- Investor distributions, and fundraising, have stalled on slowdown in traditional exit routes.
- Private capital exit strategies are evolving to get money back to investors.
- Some strategies though are proving controversial.
Where will distributions to investors come from?
MSCI figures show private equity distributions were just 8.7% of valuation in Q1 2024, down from 11.6% the previous quarter and well below the 2015-19 average distribution rate of 23.5%. Early data suggest distributions decreased further in Q2, while contributions increased, said MSCI. “This combination will likely exacerbate the net-cash-flow challenges afflicting the industry as asset owners are less able to fund new commitments from their existing portfolio.”
Distribution rates of private-equity funds slow
Source: MSCI. Distribution rates for past 18 quarters. Distribution rate is calculated as capital distributed to limited partners in each period divided by the starting valuation and is annualized. All figures are calculated in USD. Data as of Q1 2024.
While illiquidity is a feature of private capital markets, investors at some point want their money back … with a healthy return. A dearth of M&A and initial public offerings – the traditional ways funds sell assets to repay investors – has complicated proceedings in recent years. Alternative exit strategies are emerging in response.
Traditional exit routes remain muted
Bain’s 2024 M&A report revealed leveraged private equity and venture capital deals shrank 37% in value in 2023. Exit value fell 66% from 2021, the company’s 2024 Global Private Equity Report noted. Data provider Gain.pro figures showed companies sold by buyout groups in Europe were owned for an average of nearly six years, the longest period since at least 2010.
Private equity companies are sitting on 28,000 unsold companies worth a record $3.2 trillion, according to the Bain Global Private Equity Report. More than 40% of buyout portfolios globally are four years old or older. Fundraising is suffering as a consequence.
“This backlog is massive by historical standards – four times by value what it was during the global financial crisis – and a flash point in the liquidity crunch plaguing private capital markets broadly,” the report’s authors noted. “With exit markets dormant across the alternatives industry, funds of all kinds are badly in need of ways to get cash back to investors and keep the private capital flywheel spinning.”
The trend has continued through 2024. European PE and VC deal activity remains subdued in the face of elevated interest rates. Annual deal value and volume have been trending downwards since 2021, according to PitchBook, with data through the first five months of 2024 suggesting further declines from 2023 by the end of this year. Exit value is down across most size brackets, sectors and geographies.
M&A will pick up eventually. In the meantime, industry participants have turned to a range of alternatives to return money to investors.
Continuation funds
Limited partners surveyed for the Summer 2024 Coller Capital Global Private Capital Barometer think continuation funds will be the most common method used by general partners for generating liquidity in the coming 12-18 months. Single and multi-asset continuation funds have been growing in popularity since 2018 as an alternative to IPOs and sales across all asset classes. A record number were launched in 2023, with the trend likely to continue throughout 2024, reckoned data provider Preqin.
A continuation fund is a new vehicle set up by a GP to purchase the assets of one or more existing funds instead of selling the assets to an outside buyer. They allow sponsors to carry on managing portfolio companies that would benefit from more time to deliver on expected returns, or to maintain exposure to higher-performing investments while generating additional capital to fund their growth. Incidents of buyout firms backing the continuation vehicles of their peers – as seen with Accel-KKR’s investment in LEA Partners’ continuation fund – have “the potential to dramatically transform the sponsor-to-sponsor exit channel,” added Bain.
As well as being open to capital commitments from new investors, existing investors usually have the option to roll over their interests in the old fund into the continuation vehicle, sometimes on better terms. LPs who want to exit have the chance to cash out.
Secondary funds
The secondaries market more broadly is gaining in popularity. Secondaries allow investors to sell GP positions they no longer want or are able to hold on to – for instance, if they need to raise cash to make payouts to beneficiaries, or rebalance target portfolio allocations. Sales typically are at a discount to the holding’s net asset value (NAV). In 2021, the average discount was 79% of NAV, according to Franklin Templeton. By 2023, it was 68%, although Jefferies figures indicate the discount size has since shrunk.
Secondaries have also evolved into a way to build a diversified private market portfolio. As Preqin observed, “minimum commitments are lower (average $2.0mn vs $14.1mn for buyouts); investors get manager and vintage diversification, outsourced due diligence, and a smoother return profile.”
Secondary funds raised $91.2 billion last year (three times as much as in 2022), with 70% of funds closing above target, reported Preqin. Just under two-thirds of investors surveyed by the firm said secondary funds provide the best opportunity in private equity. Long-term net internal rates of return (IRRs) for secondaries and direct private equity closely track each other. But from 2016 onward, “secondaries have higher IRRs, partly because the underlying assets are more mature and closer to realization,” it noted. Secondaries are the only alternative asset class in which even fourth quartile funds eke out a positive return, observed Bain’s Global Private Equity Report.
The shorter payback periods compared to primary private capital investments, and enhanced liquidity profile that affords, can also help with liquidity management strategies, including for evergreen funds directed at retail investors.
Preqin predicts secondaries will see ongoing structural growth, with increasing appetite among the private wealth channel a big contributing factor. A number of secondaries funds targeting private wealth clients are coming to market. Secondaries specialist Coller Capital is one, recently launching an open-ended SICAV secondaries fund for non-US private wealth investors that offers monthly subscriptions, quarterly redemptions and a lower minimum commitment than typical private equity fund investments.
Novel deal structures
To expedite inter-private equity group deals, firms are employing a range of complex structures. Among them are performance-based earn-outs, where sellers are paid additional sums if a business performs better than expected. Deferred consideration price structures allow a fixed purchase price to be agreed, with a portion paid on completion and the buyer becoming a creditor of the seller for the balance. This can bridge a funding gap and allow the seller to maximise the purchase price.
NAV financing
The growth in NAV financing divides opinion. While 43% of LPs surveyed for the latest Coller Capital Barometer said they are happy for GPs to use the facility (36% said with exceptions), 57% are not comfortable. Bank of England financial stability strategy and risk executive director Nathanaël Benjamin warned the lack of transparency around the degree and kinds of leverage entering the system poses a risk to financial stability.
NAV loans enable private equity firms to unlock liquidity by borrowing against their funds’ assets without needing to sell them. The additional capital may be used to add accretive acquisitions, bridge financing gaps, bolster portfolio company balance sheets or accelerate investor distributions. The loan is repaid through proceeds from asset sales, fund distributions or other capital events.
One concern is that, where a fund uses leverage at the portfolio level in its investment strategy, adding a NAV loan at the fund level creates two layers of leverage. If the underlying assets lose value it could trigger covenants. The fund may struggle to repay the loan, heightening the risk of loss for the fund and its investors.
The facilities though are most often used by strongly performing funds to unlock more growth, rather than to enhance distributions to investors at the expense of a portfolio’s performance, argued NAV finance provider 17Capital.
Return to form?
While exits have been subdued across Europe, particularly within VC, the PitchBook report suggests the exit pipeline could improve in H2 2024, especially if interest rates come down meaningfully.
“Looking at the second half of 2024, we expect a moderate recovery in exits given the green shoots we have been seeing, notably from PE-backed public listings, which are tracking higher than the previous two years,” the report states. “A soft landing would boost corporate exits, while monetary easing will help exits to sponsors.”
Returns, it is hoped, are in sight.
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