Second chances

The recent liquidity crunch and financial markets turmoil drove many institutional investors to seek to reduce their commitment to private investment funds. Some sought to rebalance their portfolio, as the drop in the value of publicly traded assets caused their portfolio to be excessively exposed to alternative investments. Others soured on these asset classes.

Initially, many investors sought to sell their limited partnership interests in secondary sales. Some were successful; many were not. A fundamental supply-and-demand imbalance appeared, as willing buyers were far outnumbered by potential sellers. Also, many of the interests on offer were in recently launched funds with large amounts of undrawn commitments outstanding. An LP interest that is only 10% to 20% invested is probably better seen as a "deferred primary" rather than a "true secondary," since this is primarily a bet on future unmade investments.

Given the difference in price perception, potential sellers face a choice. Some investors may continue to seek to sell their LP interests in the secondary market but at a lower price. Others may decide not to re-enter the secondary market because they believe that using other methods to reduce their exposure to the asset class will be more effective. Further, selling an LP interest at too low a price raises a concern over "embarrassment risk," i.e., when the markets (we hope) recover in the near future, what was sold now at a fraction of its true value may in time generate an oversized return for the buyer.

Rather than re-entering the secondary market at a reduced price, three methods to reduce LP commitments that are often considered include:

Negotiating with general partners to reduce the size of the fund. This proportionally reduces each LP's commitment. Notwithstanding the adverse financial effect on the GP, some GPs have been open to discussions with LPs about reducing the size of the fund. GPs may be amenable to this measure for several reasons. First, some are concerned that in the current economic environment, it is difficult to see with clarity how they will invest a big fund and produce the returns that the LP community expects. Second, some GPs want to stay in good standing with the LP community so that someday when the GPs are fundraising again, the LP community will view them as having been cooperative in a difficult time and situation.

Negotiating with GPs to limit or freeze capital calls in the short to medium term. Some GPs and LPs view the current market conditions (for both publicly traded securities and alternative investments) to be temporary. Rather than reducing the fund size and LP commitments accordingly, GPs may prefer to agree to limit or freeze capital calls over the short or medium term (12, 24, 36 months) so as not to strain the financial resources of their LPs. This approach will allow time for the LPs to obtain more investable assets and the public market to recover and rebalance the LP portfolios to some degree. This approach is also consistent with the view of some GPs that finding quality assets in significant quantity in this financial environment will be difficult. This may be offered as a compromise to an LP's request to reduce the size of the fund. It should be noted that for some larger LPs with more influence over GPs, this type of agreement may be reached informally and in the context of how the LP will react to future fundraising efforts by the GP if the LP's appetite for capital calls in the short and medium terms is not accommodated.

Informally organizing within the LP community a bulletin board-type system of matching buyers and sellers. Even though a formal secondary market for LP interests is often discussed, an active, liquid market has not developed. Bid-ask spreads in the current "over the counter" market are larger than would be the case if buyers and sellers could access an organized market and the flow of pricing information was more robust. A broker community is developing to support these secondary sales, but few secondary sales actually occur for various reasons that afflict many young and illiquid markets.

For a more formal market to be a platform for increased liquidity in secondary LP commitments, significant players in the LP community will have to come to implicit or explicit agreement on certain trading methods and standardization of the traded product. Enterprising investment banks seek to take advantage of this opportunity.

Thomas Stromberg is a partner in Kaye Scholer LLP's Los Angeles office and a member of the firm's corporate and finance department. Timothy Spangler is a partner and chair of the firm's investment funds group in the New York and London offices.