Rain, I Don’t Mind: Liquidity Options for Private Equity Funds to Withstand a Recession

I can show you
That when it starts to rain
Everything’s the same

 
In our last article on avoiding the Wile E. Coyote Effect, we discussed certain fund terms that sponsors should review to prepare for potential markdowns in valuations. In this article we will discuss the issue associated with the lack of liquidity, and two mechanisms available to fund managers trying to preserve and bolster liquidity:

1. NAV Financing; and
2. Fund-level preferred equity.

A poor macroeconomic forecast can be daunting, but it should not automatically ruin a private equity fund’s ability to generate profits and keep Limited Partners (“LPs”) satisfied. In order to achieve these goals, however, managers need to ensure that they are in a position to anticipate liquidity challenges. Liquidity is paramount in a recessionary environment, as funds need to be in a position where they can:

1. Capitalize on declining valuations and distressed opportunities; and
2. Ensure that their portfolio companies have the ability to meet their obligations.

While the pandemic forced sponsors to frantically evaluate the relative risks and merits of different liquidity options, managers now have the advantage of deliberately mapping their course before sailing into rough waters.

NAV Financing

Net asset value (“NAV”) financing, historically limited to hedge and credit funds, has become an increasingly popular option for private equity funds.  
Compared with “upward-looking” (and more common) subscription facilities which are backed by unfunded commitments, NAV facilities can be described as “downward-looking”, as they allow funds to use portfolio companies as collateral. NAV financing is especially appealing to late-stage funds that wish to avoid the administrative burden of capital calls, and allows fund managers to leverage portfolio assets in a way that goes beyond subscription financing.

NAV financing can be used as either a sword or a shield. It can be used offensively by funds in opportunistic situations where struggling businesses are available at attractive valuations. An economic downturn may provide funds with the opportunity to strengthen their platforms with bolt-ons, and a NAV facility may be an effective way to ensure that they are ready to take advantage of those opportunities. They can also be used defensively to safeguard portfolio companies that may experience reduced cash flows and require an injection of external capital to stay afloat. Some funds also obtain NAV financing to refinance more expensive asset-level debt.

The NAV financing market is still evolving, and these facilities tend to be sui generis in nature. There are however, certain legal considerations that frequently arise:

1. Collateral: From a lender standpoint, the collateral package is to give the lender the ability to foreclose on and dispose of the fund’s asset portfolio a default. The collateral may include, among other things: (i) liquidation proceeds from the fund’s investments or (ii) a pledge of the bank account into which such distributions are to be paid.
2. Loan to value: Most NAV financing is by definition subordinated to creditors at investment-specific debt. Lenders therefore protect themselves against the risk profile of NAV financings by advancing only a small percentage of the NAV to the fund – typically in the range of 10-30%.                 

Preferred Equity

The pandemic marked the rise of fund-level preferred equity as a source of rescue capital for portfolio companies in need of capital.

In simple terms, fund-level preferred equity is a security that is senior to LP interests in a fund, yet junior to any fund-level debt. It gives the investor a priority right to distributions from the underlying portfolio companies and a pre-negotiated minimum return profile. In a standard preferred equity deal, the equity provider is entitled to a share of future fund distributions up to an agreed-upon rate of return which is subject to an agreed-upon waterfall.

Unlike NAV facilities, which is a debt solution, preferred equity is, as the name suggests, a quasi – equity solution. They are equity-like in that it represents an ownership stake in a company or assets, and is neither treated as a liability on a balance sheet, nor is it secured. It is debt-like in that it behaves somewhat like interest on a loan, and it is paid out in priority ahead of common equity in the event of insolvency.

The principal legal hurdle when issuing preferred equity interests is that the fund’s existing limited partners may need to consent to amending the fund’s Limited Partnership Agreement to implement the arrangement. Investors are typically concerned that the additional capital may reduce the potential returns and/or put at risk gains on the fund’s existing portfolio investments.

When considering the price of preferred equity vs a debt vehicle (such as a NAV loan), funds should consider that preferred equity will typically have a dividend rate between 8-15%. By contrast, debt facilities are subject to interest rates of around 6-9% under current market conditions.

GP-Led Secondaries

Our next and final article in this series will be on GP led secondaries - a previously niche strategy that has become an increasingly popular path to liquidity.