The tremendous and ongoing uncertainty surrounding the global economic outlook is forcing GPs to get creative with their exit options. Ed Ford and Katie McMenamin, partners at law firm Travers Smith, explain how alternative secondary solutions and fund-level liquidity tools could be the solution companies are looking for.
GP-led continuation fund deals for single assets or concentrated portfolios, which have experienced significant growth in recent years, are becoming increasingly attractive to a wider range of GPs (including many mid-market GPs) and now account for the majority of secondary transactions.
As the secondary market reacts to a tougher economic environment, there is likely to be a flight to quality, meaning GP-led continuation fund deals based on individual “crown jewel” investments held by high-quality GPs will continue to play a significant role become part of the market. This may be compounded in particular by the fact that individual assets are easier to value/price with care for secondary investors than “portfolio” deals, which may include multiple assets across a range of industries, sectors and geographies, with associated risks and exposures that are more difficult can be valued even though they offer diversification benefits.
Furthermore, it is possible, perhaps likely, that buy-side hesitation generally means that a continuation fund capitalized by a secondary investor will be able to change its focus on the GP, the GP’s knowledge of the assets and the GPs to leverage relationship with management to make an offer higher than that of an understandably cautious third-party buyer. For the right assets, therefore, there remains a clear use case for continuation funds – moving assets into a new fund vehicle that offers greater reach for value creation and better access to follow-on capital can create significant opportunities for GPs and offer LPs the best exit path in this one Surroundings.
Current market conditions can also present good opportunities to consolidate a market through GPs adopting a ‘buy and build’ strategy, while valuations are generally lower and unstable asset-level cash flows allow targets to be ‘under-picked’.
Navigating the bid-ask spread
Conversely, as the exit environment generally becomes more difficult from a pricing and transaction certainty perspective, GPs attempting to dispose of non-trophy/multiple asset assets through a continuation fund are likely to be faced with discounted offers that may not be attractive and may exit assets that remain in short-term vehicles with limited access to follow-up capital.
GPs can therefore find themselves in a dilemma – closed-end fund structures carry an implicit promise that LPs will receive liquidity within a set period of time, and LPs’ alternative programs have been in negative cash flow territory for a number of years now. In fact, some LPs are increasingly expressing their desire to receive distributions to fund their alternative programs and/or rebalance their portfolios in response to the current macroeconomic situation.
Against this backdrop, GPs are increasingly implementing a more complex fund-level capital structure to provide direct liquidity to LPs and reduce further LP funding requirements (creating indirect liquidity). This has become particularly important for GPs as the liquidity made available to LPs is often reinvested in another fund held by the GP.
In recent years, the first port of call for liquidity has been the NAV funding market, which allows funds to borrow cash hedged against the NAV of their portfolios. Typically, NAV funding has been used to fund further follow-on opportunities in a portfolio, but increasingly these products are used, at least in part, to fund distributions to LPs and/or in lieu of LP drawdowns to fund follow-on capital. This provides GPs with a cost-effective way to create liquidity, however, relatively low LTV ratios available when borrowing is not adding value to the portfolio may limit meaningful distributions to LPs, particularly in relatively concentrated or long-term portfolios.
Another possibility is for a GP to offer liquidity through a “preferred” or “structured” equity transaction, where a secondary investor injects further capital into a fund structure similar to NAV financing, but typically at a higher LTV, without security and at correspondingly higher capital costs. In these structures, the secondary investor receives preferential rights to cash flows up to a specified rate of return on their investment, as well as a form of “stock kicker” and can be used effectively to bridge the bid-ask spread on certain GP-led securities transactions. Furthermore, as the secondary investors are often able to acquire interests in funds/assets as well as as part of their strategy, a ‘preferred’ or ‘structured’ stock transaction may be carried out alongside an offer by the secondary investor for the interests in the funds – either through self-funding a formal “LP tender” (where the GP arranges for all LPs to receive an offer for their fund shares) or through a bilateral deal (where the secondary investor approaches the LP directly to purchase its fund shares).
As market conditions remain unstable and the factors adversely affecting a buoyant M&A market remain prevalent, GPs will increasingly explore secondary liquidity solutions as an alternative to traditional M&A exits. Meanwhile, portfolios impacted by current trading conditions are likely to result in more innovative fund-level liquidity solutions being deployed to strengthen, protect and insulate portfolios.