Q4 | Torys QuarterlyFall 2022

How the secondaries market can unlock PE liquidity in a recessionary environment

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.

Watch Aaron Hunt and Meghan McKeever discuss the emerging secondaries opportunity.

Meghan McKeever (00:06): Hey there, and welcome to our video discussing secondary private funds transactions. My name is Meghan McKeever. I'm a Senior M&A Associate in our New York office. And I'm joined here by Aaron Hunt, a Senior Funds Associate in our Toronto office. So to kick it off, what is the secondary market in private equity? Secondary markets involve transactions where one or more limited partners invested in private funds sell their investments prior to the end of the fund, either on their own initiative or through a GP-led transaction. These are differentiated from primary fund investments, which are simply the investments made into a fund at the time of the fund closing. So we'll talk a little bit today about LP-led secondary transactions and GP-led secondary transactions and what those look like. But first, Aaron, do you want to tell us a little bit about why LPs might find themselves on secondary transactions in the near future?

Aaron Hunt (01:04): Yeah, sure Meghan. And thanks for the introduction. So the current negative economic conditions and sentiment, and especially the downturn in public markets, has led to a situation where many LPs, and especially institutional investors with certain portfolio allocation mandates, find themselves in a position where they're over-allocated to their private fund holdings. And this is in part because of what's known as the denominator effect, whereby the rapid decrease in public market valuations, which are marked down immediately, have not yet been matched by valuations of private fund holdings, largely due to the inherent time lag that's built into private funds, where updated valuations are not mark-to-market until the end of the given fiscal quarter or year.

Meghan McKeever (01:47): Yeah, that's interesting. And in addition to that, a cooling seller's market, given rising interest rates, may mean that LPs are less likely to see liquidity events from exit transactions and receive distributions in that manner.

Aaron Hunt (02:02): Totally agreed. And fewer liquidity events mean there's less flexibility for investors to deploy capital to sort of chase those buying opportunities in a down market, and especially to invest in subsequent fundraises for their preferred partners or new fund managers that they're looking to work with in the future.

Meghan McKeever (02:19): Aaron, what are a couple of examples of how LPs can participate in the secondary market?

Aaron Hunt (02:25): Yeah, so at the most basic form, an LP-led transaction is where an investor goes out and finds its own buyer for the fund interest it holds in one or more of its private funds. And this is called a portfolio sale and is accomplished by selling a basket of fund interests in most cases to an opportunistic market participant that's looking to buy into a fund on a secondary basis. And in recent years, the growth and explosion of secondaries funds has seen an increased amount of dry powder in the space, with sponsors like Blackstone, Ardian, Whitehorse and Northleaf, for example, seeking to be opportunistic in certain circumstances where other institutional investors, by virtue of their different mandates and position in the market, tend to need to be a little more conservative. And in this type of transaction we're seeing, you know, a secondary investor will, subject to the consent of the GP of each of the funds, typically purchase a basket of fund interests from the selling party on the secondary market and become a limited partner after the fundraising period of the given fund. And one of the challenges we're currently seeing with respect to these kinds of deals is a valuation one, as we discussed earlier. It's one where the difficulty of pricing these deals in a very fast-moving and dislocated market has created a situation where there's a bit of a holding pattern and people are a little unsure how to value these types of deals. And we're expecting that with the next round of annual audited reporting in early 2023, we could see some more room for opportunity for these deals to get done in the future. So in the short term, you know, an area we think where there may be a little more room until such time as these new valuations come out for getting deals done, maybe in the GP-led space. And Meghan, how do we think GP-led deals can be used in this market environment?

Meghan McKeever (04:12): Yeah, thanks Aaron. And so given what you've just described, sponsors who find themselves facing demand from their LPs for liquidity, may instead want to take the reins and directly manage the secondary sale process. And like you said, this is the best way to keep close tabs on valuation and ensure the best results for their LPs. So just to discuss a couple of different types of GP-led transactions, we can talk about continuation fund transactions, right? So a continuation fund transaction is a way to describe a transaction where the GP sponsors a new fund to purchase one or more assets or a strip of assets currently held by the existing fund. And so existing LPs can either cash out and obtain liquidity, or they can roll into the continuation vehicle to ride out a potentially unfavourable market. And then new investors, including funds focused on secondaries, like you talked about, Aaron, and pension funds often commit new capital into the continuation vehicle. So the benefit for investors is, of course, liquidity for those who cash out, the opportunity to participate more directly in the best assets of the fund, and for those that don't cash out and roll into the continuation vehicle, this allows them to stick around until market conditions for an exit may improve. This is a good option, especially for sort of assets that are most challenged in the current market, long-hold assets like real estate and infrastructure. And then a major benefit for the GPs is of course control. So importantly, this helps the GP retain control over timing and valuation, and while an independent fairness opinion is most likely going to be required, the GP can pull back on the process if that process yields an unsatisfactory valuation. So beyond that, the answer to the continuation vehicle transaction, Aaron, what are some of the other GP-led paths that we might go down?

Aaron Hunt (06:08): Yeah, so outside of the continuation fund context, which has been really popular since, you know, the development of the COVID crisis in early 2020, we often also see more and more in this context the use of preferred equity arrangements and tender offers as a way for sponsors in the GP-led space to find liquidity for their fund investors. And preferred equity deals typically involve the insertion of an SPV below the level of the fund, which then takes a strip of equity in advance or in priority to investors participating in the fund above. And in these arrangements, the new investors at the SPV level would receive a preferred return on distributions until a certain return threshold has been met by virtue of their participation in this vehicle, while also allowing existing fund investors to still retain their economic interest in the underlying asset, albeit on a subordinated basis in that case. So these arrangements can be used pretty effectively to create supplemental follow-on capital for a given portfolio asset, which can be useful in a down market where there is additional and attractive buying opportunities. And also it can create new liquidity that can be distributed out to investors to the extent that a follow-on works. And similar to an LP-led deal, like we were discussing earlier, a tender offer can involve the sale of LP interests led primarily by the GP to a more opportunistic market participant. And in this circumstance where the GP organizes the deal and tenders the offer to a potential secondary fund, for example, sponsors can both control the valuations being assigned to their fund interests, while also potentially achieving a better price because they're going to be able to sell off a larger chunk and on a more synchronized basis to the buyer. And one potential option in these kinds of deals is packaging a tender offer for existing investors with a staple in respect of any new fundraise for a future fund that the sponsor’s raising, which can allow managers to find fresh new capital allocations for newer vintages of their funds that are being raised at the present time. And while there is a bit of a valuation issue in respect of these deals which is similar to the concern we’ve flagged above with respect to LP-led transactions, you know, we think there's a lot of room for GPs to sort of take the wheel on these kinds of deals and find space for an attractive price for a potential buyer in this kind of secondaries market.

Meghan McKeever (08:36): Yeah, great. So I guess to sum it all up, you know, we think that 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 really to bite most aggressively in 2023.

Aaron Hunt (08:58): Yeah, and while there are investor concerns around valuation and transparency in respect of GP-led processes, and also a focus from regulators on transactions where we've seen a recent SEC proposal for mandatory fairness opinions, you know, we think these considerations are really manageable in any well-run process and we view the increased possibilities for secondaries to unlock liquidity for fund investors as being one of the key 2023 stories to watch in the private funds industry.

Meghan McKeever (09:26): Well, that about wraps it up. Thank you for watching. And of course, we at Torys are always happy to connect with you to discuss how pursuing secondary transactions may align with the needs of your LPs. Thanks very much.

Aaron Hunt (09:39): Thanks very much.

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.

However, 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 deployed1, while secondary deal volume in 2021 hit a record US$134 billion in total2, 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.

To discuss these issues, please contact the author(s).

This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.

For permission to republish this or any other publication, contact Janelle Weed.

© 2024 by Torys LLP.

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