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Necessity is the mother of invention

Liquidity constraints are behind a great deal of innovation in the debt finance market, says Tim Toska, Global Sector Head for Private Equity at Alter Domus


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What challenges are private equity managers currently facing around liquidity and funding?

The difficult dealmaking environment is really steering all the liquidity issues that managers are facing right now. The fact that dealmaking has significant­ly slowed down over the last 12 to 18 months – and the same is true for fund­raising in the last six to nine months – is creating a bit of a challenge.

We still see managers observing the availability of follow-on investments or quality assets; the economy hasn’t stopped and there are plenty of oppor­tunities. However, LPs have slowed down their commitments because of a lack of liquidity, and that has created constraints. Institutional investors still believe in private equity, but they have been impacted by both a slowdown in distributions and the denominator effect. As a consequence, their own liquidity has become more correlated with other asset classes – this creates challenges for them.

For a long time, constrained private equity managers relied on subscription line financing, but in the wake of the regional banking crisis in the US at the start of this year there are now fewer lenders and slightly higher rates in that space. LPs are questioning the use of those facilities, which were always a bit of a short-term solution.

What financing options are PE funds embracing?

We have seen a growing number of cli­ents looking to GP-led secondaries as an interesting solution to the current challenges. This is taking place at both ends of the spectrum: GP-leds are being used as a means of providing liquidity to LPs, as well as a route to new funding for some of the assets in their portfolios.

In most of these deals, we are talk­ing about high-quality assets that might have been in the portfolio for a while, have been performing well, and the GP believes there is more value to be ex­tracted. A GP-led secondaries deal of­fers an opportunity to release liquidity to LPs that have been in the fund for some time so that they can continue to invest and re-up into the next fund.

In terms of other financing options, we still see sub lines being used a lot, while NAV financing solutions are also picking up steam. Those tools have been out there for many years, but they are receiving increased attention in the current climate. However, they are not without complexity.

From a lender perspective, the NAV financing market has started to evolve, with a wave of key players leaving leg­acy banks to join asset managers that are creating dedicated NAV financing funds. Those individuals really under­stand the asset class and are able to increase that velocity of distributions back to LPs so they can re-up with ex­isting managers.

The other issue here is the slow­down in exits, with the tide having shifted significantly in the last three or four years. LPs have turned their focus from IRRs to distributions, and while they understand that it is not always in the manager’s control to decide when to sell, at least with NAV financing they can achieve some predictability of cashflow. What’s more, this is not nec­essarily just for right now: we don’t see NAV financing going away, but rath­er becoming a much more commonly used liquidity tool for managers.

How would you describe the current health of the PE secondaries space?

The PE secondaries space is very healthy, both for GP-led and LP-led deals. Last year, GP-leds considerably outpaced LP-led transactions. That had more to do with the exit markets as managers didn’t want to be forced to sell when rolling LPs could see more runway. A lot of LPs chose to go into those deals because they weren’t ex­periencing quite the same liquidity crunch as we saw going into 2023. To­day, GP-leds are still getting done for high-quality assets.

On the other side of the equation, LP-led deals have picked up in 2023. Those deals are not trading at major discounts – they are right around NAV, or maybe at 80 or 90 percent – and there is a healthy volume of activity.

Immediately after the global finan­cial crisis, we saw LP-leds trading at 20 or 30 cents to the dollar, and at that point we started to see the use of defer­rals. Then portfolios started to mark to par, and sub lines came back into use.

Today, we are seeing another pick up in the use of deferrals, where a seller and buyer agree a price and then agree to defer some of that purchase price out a few years. Maybe a buyer is willing to pay closer to par on the valuation of the portfolio in that instance and the sell­er is willing to wait in exchange for a higher purchase price. For some selling LPs, the result is enough liquidity to bridge the gap they are facing thanks to a lack of distributions. It doesn’t work for everyone, however, with some sell­ers preferring to accept a purchase price at 80 percent of NAV for cash upfront.

What challenges do managers face when tapping the GP-led market?

One of the biggest challenges is under­standing and meeting the expectations of LPs. Most GPs are rolling more carry into a continuation vehicle and taking a bigger stake, because there is much more focus on alignment in these deals. LPs want to see managers put­ting more skin in the game.

Another issue is the SEC is putting a lot more regulatory focus on these deals, introducing a regulatory process around third-party valuations, for ex­ample. And, of course, the economics will be a little more friendly to the LP base in a continuation vehicle, which managers can find challenging.

Finally, there are the issues asso­ciated with convincing LPs that this is the right decision, which requires managers to be ready with the data on the portfolio company and with a plan of where they see things going. The transparency is something that most managers have caught up with, but the volume and frequency of data required from the portfolio is nevertheless a challenge.

The good news is that there is cap­ital available for these transactions and there are LPs that want to cash out, which means there is appetite on both sides.

We are seeing growing sophistication in the NAV financing market, shifting from a focus on lending from banks towards other funders with more li­quidity. No doubt over time we will see more use cases, and an industry that started out as pretty vanilla will attract more expert professionals.

We are also seeing a lot of clients struggling to achieve anything mean­ingful with capital call facilities because the banks are hesitant. Over time, we expect less reliance among PE man­agers on traditional bank lenders and more use of the tools being created by a new wave of asset managers who are combining private equity and credit market expertise.

This article was originally published in PEI’s Debt Finance Report.

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