Sin and redemption

Nine months ago, when Guy Hands first began telling private equity managers to consider scaling back funds or giving limited partners the option to cap their commitments, his was a lonely voice. Over the past few weeks, the solitary prophet of London's Terra Firma Capital Partners Ltd. has come in from the desert. He now plays a starring role in the biblical epic of sin and redemption engulfing his industry.

As the ground has softened under Terra Firma's £4 billion ($5.6 billion) buyout of British music company EMI Group Ltd., Hands has practiced what he preached with almost prideful martyrdom. He wrote to all 170 investors in his latest fund to ask whether they faced liquidity problems and then paid three of them a premium to buy back €25 million ($31 million) of outstanding commitments. At the same time, he handed back to LPs five years' worth of carried interest accrued on every deal and from every Terra Firma fund since 2004.

Cynics might argue that the sacrifice is less than it appears. The £80 million of carry returned would not have been paid out until the expiration of the firm's respective 10-year funds. Although Hands and his partners might eventually have benefited from some of Terra Firma's early, more successful deals, some of the later funds and wilder deals are unlikely to achieve any carry at all.

As for bailing out his investors, Hands is far from the only player to have acted to preserve relations with his LPs before the ground opens and swallows them all. Others might have struck a tougher bargain. Permira Advisers LLP seems to have made investors pay a heavy price in fees and reduced returns for the benefit of being allowed to cap their commitments. Alternatively, as in the case of Candover Partners Ltd. and its cornerstone investor, the quoted vehicle Candover Investments plc, the balance of power may favor the LP.

Nevertheless, these are bleak times for private equity, and both general partners and LPs are under heavy stress. SVG Capital plc, Permira's cornerstone investor, and one of those to benefit from the cap in commitments, tried to raise a further £200 million through a mixture of share placements and a whip-round among existing shareholders. In the end it raised £70 million through the placement, as planned. But it was only moderately successful in raising funds from existing investors. Just 53% of its £139 million offering was taken up, and the remainder was partly underwritten.

Meanwhile, as Candover negotiates a reduction in its fund size, under pressure from its LPs and following a 50% fall in net asset value, Kohlberg Kravis Roberts & Co.'s Amsterdam-listed co-investment fund KKR Private Equity Investors LP, declared a 47.5% fall in net average value. The investment fund postponed indefinitely a merger with its parent company and relisting
in New York.

Logically, the trouble at the biggest outfits ought to be reflected among the smaller and midmarket firms. GPs throughout the industry should be feeling pressure to shrink funds, slash fees or cap commitments.

Anecdotally, at least, there has been little evidence of such pressure in the European midmarket so far. Although secondary private equity investors are reluctant to acquire LPs' assets until valuations sink to well below current levels, giving distressed LPs no alternative but to turn to GPs for relief, U.K. midmarket sources say they have not heard of this happening on any scale. On the contrary, pension fund managers still have a regular inflow of cash, and sovereign wealth funds are, for the most part, still flush with money built up during the boom years. The exceptions to this benign environment may be high-net-worth individuals and family offices, whose wealth may have declined dramatically, or endowments, especially from North America.

Nevertheless, where the megafunds and quoted private equity firms lead, others may still follow as the recession deepens. That's why most GPs, from Terra Firma to the smallest local firms, are working hard to keep their LPs sweet -- and LPs, by and large, are trying to stick with their investments. Private equity is an industry with 10-year horizons and long-term relationships. When the ground does open, there may be an unseemly struggle to push one's partner into the abyss. But until that moment, LP and GP will walk in loving lockstep right up to the edge.