Stretching and Flexing – Part 1 Addressing Longer Hold Periods

Part One: Meeting Liquidity Needs in the Face of Longer Hold Periods

Introduction

• Patience is proving to be a virtue for a private equity industry that began 2024 sitting on more than 28,000 portfolio companies valued at more than $3 trillion, according to a report by Bain & Company, as average hold periods extend markedly beyond the traditional three- to five-year horizon. According to Preqin, in 2023 North American private equity funds had an average hold period of 7.1 years, and in Europe the picture was similar, with an average hold period of 5.9 years. And while exit conditions appear to be easing, liquidity for limited partner investors (LPs), and the corresponding attainment of attractive distributed to paid-in capital ratios, cannot come quickly enough for the next wave of fundraisings that will enable financial sponsors to take advantage of the opportunities of tomorrow. 
• Sponsors have been adapting to these stretched exit horizons by finding creative ways to unlock asset value and address liquidity needs in their portfolios. This, in turn, is creating new considerations for management teams facing a longer journey with incumbent sponsors, and equity incentive plans may need to be flexed to enable participation in interim liquidity while realigning interests for the road ahead.
• In part one of this two-part note, we consider liquidity interventions that are increasingly being employed by sponsors to generate cash for LPs within the life of an investment. In part two, we discuss what these solutions may mean for management incentives at the time of intervention and beyond.

The Landscape

• The traditional private equity investment followed a structured life cycle, with expectations of an exit within three to five years. During this hold period, the sponsor and management team focus on value creation through operational improvements, rationalisation, and strategic growth. The gain in value is then realised through a sale to a strategic buyer or another private equity investor or through an initial public offering (IPO). Realised proceeds are then distributed to LPs of funds that have been established for fixed periods of about 10 years. 
• In many instances, value creation is taking longer in what has become a complex business environment shocked by COVID-19, higher interest rates, inflationary pressures, and shifts towards sustainable growth. For many investments, the situation is compounded by high entry valuations having been underwritten by ambitious growth targets that have become more difficult to realise in an exit environment constrained by diverging expectations between buyers and sellers. 
• The effect is more pronounced among large-cap sponsors for which exit strategies are more limited;  they are typically via IPOs (the recent market for which has seen a particularly significant downward shift) or sales to other large-cap players (who may be averse to burdening themselves with expensive debt in the current high-interest-rate environment). 
• A private equity sponsor does not need to achieve a full exit to realise returns, however, and longer hold periods do not necessarily need to come at the expense of liquidity. The following innovations enabling sponsors to achieve interim liquidity have become an important part of the private equity toolkit as sponsors pursue investment goals while managing LP and management relations.

Liquidity Solutions

1. The partial exit

Minority-stake sales enable incumbent sponsors to realise partial liquidity while retaining exposure to potential upside alongside a new partner who may bring fresh expertise, connections, and capital to help take the asset to the next level. Investor interest in acquiring minority positions has grown as traditional buyout firms have become more comfortable with forgoing control for access to high-quality assets, and this segment of the market made up almost a quarter of all US private equity deal activity in second-quarter 2024, according to PitchBook data. By bringing on such a partner, the original sponsor may also lay the foundation for further stakebuilding that may eventually deliver a full exit. The minority investor will often take significant comfort from the continued stakeholding of the incumbent sponsor, with more focused due diligence, fewer contractual protections, and no or low leverage and regulatory scrutiny, facilitating leaner deal execution as compared to a buyout. However, if the proposed minority investor seeks to negotiate preferential economics and hold up governance or exit rights, there is scope for misalignment to occur later in the process. Accordingly, finding a like-minded partner is often key to their success. As appetite for minority stakes builds, we may see an uptick in the so called “private IPO”, where multiple minority investors join the portfolio company’s shareholder base without requiring a public listing.

In a similar vein, the secondary market for fund stakes enables LPs to sell down or exit their interests within the fund life cycle; investor interest in this market is on the rise, with 2023 seeing just under $100 billion raised globally by secondaries funds, including Lexington Partners raising the largest-ever secondaries fund at $22.7 billion, according to Buyouts Insider. LP-led deals made up $63 billion of private funds secondary transaction volume in 2023, compared with $26 billion in 2016, according to Evercore.

2. The cross-fund deal

A minority-stake sale is often a precursor or complement to a related fund transaction through which a newer fund or an alternate fund raised by the same sponsor takes ownership of the asset by cashing out the original fund. LP advisory boards have developed protocols to navigate conflict issues that may arise with related funds being on either side of the buy-sell trade, and a contemporaneous third-party stake sale and/or fairness opinion provides a valuation check for the cross-fund transaction.

As a variation of this theme, single-asset or multiasset continuation vehicles have emerged as an alternative form of fund-to-fund deal and involve setting up a new fund for the purpose of holding the assets and providing a liquidity option for existing LPs; they can decide whether to cash out or roll their investment into the new vehicle alongside new capital raised from secondaries investors. While once used primarily in relation to underperforming assets, these deals are now mainstream and enable sponsors to extend the value-creation runway of well-performing investments while refreshing their own incentives. According to Evercore, GP-led secondary transactions (which are principally made up of continuation fund deals) accounted for $51 billion of secondary transaction volume in 2023, up from just $17 billion in 2016.

3. The dividend recapitalisation

A traditional dividend involves a distribution to shareholders of the company’s profits from operations or asset sales. Dividend recaps, by contrast, fund such distributions by way of debt obtained from third-party lenders. The debt can be incurred through upsizing of existing facilities or layering on mezzanine or payment-in-kind (PIK) debt above the group companies already encumbered by the senior financing, and sponsors take advantage of permitted payments ‘baskets’ to upstream cash to LPs that effectively take an advance payment of ‘equity value’ without any change in equity ownership. Lenders are repaid in due course from future sales of the underlying assets. As interest rates start to ease (or at least stabilise), sponsors can use the available leverage capacity within their longer-held assets to meet some of the pressures to return cash to LPs. According to PitchBook LCD data, $30.2 billion of leveraged loans have been raised in the first half of 2024 for such a purpose.

Net asset value (NAV)-based financing has emerged as a fund financing tool that enables sponsors to raise cash in the form of debt secured against the NAV of all or a subset of the fund’s portfolio. According to estimates by the Fund Finance Association, the market for these facilities is currently about $100 billion and is expected to reach about $600 billion by 2030. This borrowed cash can be used for various purposes, including in some cases being distributed to LPs, akin to a dividend recap. Preferred equity can be an alternative (or complementary) to NAV-based financing whereby an equity provider will typically subscribe to an equity interest in a fund structure in return for receipt of a ‘hurdle’ payment before cash flows are paid back up through the structure to LPs. Preferred equity is a flexible liquidity tool and may come without some of the controls associated with debt in terms of maturity and security, although its feasibility requires analysis of the underlying documents and can be notably more expensive than debt financing.

Carl Bradshaw is a partner and Charles Elsom is an associate in Goodwin’s European Private Equity team based in London, UK. Other contributors to this piece include John LeClaire, founder and co-chair of Goodwin’s global Private Equity group, based in Boston, US; Jacqueline Eaves, a partner in Goodwin’s Secondaries team; and Ed Saunders, a partner and co-chair of Goodwin’s Fund Finance group.

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee a similar outcome.