Private Equity, Public Anger

Once-hot funds are struggling. Their tony clients want out -- but still owe them lots of money

By promising ground-floor access to upstart telecom companies in 2000, money manager John C. Baker of New York's Baker Capital Corp. quickly raised $1.1 billion, no problem. The money was earmarked for the Baker Communications Fund II LP. But before he had spent half the money, the market for digital networking outfits and equipment makers had tanked. Big problem. Now, the Madison Avenue firm's original investments are worth about 35 cents on the dollar, and its blue-chip investors are hopping mad. They staged a revolt at the May 8 annual meeting, demanding that Baker buy back their shares or reduce the fund's assets. Baker won't. Worse, they will eventually have to cough up the some $600 million remaining that he says they committed to the fund and still owe. Baker did not return calls.

Thousands of wealthy individuals and institutions such as pension funds are in the same fix. They thought that such so-called private-equity investments were a surefire way of making a fast buck when the initial public offering market was white-hot. Since 1996, they have poured $850 billion into these funds that invest in startups or private companies with the aim of cashing out by taking them public later.

They're out of luck. The IPO market is bone-dry, and many of the companies still owned by the funds are on life support. Until disillusioned investors are appeased, they're reluctant to bankroll new investments that could help kick-start the economy. Even the big guns on Wall Street are desperate to cut their losses. Deutsche Bank sold $1.8 billion of its private-equity portfolio in February, while J.P. Morgan Chase (JPM )& Co. Chairman William B. Harrison Jr. says he wants to halve the firm's private-equity investments after reporting a $224 million operating loss on them in the first quarter. Says Greg Feldman, founder of New York's Wellspring Capital Management LLC: "The investment banks tend to come in and get out of the [private-equity] market at the wrong time."

Getting out is hard to do. Managers aren't eager to let their clients bail because it advertises that their funds have problems. Internal Revenue Service regulations give them plenty of rope to hogtie investors: Managers can allow only 2% of a private partnership to change hands each year. If it goes above that, the IRS can rule the fund has become publicly traded -- and tax it as a regular corporation. "That would be a disaster," says Laurence G. Allen, chief executive of the New York Private Placement Network LLC, an online auction site and agent for such private transactions. Tax-exempt institutions that are big buyers of these funds would likely turn around and sue the managers, says Allen.

Despite the obstacles, investors are banging on the door to get out as hard as they once did to get in. Allen says he has sell orders for shares in 2,100 partnerships with about $1.3 billion of committed capital on the Web site. In many cases, owners of more than 10% of the shares are waiting for an O.K. to exit. All told, he says, there was a backlog of $3.75 billion at the end of the first quarter in sell deals waiting to be inked, up 146% from last year. The value of shares traded between investors, the so-called secondary market, rose threefold last year, to $2.5 billion. Corporate America has another $10 billion of private investments it will unload by 2005, according to Columbia Strategy, a private-equity specialist. "I've been hearing that the secondary market is about to explode every year since 1989," says Jesse Reyes, vice-president of Thomson Financial Venture Economics (TOC ) a Newark (N.J.) data company that tracks the industry. "I finally believe it."

Not only are investors trying to sell what they own, they're hoping to wriggle out of what they still owe. The delinquency rate for individual private-equity investors who are behind in paying the latest capital call, or installment, owed to their funds shot up 450% in the first quarter of 2003 from a year ago. Delinquencies are expected to rise to 18%, from 11% last year. That's a worrisome trend because many of the partnerships allow managers, quite legally, to confiscate the shares of investors who don't pay up. However, the threat isn't much of a deterrent right now. "You've got a lot of people balking at putting up more money when they are already so underwater, with no hope of recovery," says WellSpring's Feldman.

Managers say the delinquents are threatening their ability to manage the business and to give companies in which they're invested the follow-on financing needed to survive. Some managers are suing to wrench the money from disgruntled investors. Marshall G. Berol, chief investment officer of Malcolm H. Gissen & Associates LLC, which specializes in untangling investors from the lingering and botched real estate and oil and gas partnerships of the 1980s, anticipates a wave of lawsuits as investors realize there's little hope of recovering from big losses in private equity. "It's desperation on the part of the seller and opportunistic on the part of the buyer," adds Lawrence A. Sucharow of Goodkind Labaton Rudoff & Sucharow LLP, which handles class actions involving partnerships. "Investors start by writing a letter and hope that the manager sees the light of day, and usually end up with a lawsuit."

Even if delinquent investors are lucky enough to find a willing buyer, they're not home free. They may be offered only pennies on the dollar, because their holdings are very tough to value. The average prices on NYPPE's Web site are 10% to 15% of original investments. "This is a new market that's just beginning to provide liquidity to investors," says Allen. "There are a lot of sellers who must learn to negotiate with a few buyers. Many prices start out very low."

For now, banks and insurers are getting the best deals because they can sell whole portfolios in a single transaction. Venture Economics says funds that specialize in buying shares from such investors are becoming increasingly active. For example, London's Coller Capital Inc. just closed a $2.5 billion fund, the largest ever, to scoop up distressed shares at bargain prices. Last year, such funds mopped up $3.6 billion of deadbeat investments. In a new development, some insitutions are now repackaging private-equity funds as bonds and selling them to other pros: About $1.5 billion of such deals have been done so far this year. Says David Snow, editor of, an industry news Web site: "It's the Wild West. These new products are totally unproven -- and there's some debate about how effective they will be."

Until investors find a workable escape hatch, managers are likely to face uprisings of the sort Baker Capital did. If managers have got any smarts, they'll get ahead of the game. "Just liquidate and do it quietly," says Jonathan Silver, founder of Core Capital Partners, a $180 million private equity fund that invests in early-stage tech companies. "That way nobody's feathers are ruffled."

It makes good business sense, too. Scrapping losing funds could rebuild investor confidence -- so that when the markets start to recover, investors may not be as reticent to take the private equity plunge as they are now.

By Mara Der Hovanesian in New York

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