Limited partners in private equity are getting cranky. After enduring all things savage in 2008 and part of 2009, many LPs are bedeviled by lingering uncertainties, despite recent market improvements. Nervousness about performance, particularly by large buyout funds, is pervasive. Things could all be better still. The economy could be better. Leveraged finance markets, valuations and distributions could be better.

"No one's getting really excited," one LP wryly observes.

Not to belittle the positive signs of late. Certainly, liquidity pressures may not be as harrowing as they were this time last year. Thanks to the remarkable recovery of stock markets and high-yield markets, investors feel a bit more comfortable, if somewhat conflicted, about what's going on with their portfolios. Yet even those that have capital to commit to new private equity funds are husbanding their cash and being Scrooge-like in doling it out.

Publicly, many limited partners profess their long-term commitment to the asset class. That's seen less as a public relations gesture than a tacit acknowledgment that they've done very well indeed with private equity historically and feel compelled to stay in. Many will maintain their programs, though not at the levels they were when times were good. But whatever largess that may be dispensed to general partners' fundraisers will be accompanied with more persistent demands for better economics and governance when it comes to negotiating partnership agreements.

On the plus side, nothing compares with the anxieties in the months following the collapse of Lehman Brothers Holdings Inc. Pension funds, endowments and other institutional investors saw values evaporate across entire portfolios. With much of their holdings in illiquid assets, university endowments especially were hit hard. Annualized unrealized losses hovered at 25% to 35%, depending on the fund. In the immediate aftermath, investors wrestled with the denominator effect. The more desperate among them liquidated assets, taking a haircut in the secondary private equity markets, prompting predictions of an explosion in sales of private equity assets. Deals weren't happening anyway, and capital calls were pretty much on hold.

By the third quarter, people were breathing a little easier. The worst appeared to be over. A partial recovery of the stock markets and corrections in credit markets allowed portfolio companies to refinance debt, either reducing it or pushing out maturities.

As a result, secondary market buyers were disappointed as transaction volumes dropped. These are notoriously opaque markets where hard data is difficult to capture. But anecdotally, deal volumes in the first half of 2009 were only about half of what they were in the first half of 2008.

The shortfall was attributed to the combination of fewer capital calls and wider bid-ask spreads. In many cases, discounts were far too steep than sellers who were not otherwise distressed or liquidity-constrained would have been willing to accept.

Valuation -- that is to say, how much to discount an asset -- also proved tougher than ever for secondary buyers. Experts cited technical reasons, such as the delayed impact of the first full year of mark-to-market accounting in 2008 under Financial Accounting Standards No. 157 that wasn't may not have been reflected until perhaps the second quarter of this year.

Private equity portfolio valuations added a degree of volatility and inconsistency. Even under FAS 157, two different GPs that invested in the same deal could be applying different practices and come up with very different values, despite having the same auditors. Many GPs in the U.S., for instance, tend to use a mix of discounted cash flow and market multiples as an accounting approach, more so than their European counterparts.

LPs were generally encouraged by slight improvements in fund performance as markets overall began to recover. The recent flurry of initial public offerings since August certainly helped nudge results upward in the third quarter. With credit markets enabling some dealmaking, capital calls also increased.

Yet the worries haven't disappeared. There's a sense of foreboding that the economy remains fragile and that the market recovery may be short-lived. For all but the most promising businesses, financing remains tight and costly. Valuations are up from their low points, but quite a few portfolio companies remain below cost. Investors fret over commercial real estate as well, expecting the other shoe to drop.

"Guarded optimism," that trite catchall, seems to be the default mood, blended with a touch of grouchiness. "Our GPs have been in a fair amount of trouble," one investor grouses. If 2009 was a brutal fundraising climate, expect more of the same for 2010. "We're nowhere near a normalized fundraising environment," says another LP. PE fundraising reached its lowest tally of final closes since 2003 in the third quarter this year, with 82 funds raising $39 billion, according to London industry tracker Preqin Ltd.

San Francisco buyout firm Hellman & Friedman LLC completed an $8.8 billion vehicle, among the largest this year, just behind First Reserve Corp.'s $9 billion fund. But others have struggled and downsized expectations. New York buyout giant Kohlberg Kravis Roberts & Co. postponed coming to market, while Blackstone Group LP might stay in until at least June 2010, sources say.

If anything, LPs have strengthened their hand at the negotiating table. After many years of largely fruitless lobbying, some of the larger public pension funds, including the California Public Employees' Retirement System and the California State Teachers' Retirement System, have made more concerted efforts to achieve greater alignment of interests with GPs.

In October, more than 50 organizations endorsed tighter principles set by industry trade group Institutional Limited Partners Association on best practices. CalSTRS chief investment officer Christopher Ailman, among the more critical of recent private equity performance, described the principles as "the new standard for the entire private equity community" that he expects GPs to incorporate into their very next fund.

Among other principles ILPA laid out, management fees should cover reasonable operating expenses of the firm and shouldn't be excessive. LPs want stronger rights to suspend, terminate or dissolve a fund. And they'd like greater detail on underlying portfolio company performance, as well as on fees and carried interest, or share of profits, generated.

Time will tell how this will ultimately play out. Judging from recent moves, GPs are leaning toward accommodation -- to some degree. Certain GPs, notably TA Associates Inc., TPG Capital, Bain Capital LLC, London's Permira Advisers LLP and more recently Carlyle Group, have offered concessions, reducing their fund size and/or fees. To encourage investors to re-up for its latest pool, TA pared its carry to 20%, from 25%, more in line with the industry norm. It also lowered its management fee a tad.

KKR's fundraiser is expected to be a major test case when it comes to market next year. "It's not yet clear how LPs are going to apply this," says an investor. Some may be more extreme than others in laying out the blueprint for future commitments.

For now, what is clear is that there's less money to go around. Amid some hopeful signs, it's OK to celebrate. Just go easy on the bubbly.

Also see:

Related story: Digging out

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