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Like the swells, winds, tides and the other oceanic motions that concern sailors, some private-equity exposures are readily apparent as the increased mergers-and-acquisitions activity of the past couple of years has collided with the uncertainty of the subprime collapse.

With the stock market awash in recent disappointments, especially in the financial sector, lawsuits by shareholders in portfolio companies against outside directors who are also partners in private-equity companies are one such obvious exposure.

A third visible exposure is when limited or general partners bring action against the management of a private-equity company, arguing that the bets the management placed resemble those thatwould result from a blindfolded person throwing darts at a board that has pinned on it the ticker symbols of randomly selected assets.

But "it takes a pretty significant meltdown before you find that the fund investors think the manager has gone off the reservation," according to Carl Metzger, a partner in the Boston offices of the law firm Goodwin Proctor LLP.

There is another swell in the private-equity ocean that at this point has observers of the horizon watchful but in a state where they have no real gauge to measure exactly how big the exposure might be.

And that exposure, or the early movement of it, stems from the following dynamic: Take on the one hand the intense interest in mergers and acquisitions seen in 2005, 2006 and 2007. Now take, on the other hand, the braking mechanism that has been placed on that activity by the credit tightness resulting from banks realizing that their clever schemes in packaging collateralized debt obligations were self-defeating.

What you get is a lot of private-equity investors who live to see their money make money but instead are going to have to watch their capital get sidelined because private-equity managers can't find the financing to put deals together.

That promises to create something of a collision of interests. A lot of times when interests collide, people call lawyers.

"If you like doing leveraged deals, for one, it is going to be a lot more difficult to find those deals to finance them, which means that capital of these funds is not being deployed. And that just creates greater exposure among the limited partner base who are still going to want to see the returns," said Rodney Choo, a managing director in the San Francisco office of Carpenter Moore, NASDAQ's wholly owned risk management subsidiary.

"If you look at the M&A market slowing down and the credit crunch, that becomes an issue: just not being able to get deals done," Choo said.

Now, having said that, although those types of conflicts are sure to arise, how they will play out in the courts is another matter, according to Choo.

"If you are a limited partner in a private-equity firm, you are by definition from the view of the SEC an accredited investor, so it's going to be difficult for you--barring just outright embezzlement or fraud--to win that type of securities case," Choo said.

What is probably more likely is that the credit crunch is going to result in more bankruptcies of highly leveraged private and publicly traded operations, which in turn will mean more litigation.

The March collapse of highly leveraged Carlyle Capital Corp., the Carlyle Group subsidiary, and the federally backed rescue of New York investment bank Bear Stearns are two of the most prominent of these recently.

On March 13, Carlyle Capital defaulted on some $16.6 billion in loans. For every dollar of equity the fund had, it had about $32 in debt.

"You have a lot of deals out there where you have a lot of private companies that have very high debt-to-equity ratios, and with an oncoming credit crunch or if that continues and a lot of these leveraged companies start having real trouble getting real access to working capital, then you may just see an overall spike in the level of bankruptcies, which then would lead to greater exposure against the investors in general. If they happen to be private equity, then it would obviously filter into private equity," Choo said.

Nick Conca, a New York-based private-equity practice leader for Integro Insurance Brokers, said he's not sure which way the credit crunch is going to push things when it comes to private equity. He seems to strongly suggest that it is too early to tell.

"I don't know that the risks to private equity grow or contract as a result of the credit crisis. We know that some deals have been aborted with respect to some of the larger transactions, and we know that breakup fees have had to have been paid because a lot of these deals relay on significant degree of financial leverage," Conca said.

But Conca said that, if there is another, looming liability for private-equity fund managers, it hasn't shown itself yet.

"I have not seen a correlation yet between the crisis and liability exposure; on the other hand, it is something that has not come to fruition yet," he said.

DAN REYNOLDS is senior editor of Risk & Insurance®.

May 1, 2008

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