Limited partnerships are legal entities which are comprised of general partners, who manage the day-to-day operations of the business, and limited partners, who have invested capital in the business. While they may be utilized for other purposes, limited partnerships have become the dominant structure for private investment funds, allowing investors to participate financially, but with no exposure to personal liability. Some of the earliest limited partnerships were formed in the US to raise capital from investors for railroad expansion.

When we speak of Limited Partnership (LP) interests, for the most part we are referring to ownership rights in alternative investment vehicles such as private equity funds (including venture capital, buyout, mezzanine and real estate funds), hedge funds and funds of funds.  Estimates indicate that the limited partnership interests represented by ownership in fund vehicles is a $2+ trillion market. In summary, 10,000+ hedge funds managed roughly $1.4 trillion in assets at the outset of 2009, and private equity assets under management (AUM) represented approximately $1 trillion managed by 4,000+ funds. 

Over the past several years the secondary market for the $2 trillion in limited partnership interests has grown tremendously.  The secondary market is expected to grow at an even more rapid pace as many limited partners seek to reduce their alternative investment exposure. Many limited partners are requesting redemptions or simply seeking to get out of their positions largely due to a need for capital, a desire to rebalance their portfolios as well as poor fund performance. However, many are locked into their positions for years or are unable to receive capital distributions due to redemption restrictions.

For the majority of hedge funds, investors are typically locked up for a 1-year period, after which they generally have the ability to withdraw capital on a quarterly basis with 30-60 day advance notice before quarter end. Hedge fund investors, facing economic uncertainty and mounting losses, have requested record redemptions in the past quarter. One estimate by Hedgefund.net puts investment losses at $185 billion in Q4, with redemptions at $471 billion in the same period. As investors head for the doors in droves, many funds have invoked so called “freeze” and “gateway” provisions, locking investors into the funds indefinitely as they scramble to sell illiquid assets in a somewhat orderly fashion. This has blocked the typical exit strategy of most limited partners in hedge funds, with the secondary market remaining as the only potential option for liquidity.

The situation with venture capital (VC) and other private equity (PE) funds is slightly different. The typical life cycle for a PE/VC fund is 10 years and investors do not have withdrawal or redemption rights. When a PE/VC firm starts a new fund, limited partners make a capital commitment, which is called over time as the fund manager makes investments. Ideally, investors in these limited partnerships are committed investors and intend to fulfill the commitment over the life of the fund. However, changes in asset allocation, cash flow needs, management, ownership, strategy, regulations and economic climate all can lead to the need to seek early liquidity. 

These changes in allocations are often referred to as the “denominator effect”. In short, as the values of different asset classes fall, the value of allocations to other assets rises in relation to the reference asset allocations. Institutions that commit capital to private equity generally have strict guidelines for asset allocation levels. Because private equity investments are valued periodically (and often not marked to market – as there is no market), an investment that was once 5% of the portfolio can suddenly become 20% or more of assets. In order to rebalance their portfolios, investors have only one option, to sell a portion of their private equity investments. 

Hedge Funds

The term “hedge fund” is actually a misnomer, as the majority of the 10,000+ funds currently being managed and classified as hedge funds do not actually “hedge” their positions against asset deterioration (in fact, many do the opposite by utilizing leverage). What they do have in common is that hedge funds are investment vehicles which strive to produce absolute positive returns regardless of market conditions. Hedge fund strategies vary considerably, but generally generate returns by investing within the financial markets, including stocks, bonds, commodities, currencies, derivatives, etc., and/or applying non-traditional portfolio management techniques. These include, but are not limited to, short sales, leverage, arbitrage, utilizing swaps, program trading, etc. 

Venture Capital Funds

Venture capital funds are pooled investment funds which invest the financial capital of third-party investors in private equity stakes in startup and small and medium-size enterprises.  They invest in companies with strong growth potential, which are often too risky for the standard capital markets or bank loans- they are generally characterized as high-risk, high-return opportunities. Venture capital investments are generally made as cash in exchange for shares in the invested company, in the interest of generating a return through an eventual realization event such as an initial public offering (IPO) or sale of the company through an acquisition by a larger company. VC firms often act in an advisory role, bringing managerial and technical expertise as well as capital to their portfolio companies.

Buyout Funds

Buyout firms usually seek to purchase underperforming or undervalued companies in order to “fix” them and sell them, or take them public many years later. Unlike VC funds, the targets are often mature companies with significant operations. The most common form of buyout is the Leveraged Buyout, in which the buyout firm uses a significant amount of borrowed money (bonds or loans) to meet the cost of the acquisition.  In an LBO, there is usually a ratio of 90% debt to 10% equity.  Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company.   The buyout firm often makes management changes, cuts costs and streamlines operations in an effort to improve overall operating performance or performance of a division for possible divestiture. Buyout funds, in a similar fashion to VC firms, generate the majority of returns through an IPO or sale to an acquirer years later once the company’s prospects (and/or valuation) have improved.

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