Limited partners (LPs) are literally ‘limited’ because of information asymmetry. Despite thinking they’ve kept a close eye on return on investment, LPs can still fall into the following 3 traps that devastate their yields.
Trap 1: Who Moved My Cheese?
In the current Chinese market, private equity (PE) funds mature when they reach 6 years old, and some may go through a 2-year long extension. Then, it’s time for LPs to cash out. GPs start to liquidate their holdings, but LPs may eventually discover they’d been robbed of those juicy returns they so eagerly expected.
Here’s how it happens:
Good investment opportunities are priceless, and inaccessible to some individual investors. But let’s say this individual happens to be an intimate friend to the general partner (GP) of the fund that appeals to them. This interested investor can grant a small loan to the GP, which later will be secretly infused into portfolio companies under the fund’s name. When the invested companies finally generate returns, LPs hearing the ka-ching may find not a penny goes into their pockets.
“Who moved my cheese?” the LPs wonder.
The “lender” sitting in the front row has got to it first.
Never expect GPs to bring this up voluntarily. Even when LPs ask, GPs will most likely laugh it off and smooth it over with some offhand comment: “It wasn’t too big a deal. It doesn’t actually damage your interests.” But it does…
Trap 2: I Invested Another Fund…
Besides direct investment, some fund managers also invest in other PE funds for special reasons.
The most common one is that GPs find someone else doing well with a different strategy, and they invest in those funds in the hope of upgrading returns and further diversifying portfolio risk.
Another situation is that the GP’s new fund does not receive enough capital commitment from investors. To avoid wasting all those registrations, filing or other preparation work, fund managers may rob Peter to pay Paul – borrow capital from other established funds to temporarily solve the problem.
Such investing and borrowing can be dangerous. Generally speaking, the invested funds are younger than the parent fund from which the GP borrowed, and they lag far behind the parent fund when it comes to maturity.
If LPs want a normal exit as the parent fund matures, having to offload sub-fund shares before maturity usually means selling at a discount or at least profitless trading, regardless of having held them for a long time.
If LPs launch a lawsuit against the GPs’ misconduct, and the GPs cannot prove the independence of the invested fund from the parent fund, the court will freeze all of the GPs’ investments, including the invested fund shares, to protect the LPs’ interests to the greatest extent.
But this causes its own problems. The invested fund cannot be free until the litigation is done, which will affect its parent fund in exit and its underlying firms in registration changes. LPs have no choice but to undertake subsequent legal and compliance risks.
Trap 3: The Missing Management Fee
When making a fund investment and confirming a Limited Partnership Agreement (LPA), LPs tend to be vigilant of the rate of management fees and ignore how quickly they might be drawn on by the manager.
Here’s the problem. Some funds are still years away from exit, but GPs have already withdrawn all the management fees from the fund’s account. In fact, sometimes they do so at the very beginning! In practice, funds can have more fund-level expenditures during the exit period than the investment period, especially since disputes can occur when liquidation approaches. A third party is then needed, but there will not be any management fees left. Theoretically speaking, all investors should split the bill as a consequence, no matter how reluctantly.
Then there is another situation: the fund manager changing. Sometimes, GPs may be unable to keep managing the fund. In this case, a lawyer must then step in. Thus, the same problem happens again. GPs have used up all the management fees. So, how do you pay the extra lawyer fees? And what about the management fee for the next manager?
It can feel to an LP like they are trying to peer through fog at times. And it’s true that LPs have a natural disadvantage due to information asymmetry, but most of the hidden risks have early signs. Conduct full due diligence research and review key LPA terms before making the commitment. It sounds simple, but it can help LPs avoid falling into these potential traps.