After an unprecedented bull run for private equity in recent years, with investor returns generally outpacing the public markets, current negative economic conditions have created significant headwinds for the private funds industry. Many institutional investors are feeling the squeeze of the ongoing public market decline and the looming recession. We believe that this will result in an increased shift towards unlocking investor liquidity through the secondaries market.
The looming liquidity crunch
As a result of a precipitous drop in public markets in the past year, many limited partners are currently overallocated to private fund holdings. This is in part because of the "denominator effect", caused by the immediate markdown of their public holdings and the corresponding shift in the weighting of their private fund holdings which have yet to be revalued—making it difficult for them to commit additional capital to primary investments in fund interests until a rebalancing of these valuations has occurred.
Compounding this issue is the potential challenge of finding exits in an M&A market that is anticipated to become increasingly difficult to sell into, meaning liquidity—traditionally received from private funds via their distributions—is ever more important in a down market where managers are seeking to raise new capital to propel growth in newer vintages of their funds. This lack of allocable funds means that institutional investors could be forced to either drop fund managers from their roster or refrain from picking up new managers on a go-forward basis, which would see them miss out on investing into a deflated recessionary market that—from a historical perspective—has the potential to lead to particularly strong vintages of private funds resulting from the buying opportunities that are likely to be available to fund managers in the coming years.
Why secondaries are well placed to secure liquidity
Given the potential for a slower fundraising market and the need for institutional investors to continue to receive liquidity for new investments and ongoing re-up investments with their preferred partners, there has been an increased focus for fund sponsors on achieving returns for their clients through alternative means to the traditional "buy and sell" model of closed-ended private funds. The secondaries market is well placed to lean into this economic environment by providing limited partners with additional avenues to secure liquidity in respect of their existing holdings of private funds.
Even the secondaries markets face headwinds at the moment, challenged in particular by issues caused by the inherent lag in private fund valuations, which are typically revised on a quarterly and annual basis, meaning potential transactions could continue to be difficult to close until updated valuations are provided by fund sponsors in respect of their portfolio assets (which are next expected in the annual audited reports of private funds to be released in early to mid-2023).
Among the liquidity options being explored in this challenging market environment are the following:
LP-led transactions
Limited partners—and, in particular, institutional investors that are currently oversubscribed to private fund investments—continue to explore the potential for selling one or more of their fund holdings to other opportunistic market participants.
Secondary fund investing continues to grow in scale and size. As of November 2020, secondaries fund managers including Blackstone, Lexington Partners, Ardian, Whitehorse Liquidity Partners and Northleaf Capital Partners had a record US$115 billion in available capital to be deployed 1, while secondary deal volume in 2021 hit a record US$134 billion in total 2, meaning there is plenty of dry powder that could facilitate traditional institutional investors seeking liquidity from their private fund holdings. Canadian pension funds have also historically been buy-side leaders in these markets, and we anticipate they will continue to be active and opportunistic.
However, a major challenge for sales of LP interests remains one of difficult-to-ascribe valuations as between potential counterparties, a problem which may be alleviated (at least in part) in 2023 with the release of annual audited reporting across the industry. While sponsors do tend to be inherently conservative in their approach to valuation, which will help mitigate this issue, the time lag inherent in typical private fund reporting requirements will still mean that many sponsors will not immediately mark down the NAV of their portfolios even considering the ongoing dislocation in public markets, with these valuations instead most likely to next be revised following the annual audited reporting that will be released in respect of the 2022 fiscal year. Still, even at a discount as compared to the market peak, many investors will be willing to lock in strong gains from the super-cycle of the past few years—meaning there is room yet for deals to be done in this space. More structured transactions are also an option in this area, with the potential for secured debt or preferred equity elements being inserted into these transactions as between counterparties rather than an outright sale of the investors' ownership of their underlying fund interests.
GP-led transactions
General partners who are facing increased investor demand for additional liquidity may be the better placed party to unlock liquidity for their clients. By directly managing the secondary sale process, sponsors are able to keep close tabs on the thorny valuation question and ensure they are achieving a favourable result for their existing investors in respect of strong assets in their portfolio.
Fund sponsors have several potential options to consider when executing GP-led transactions.
Continuation funds
Managers can give investors demanding liquidity in this challenging market environment the option to either "cash out" or "roll into" a new continuation vehicle that will purchase one or more assets (or a strip thereof) currently held by the existing fund. New investors—including the aforementioned secondaries funds and pension funds that are looking to be opportunistic in this environment—will also often be given the opportunity to commit new capital to the continuation vehicle. These investors seek high-quality assets that they can diligence on a one-off basis and where they believe additional value can be unlocked, which allows them to be more comfortable jumping into a new fund in a challenged market environment.
Since the original crisis caused by the COVID-19 pandemic in early 2020, this has been a popular mechanism for allowing fund investors to cash out on specific assets earlier than they would otherwise be able to, while also allowing new investors the opportunity to participate more directly in trophy assets for which fund managers have a strong belief case on a one-off basis. In the current market downturn, challenged long-hold asset classes such as real estate and infrastructure may be well placed for this type of structure such that managers can ride out the current storm and make a final disposition in a more favourable economic environment.
From a valuation perspective, a fairness opinion is most often required, but the general partner retains control of the process and can pull back a proposed sale if it does not obtain a suitable price. Existing fund investors may also be willing to take a discount to NAV in order to unlock some liquidity and cash out earlier than they would otherwise be able to, particularly if the asset has performed well in recent years and they can get comfortable with the price on offer.
Preferred equity options
Fund sponsors can also unlock liquidity through the establishment of a new vehicle below the level of the fund which takes a priority strip of equity in advance of the investors in the fund. This can also be accomplished at the fund level, but any such material changes to the fund agreements typically require investor consents. This priority right is provided in exchange for the additional liquidity allocated by the new investors in such vehicle that is then either distributed out to the existing limited partners at the fund level or reinvested as follow-on capital.
This type of mechanism can be employed to unlock liquidity for limited partners while still allowing them to retain their indirect interest in the underlying portfolio assets of the fund moving forward. In these arrangements, the new investors will typically receive a preferred return on distributions until a certain return threshold has been met by virtue of their participation in the new special purpose vehicle. This has the benefit of both providing some liquidity for existing investors while also injecting additional capital into the fund to be distributed out to investors (or, alternatively, used as follow-on capital).
Tender offers
Fund sponsors may also look to directly organize a secondary sale process in order to allow existing investors to unlock liquidity. This has the benefit of allowing sponsors to better control the valuations being assigned to their fund interests, while also potentially achieving a better price for investors given the highly synchronized nature of this type of process and the bigger portions of a fund that can be sold off under these conditions to other market participants.
Packaging a tender offer for existing investors with a "staple" in respect of any new fundraise for future funds in the process of being raised by the sponsor could be a particularly compelling opportunity for managers seeking fresh new capital allocations for forthcoming vintages of their fund products.
These types of processes, while attractive to existing investors seeking liquidity, are likely to run into similar valuation issues in the current market environment as those hampering one-off LP- driven sales of fund interests, but the strong desire for liquidity and substantial run-up in asset values over the past few years could create space for arrangements where existing investors take a slight discount to NAV in exchange for freeing up their capital to be put back to work in a down market.
The secondaries opportunity for fund sponsors—and the challenge
The desire for fund investors and, in particular, large institutional investors, to unlock liquidity in respect of their private fund holdings is likely to only grow as the demand for cash rises in a recessionary environment that is forecasted to bite most aggressively in 2023. (The liquidity crunch in private equity also explains why NAV fund financing is on the rise.) In such an environment, managers will come under increasing demand from their clients to find creative ways to distribute out capital.
In light of the dry powder available to be deployed by secondaries funds and other cash-rich market participants looking to be opportunistic, creative fund sponsors should look to new structures to help facilitate this demand and unlock liquidity for their clients that can be put back to work in a down market. While there are ongoing investor concerns around valuation and transparency in respect of GP-led processes and an accompanying focus from regulators on these transactions (including a recent SEC proposal for mandatory fairness opinions), these considerations are manageable in any process run with sufficient rigour and with a suitably compelling narrative around the underlying assets of the fund.
In a recessionary market environment where new fundraising could become increasingly difficult for managers seeking to be opportunistic and make new acquisitions at compelling prices, we view the increased possibilities for secondary transactions to unlock liquidity for fund investors as being one of the key 2023 stories to watch in the private funds industry.
Footnotes
1. www.wsj.com/articles/gp-led-deals-take-center-stage-in-the-secondary-market-11609677000.
2. www.wsj.com/articles/single-asset-deals-face-tougher-sell-on-secondary-market-11651143601.
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