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— Capital Calls —
The solution turned out to be less than satisfactory. In many cases it created conflict-of-interest issues related to cross-fund investing. When separate vehicles invest in the same companies at different times, terms and pricing, LPs get diluted. Besides, many of the annex funds performed poorly.
Now it's private equity's turn. With few exits and distributions, no
fresh capital is being plowed back into otherwise viable companies that
can't be sold at acceptable valuations.
General partners are persuading LPs to participate in the extra rounds, citing their track record of delivering the goods. But there's a gentle way, and there's a cramdown way. New York distressed investor MatlinPatterson Global Advisors LLC recently closed on $165 million for its Supplementary Fund II, intended to support companies held by its Global Opportunities Partners II, a $1.66 billion fund raised in 2003. The firm offered the annex to LPs invested in the main fund, though not all anted up. Still, the annex fund was oversubscribed, sources say. Landmark Partners Inc. of Simsbury, Conn., the only new LP, anchored it with $68 million. The rest came from existing Fund II investors. The U.K.'s Pantheon Ventures Ltd. put in more than its pro-rata share, and MatlinPatterson contributed $5 million. Annex fund LPs are entitled to a preferred return out of the portfolio, a source says, and it's amply collateralized. There's not much of a choice, say participating LPs, who are in effect doubling down on their bets. "While there's some dilution, the alternative could very well be to have value destroyed," says a longtime MatlinPatterson investor. "By ponying up, existing investors can benefit from any upside through exits" that may offset some losses on the main fund. New York buyout firm Kohlberg Kravis Roberts & Co. is in the market for an annex to its European Fund II LP, a €4.5 billion ($6.1 billion) fund raised in 2005. KKR is targeting between €500 million and €750 million. The extra capital will be used primarily to help delever companies saddled with too much debt, as well as to provide some equity cushion, sources say. It's still early, but as of Sept. 30, KKR's European Fund II had a minus 10.6% internal rate of return, according to disclosures. KKR is said to be tapping existing LPs in that fund, though it is reportedly allowing some investors in its latest fund to transfer commitments to the annex. To placate LPs, it also waived its 1.5% management fee on the annex, among other incentives. Sun Capital Partners Inc.'s approach, however, has been tougher to swallow, say some LPs who attended the firm's annual meeting last month. The Boca Raton, Fla., buyout shop wants to raise $150 million to prop up Fund IV, a $1.5 billion, vintage 2005 pool. Sun has sent documents to LPs detailing an "amendment" to Fund IV's partnership agreement, but it's asking not only existing Fund IV LPs but also investors in its $6 billion Fund V, raised in 2007, to contribute. Presumably, some LPs in Fund IV may be tapped out. Like others, Sun Capital is offering a preferred return, giving investors a reported 25% IRR before distributions reach nonparticipating investors. The new money will support Fund IV's portfolio, which has 41 companies including at least three in Chapter 11: Mark IV Industries Inc., Big 10 Tires Inc. and Fluid Routing Solutions Inc. Sun has had 11 companies go bust, about 10% of the 98 PE-backed companies that landed in bankruptcy courts in the last 16 months, by The Deal's count. Sun Capital declined comment. A few more annexes are being considered, sources say, but worries abound. LPs wonder whether they're throwing good money after bad, or if the extra capital can generate appropriate returns to offset losses. Moreover, given the large amounts of capital needed by companies, it isn't clear if the annex funds will be sufficient to support them. "It's not something we're fond of," says one disgruntled LP. "You have to weigh the costs of capital with the dilution that hedge funds and other creditors are likely to impose in the worst-case scenarios. It's a tough decision to make." Either way, it's no fun. |
Annex funds are staging a comeback, much to the chagrin of limited partners. Such vehicles, so called because they're raised alongside larger, often cash-strapped existing funds, became sources of controversy -- and much griping by LPs -- when they first appeared in the post-tech boom era. Amid the downturn, many venture capitalists found their funds had run out of reserves to shore up portfolio companies during a protracted downturn, so they raised additional capital through annexes. 
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