With the global health crisis dominating headlines around the world, the true effect that this will have on the PE industry is yet to be seen. In this article we highlight eight trends we expect to emerge from the crisis.
Public and private pension plans are the largest class of LPs investing in private equity and infrastructure funds, accounting for an estimated 30% of annual fundraising. They are long-term investors, but some pension funds are now under pressure on multiple fronts: a steep fall in public company dividends and fund distributions, the likely reduction in NAV across the board, and, in some cases, bigger drawdowns on their existing fund commitments. Trustees who face a pressing need for liquidity may eventually be compelled to divest some holdings or slow down on the investment rate.
The denominator effect is also attracting attention. While it has yet to play out – public and private assets alike have declined – the risk remains that pension funds will need to rebalance their portfolios in order to maintain their diversified allocation ratios, which may mean that some pension funds reduce their private equity exposure. Established management firms, secondaries funds and sovereign wealth funds, all of whom have substantial available capital and more flexibility on outgoings, are well positioned to benefit from that.
With managers looking at ways to make follow-on investments or refinance portfolio company level debt, we expect to see increased appetite for NAV facilities. Such facilities provide debt at fund level (or just below) and are secured against the NAV of the fund’s portfolio. Given the current market volatility, borrowers already using NAV facilities should be wary of any potential issues relating to quarterly valuations that may cause LTV covenant breaches or require prepayment.
We also expect to see a rise in fund level preferred equity solutions. Typically, the fund transfers shares from all or some of its portfolio companies into a new SPV, which issues preferred securities in return for cash (which can provide the required follow-on capital for portfolio companies, be used to refinance asset level debt, etc.). The preferred investors receive a priority right on distributions until they have received a pre-agreed multiple on invested capital and/or a minimum IRR. Some preferred investors also receive a small further upside from future distributions. Since preferred equity is not debt, there are generally no covenants or security. It is worth noting that preferred equity solutions, which have the option of being backed by a more diversified pool of assets, can provide more favourable financing terms for the fund than financing solutions at individual portfolio company level (particularly for those more severely hit by the crisis).
As happened during the GFC, prudent managers will get ahead of the game when it comes to a potential LP liquidity crunch. GPs can help by (i) staying in close contact with LPAC members and other LPs, (ii) slowing the pace of drawdowns and, if necessary, giving informal warning ahead of the formal notice period so that no one is taken by surprise, (iii) arranging for fellow LPs to buy out a struggling LP, (iii) buying out the LP themselves, and (iv) helping to find buyers on the secondaries market. If the portfolio assets themselves are in distress with limited hope of recovery during the fund’s remaining term, GPs will need to consider restructuring options for the fund.
For funds that have already held a first close and made investments, expect some difficult questions from prospective investors at the next close. These ‘subsequent investors’ (who are normally treated as if they had invested at first close, and therefore equalised at par with existing investors) will be especially concerned about underlying asset valuations falling (especially in industries adversely impacted by COVID-19) between the acquisition and the next close.
Subsequent investors are also invariably obliged to pay an equalisation interest premium, which is paid to existing investors to compensate them for their additional cost of capital between closings. But can subsequent investors justify paying equalisation interest on top of drawdowns for assets which have tanked since acquisition?
Although secondaries deal flow has been badly hit by the crisis, we expect to see it recover at least partially via more fund restructurings and compelled LP sales. Secondaries funds are well positioned to take advantage, given the dry powder amassed from several years of very strong fundraising. Indeed, the secondaries market itself took off in a big way during an earlier crisis, the bursting of the dot-com bubble at the turn of the millennium.
With GPs focused on saving existing investments, and institutional investors reviewing their own co-investment deals in similar fashion to gauge the effect of the crisis, the door on traditional co-investments may be closing for now. That translates into higher average fees for those LPs who were banking on a certain number of co-investments to lower their overall fees. However, a fresh source of co-investment opportunities can already be glimpsed, because a lot of portfolio companies are going to need equity cures – and some of the required capital can expect to be provided by LPs via co-investment.
One difference between the global financial crisis (GFC) and the COVID-19 crisis is the growth of fund finance in the intervening years. How lenders behave in the crisis is a key question for GPs and LPs. Subscription lines are typically light on covenants, with the lender relying on the creditworthiness of investors and financial limits (e.g., on undrawn investor commitments). If investors fail to satisfy a drawdown notice, that could be enough to trigger the right to repayment on demand. Even if that doesn’t happen, some GPs are now opting to repay at least part of the loan early and drawing down from LPs.
Private Equity International reported this week that ILPA, the LP trade group, is working on recommendations that would require funds to make detailed routine disclosure of their subscription lines – the idea being that better information will help everyone to better manage systemic risk and avoid a future liquidity problem.
With corporate decisions under the media spotlight in the crisis, it presents PE firms with an opportunity to ‘do the right thing’, publicly. Many PE firms are taking direct, practical steps to mitigate the impact of COVID-19 and the lockdown at portfolio company level – e.g., hiring infectious disease experts to advise company management on steps to take to reduce the spread; creating online information portals for companies to tap into; making direct cash contributions to emergency relief/hardship funds.
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