Investors in buyout funds haven’t had to worry about cash calls for a while. When asked for fresh capital by Blackstone and others, they could find the money in a steady stream of profits from older vintages. That won’t work in a prolonged market slump.
Private-equity backers, like pension funds, pledge cash when a fund launches but only hand over the money when dealmakers need it to buy a company. Meeting those so-called capital calls is usually easy, since buyout barons tend to distribute more profit from past funds than they require for fresh bets. U.S. and European managers paid out $2.7 trillion from 2011 to 2021, according to Preqin, and called up $2 trillion. Distributions exceeded cash calls almost every year, meaning investors could simply recycle their winnings into new funds.
But those numbers may fall out of balance if the world tips into recession. Buyout barons are understandably reluctant to sell companies at the trough of the cycle, meaning distributions may slow. They’re also eager to buy at the bottom, mindful of the fact that crisis-era funds often outperform. The deal spree hasn’t started yet, because getting debt funding has been hard to find. But that may be changing.
Thoma Bravo, for example, is sniffing around 3.5bn-pound UK cybersecurity group Darktrace. The upshot is that private equity firms like Carlyle and KKR may soon ask for much more cash than they are handing out. During the last big slump between 2008 and 2010, capital calls on average exceeded distributions by $43bn a year, equivalent to 5% of total buyout assets under management (AuM), Preqin data shows.
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Today, at 5% of AuM, the net annual cash call would be $115bn. Investors are bracing for pain, having sold a record $33bn worth of fund stakes in the first half of 2022, according to the Financial Times, partly to raise cash for capital calls.
This is a painful option, since secondary sales typically occur below face value. The California Public Employees’ Retirement System recently sold $6bn of assets, according to Bloomberg, with the discounts ranging from the high single-digit percentages to 20%.
Other options, like setting aside idle cash or buying hedges that pay out in a downturn, also drag down performance. Funds’ advertised internal rates of return, which often exceed 20%, fail to reflect the impact of these periodic cash crunches.
Investors seemed to forget that lesson over the past decade, when buyout AuM more than doubled to $2.4 trillion according to Preqin. A looming capital-call mess, much bigger than in 2008, should sear it in their memories.
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