by GP, Carried Interest

I've posted before about the problem of defaulting limited partners (see The Cheque Is In The Mail).

The media has made lots of noise about this risk, and the disaster it supposedly represents for the PE industry, but on the ground the reality is a bit different.  An LP default can actually be great news for a private equity fund manager. 

For example, imagine a situation where a fund is four years old, is two-thirds drawn down, has a solid portfolio, and issues a capital call for what may be its final investment.   The days tick by and then an LP (let's call them a large American bank) breaks the shameful news that they can't honour the call.  They're in default.

Shock! Horror! What happens now?

Well, if the PE fund has a diversified group of, say, twenty LP investors, then the manager will simply increase the capital call to these other partners and make the acquisition.  He then has to deal with the defaulting LP . . . and his powers are usually draconian. 

It's not uncommon for the manager to seize defaulting units without paying any compensation.  Notice the important detail?  The manager gets the units.  These units have already been partly paid to 66% and the GP is now free to sell them to a secondary buyer, or hold them and meet future calls himself.

So . . . a fund is performing solidly and is almost fully invested.  An investor defaults by failing to meet a call.  A disaster?  Not at all, it can be a financial windfall for the fund manager.

On this theme, I know of cashed up managers who are actually approaching their LPs and offering them liquidity . . . offering to buy their units at a big discount.  The GP is in an unbeatable position to recognise the potential for a secondaries bargain.