Agreed. Many GPs have told me the same: they cannot risk calling right now. Makes me wonder what the private equity value proposition really is, if the capital isn’t there through thick and thin.

My final point is that many of these equity investments are clearly worthless, and not by a little bit. Those are easy to value, if anybody had the incentive to mark them. Of course, nobody does: certainly not the LPs.

It just lowers the value of the bond.

True, and increases the volatility (beta) to more equity-like levels. I think we’re both right: you looked at equity in terms of control (which is appropriate), and I looked at it in terms of risk and volatility.

I too find the impact of cash-poor LPs interesting. What I do know is that GPs are not nearly as long-term in nature as they think they are. I can’t tell you how many times I’ve heard, “We’re long term investors with a 7 year hold.” Yeah, that’s forever to a 25 year old PM, but a pretty short time for a startup business.

Therefore, I surmise that interim valuations are suddenly going to really start to matter.

Thanks for your insight.

Thanks for taking the time to respond.

Macnub: Cov-lite terms reduce the ability of bondholders to exercise their rights, which increases the risk of the bond to be more equity in nature.

But I still disagree on this point. Cov-lite does limit the conditions under which bondholders can excercise their rights, which might increase the risk that the recovery of the bonds is lower. But that does not make the instrument more equity like. It just lowers the value of the bond. The investment risk might be more like equity but the nature of the control ( as you pointed out) is definitely not more equity-like (the same goes for mezz PIK).

Macnub: Have you heard of secondary deals that failed because of a GP veto? Or secondary investor qualification by selling LPs?

Phrased in this way, the point is closer to the truth. All LPAs give the GP the right, but it is fairly uncommon that it is exercised. That said, I am aware of a few instances where it was invoked. And in many cases there is no need to technically invoke it because a preliminary conversation between a secondary buyer and the GP makes the potential for a transaction clear. The effect of all of these restrictions (and others) leads to a relatively inefficient and therefore opaque secondary market.

But more importantly, while GPs have clearly slowed investments in Q3/Q4, and in some cases renegotiated commitments with LPs, they will call as needed. GPs will however actively speak with LPs to try and avoid any defaults. That said, I agree that there are a lot of severely capital-constrained LPs out there.

Macnub: The fact that secondary purchasers are more rational should be terrifying to PE funds.

The impact of capital-constrained LPs selling commitments has made this issue a very interesting one. Although PE funds have traditionally been thought of as long-term investments where interim valuations don’t matter will be eroded as sales begin to make clear what those valuations are. Whether the much-vaunted illiquidity premium that used to be the basis for PE returns will disappear or be reinforced as a result will be interesting to observe.

I’m not sure if I understand your final point. But as was mentioned previously by conservative and reasonable valuation methodology many of these deals might are likely not worth much more than a fairly far out of the money call option. The point is, let’s see if that’s how they are valued.

Maybe.

The extent to which deals are “cov-lite” has no relation to the leverage in the deal.

Not legally, but economically, it makes all the difference in the world. Cov-lite terms reduce the ability of bondholders to exercise their rights, which increases the risk of the bond to be more equity in nature. That’s what I meant by cov-lite bondholders being the equivalent of equity now… the degree of economic leverage is less than the degree of accounting leverage, particularly after the market value of equity blasts through the zero bound (as the BCE deal would have been on day 1).

In the limit, for example, PiKs (payment in kind) deals are pure equity risk.

Almost every LPA gives the GP control over the transfer of an interest from one LP to another.

Here we are at an impasse. My source assured me the opposite (with a few exceptions). I may well be wrong here, but I pressed him hard on this, rephrased different ways, because I just couldn’t believe it. He told me, basically, “Yup.” Have you heard of secondary deals that failed because of a GP veto? Or secondary investor qualification by selling LPs?

While secondary buyers might not care alot about the value of the existing portfolio, they certainly might take it as a good indication of the ability of the GP to select good investments and manage the portfolio.

Agreed. But economically rational actors (unlike human beings) don’t care about sunk investments. Secondary market purchasers are more economically rational than founding LP investors
because human beings care very deeply about sunk costs. The fact that secondary purchasers are more rational should be terrifying to PE funds.

That said, figuring out by how much an asset would be sold if it had to be sold is a guessing game.

Agreed, until the value is a low value of zero (in the sense that 2+2=5 for high values of 2 and low value of 5; an 80% leverage deal which has fallen in value by 40% has equity valued at a low value of zero), which should make up a lot of highly levered deals right now.

Macnub misses several of the key points. e.g. The extent to which deals are “cov-lite” has no relation to the leverage in the deal. The term reflects the number/tightness of the terms which govern the debt and therefore reflects the ability of the lenders to influence/exercise control over the company’s managers/equity. This might limit the number (or at least timing) of PE portfolio company defaults but is relevant to estimating the value of the equity in the company.

Almost every LPA gives the GP control over the transfer of an interest from one LP to another. PE funds are in an enviable position wrt capital, they only need to call after an investment has been made. If they think their LPs can not meet their capital calls (which is a massive issue in the industry) they simply do not need to execute the transaction. (Yes, there are a limited number of transactions that might have been made before the extent of LP problems was clear).

While secondary buyers might not care alot about the value of the existing portfolio, they certainly might take it as a good indication of the ability of the GP to select good investments and manage the portfolio.

Again, the basic thrust is correct, on MTM earnings are down on 2007, valuations have fallen in public market comps, and leverage is higher than in comp public markets. Therefore valuations could/should take a strong hit. That said, figuring out by how much an asset would be sold if it had to be sold is a guessing game. Most economic theory is based on prices transacted between the marginal willing buyer with marginal willing seller. Asking the holder of the asset to estimate what others might pay for a similar asset IF it were sold is a different story entirely. Ask oil companies about the calue of their reserves in the ground; insurance companies about the value of customer’s assets; or municipalities about the value of a taxpayer’s real estate.

Add TXU, Toys R Us, a ton of other garbage deals that don’t make sense anymore. The Bell Canada buyout firms probably thank their lucky stars every day that they didn’t have to close that either.

Kevin O’Leary is a HNW individual active in investing. Last night He reported from West coast after talking to a PE firm there.

According to the guys at the firm, they expect 25-40% of PE firms (or was it companies?) to go under, and that there will be heavy losses and lots of bankruptcies of the portfolio companies.

So, he wanted to get a hold of the debt of these companies, as the debt holders will become the new equity holders.
That might be a good idea. Anyone know how a smaller guy could get a hold of that? Any fund that might go hunting for bargains there?
Just a thought.

Will