private equity funds do not draw down all their capital on formation. The undrawn capital (known as “dry powder”) is drawn down in tranches as new investments are made and to cover fees incurred through the life of the fund. Thus, at any one time a significant portion of the private equity commitment will be legally committed under a Limited Partnership Agreement but will be undrawn. Collectively trillions of the sector’s assets are currently undrawn. For years the belief had been that this dry powder was highly unlikely to be drawn down. However, this is changing and LPs are now being painfully disabused of this assumption as the sector calls for their committed cash to be invested.

 

There are several reasons why current market circumstances may lead to increased litigation. A few of them are set out briefly below.

 

1. Ratio of public to private investments breaching LP guidelines: Imagine a scenario where a pension fund sets out to commit 8% of its assets to private equity with a 10% ceiling on the proportion of the fund that they can invest in the Their public equities will have rapidly dropped in value this year, whilst their private equity assets will have fallen more slowly and possibly not to the same extent. The denominator effect means that, without changing any investments, the proportion of the fund invested in private equity will rise, potentially in excess of the permitted investment guidelines.

 

Many such pension funds will be able to recalibrate their investment guidelines, however, where the imbalances are too great, some funds will be unable to do so as they will have insufficient cash to pay both current pensions and meet the calls on their dry powder described above. There is considerable potential for disputes in this area to arise.

 

2. Inability to meet calls on “dry powder”: For several years since 2008, the demand for private equity investments has been so great, and the return of cash following commitment has been so swift, that most LPs (i.e., the pension fund) have been over-committing, leading to them committing to a level of perhaps 12 or 15% of their assets in the example above, in the hope of getting at least 6 to 8% of their assets invested and working in the asset class (with the rest undrawn).

 

In the current market, the LPs will find that this over commitment will have resulted in them breaching investment guidelines (and potentially facing calls for significant drawdowns from the GP, resulting in them struggling to meet their obligations to pay current pensions out of the cash they hold). This will lead to pressure from regulators to bring the fund back within investment guidelines through slowing follow-on investments into private equity or even asset sales. There is potential for increased litigation in this area, and in previous market

 

corrections, the GPs were resistant to helping out their LPs by slowing, or granting holidays on drawdowns.

 

3. Management of “dry powder”: With public market prices being depressed, GPs are increasingly keen to make new investments as valuations have become more attractive, alongside restructuring some of their existing portfolio investments that are experiencing difficulties. The GPs draw down further committed funds (i.e., dry powder) to do so. So, just as LPs are seeking to conserve cash their private equity managers may be demanding growing drawdowns of There is considerable room for GPs and LPs to disagree on how the dry powder should be managed and thus for disputes to arise.

 

4. Failing in investment practices due to time pressure: For several years, GPs have been making investments in a frantic and highly competitive market where their due diligence has consequently been strictly The time from agreeing heads of terms to completion has sharply reduced over recent years, and purchase prices have been agreed on highly optimistic formulae. Inevitably some investments do not perform as expected, and some investments fail. In these instances, we may see LPs claim that GPs did not adhere to the investment practices set out in the fund-raising Private Placement Memorandum or were just unprofessionally inadequate. This may well lead to litigation.

 

5. Inexperience leading to failings in investment practices: The fervent activity and growth of private equity over the last 10 years in particular, has led to a range of new entry GPs in the market. These GPs have been able to raise commitments of several $billions in rapid The current market will likely highlight the lesser experienced amongst them, which could lead LPs to claim that the expertise and track-record of the GP was inadequately, or misleadingly, set out in the fund-raising documentation.

 

6. Termination: The LPs commit their investment to a GP and fund, as typically set out in a binding Limited Partnership Agreement. The LPs may have some rights to change the GP of the funds they have committed to, albeit that those rights tend to be weak unless cause can be proven. Nevertheless, it seems likely that due to dissatisfaction with investment performance at least some of the newer GP entrants may be subject to termination, which may be fertile ground for litigation from both sides.