The pros and cons of Net Asset Value (NAV) financing, the rise of deal-by-deal investors and the deal and fundraising slump of the last two years were among the topics discussed as part of a high-level investment strategy dialogue on private markets in Luxembourg this summer.
With private equity firms currently sitting on a record $3.2tn in unsold assets, equating to roughly 28,000 portfolio companies, the roundtable began, however, with a discussion around private capital’s current exit problem.
As dealmakers have found it increasingly difficult to find attractive new deals in today’s higher interest rate environment, leaving them sitting on an estimated $4tn of dry powder, or uninvested client funds, the panellists debated the prospects for private capital investors.
Raphaël Remond, deputy chief executive of Northern Trust in Luxembourg, said that current “huge” levels of dry powder and unsold assets demonstrated the success of private capital in the past. His current sense of the market was that everybody was waiting for more stability before deciding whether to move “one way or the other”.
Finbarr Browne, chief executive of Schroders Luxembourg, said there was evidence that some aspects of the IPO market were picking up slowly and dealmaking was picking up in Germany and the Nordics.
“There’s a link here to what’s happening in private markets as well, because bringing anything to the stock exchange in an inflationary environment when investors are risk-off is not very attractive,” he said.
“There’s a kind of cascade effect that needs to happen and we need public markets, the stock exchanges, to behave a bit more normally. Inflation coming out of the market will help.
“And then you have investors or companies that want to IPO asking whether they will get a reasonable price for their companies. If the markets were more normalised, financing would be available. So at the moment we are kind of caught in a cycle where things need to start moving at the same time for the wheels to start turning properly – and that includes public markets as well.”
Camiel de Vries, managing director and head of Benelux & Nordics institutional and wealth at Wellington Management, said that the record-high amount of dry powder awaiting deployment in the private capital industry was an outcome of two factors: a lack of deals and valuations being perceived as too high.
“For instance, if you look at the software sector the growth space, until two years ago companies were easily selling at 20 times forward sales. Now that’s come down to six.
“So now you see savvy GPs coming back to that market. A correction might actually be a good thing in the long-term and mean that people start deploying dry powder again.”
Valerie Tixier, client and market private equity leader at PwC Luxembourg, said that dry powder was, despite being at record high levels, nevertheless being deployed in some niche sectors such as energy transition, infrastructure, ESG and artificial intelligence (AI).
The dealmaking and fundraising slump in the private equity industry led to a record $31bn being deployed by so-called “deal-by-deal” investors last year, according to data from private equity advisory firm Triago.
This was five times more than the amount raised and invested for the purchase of individual companies on a deal-by-deal basis in 2019.
The question confronting the industry is whether this is the new normal or will fundraising return to form as and when the macro-economic situation improves?
Browne told the panel he did not believe the current situation had become the new normal. “It’s a new option that has become more popular if you have capital raising challenges as it allows firms to bring investors to the table that don’t have a very clear capital raising pipeline for their fund – but in reality most firms don’t want to be doing deal-by-deal because it’s less effective and costly”
“Once you bring investors in deal by deal, it just creates a lot of extra effort, a lot of extra cost. Nevertheless, it’s a good mechanism to have particularly in a situation where a large institutional investor pulls out but you still need to go ahead with the investment.”
“At least from my perspective it’s more of a mechanism for that rather than a new norm that you see growing, because there’s an inherent inefficiency in it.”
Louis Lamotte, managing director of JTC Group AIFM Solutions, said that current market conditions had led to a cautious approach to dealmaking over the last couple of years making deal-by-deal transactions more attractive.
The independent structure involved in deal-by-deal had generated more costs for companies.
“We see a lot of GPs launching products from Luxembourg and they are coming from all over Europe. Some choose Ireland, but Luxembourg is far and away the most attractive jurisdiction for GPs,” he said.
Stephane Pesch, chief executive of the Luxembourg Private Equity & Venture Capital Association (LPEA), said that Luxembourg’s long-established expertise in back office functions had in recent years evolved to include also middle office services and functions.
A further evolution could be for general partners to progressively base more analysts or principals in Luxembourg, though not entire deal teams which still need a certain proximity with the deals and investors.
“That new model doesn’t work for every firm in the world, but for some, it could rally make sense because of the current changing environment, growing substance and constitute with the already existing community of front office experts a complete new ecosystem,” he said.
Luxembourg has the capacity to “reinvent itself and enjoy a tremendous second success story with the alternatives.”
Tixier said that well over half of alternative managers setting up funds in the European Union were choosing to domicile their funds in Luxembourg.
Remond said that Luxembourg’s brand reputation had been steadily built over the past 30 years, starting with Ucits funds. New products were still being launched while some funds were being moved from one domicile to another. “It is important to make sure that clients can develop a product they want for the market. That’s really what we’re focusing on our side.”
The IPEM private equity conference in Cannes earlier this year saw much discussion about the rise of Net Asset Value (NAV) financing, which allows PE firms to take out loans secured against the underlying assets in their portfolios or undrawn capital.
While some limited partners fear a lack of transparency by fund managers others say that the case for NAV loans deserves to be made and are calling for an industry-wide discussion on their benefits.
Pesch said that the transparency question around NAV loans needs and will be addressed by the industry.
“Firms need to share and be transparent concerning the risks, the costs and the purpose of what they are doing, and also to demonstrate that they have used that financing for its stated purpose,” he said.
De Vries said that, when it comes to creating liquidity, GPs have four main tools: continuation funds, extensions, secondaries or NAV financing.
“All of these have a role to play, but they should be used conservatively, but we need to ensure as an industry that it isn’t artificial liquidity because then you’re coming into the realm of financial engineering and that often ends in tears,” he said.
“NAV financing works if it’s used sparingly and the same with secondaries. If you’d sell all your assets to a secondary manager you take a 40% haircut. But if you do it towards the end of the term of the fund, you’ve already made your returns on your 38 companies and you have four left. And you say, you know what? I’m willing to take a haircut and close the fund and return capital.”
“The key to all of this will be opening up of the IPO market, which will be good for buyouts and also good for growth. The IPO market has always been cyclical: it’s been shut in the past before and it always tends to reopen and that moment is coming closer. When that happens it will release a lot of the pressure that’s been building up.”
Said Tixier: “Some asset managers are providing multi-purpose NAV financing from bridge capital to settlement of management fees and return of liquidity.”
“One efficient use of bridge financing is to provide liquidity during the fund raising period of the fund as it eases a number of operational burdens”.
Browne wondered whether one of the drivers of the rise of NAV financing was as a reaction to the fact there is less distribution coming up from portfolios.
“In principle, it actually makes a lot of sense as a tool managed carefully. But is the growth linked to the reduced distributions because of the portfolio perhaps struggling with inflation and other things like that?”
Pesch replied that one of the biggest drivers of NAV financing currently was the lower levels of exit activity next to scaling their portfolio companies or eventually for debt refinancing.
“Firms need to take a more granular view of what they have in their portfolios, adapt and apply it accordingly, ” he said.
A final section of the roundtable saw panellists discuss their expectations for the IPO market in Europe which has been depressed for much of the past year by high interest rates.
De Vries said that making firm predictions was hard but his firm was beginning to see some green shoots of recovery.
“There are some IPOs already sparingly happening,” he said. “Our expectation is that the market will reopen later this year or the first half next year.”
Browne said that as inflation declines it will take away a lot of the uncertainty around valuations and “this will allow people to have conversations about more IPOs”.
“There are just too many factors in there at the moment but investors are starting to show an interest in taking on risk again and valuations are getting clear and that will help open up the IPO market.”
Because of continuing market uncertainty, however, this is unlikely to materialise until early next year, Browne believes.
Pesch said that, for the private markets industry, IPOs were an interesting and credible exit route next to a trade sale or a sale to another PE/VC firm.
“There are positives about it, but you also need to take into account transparency, liquidity and regulatory requirements,” he said.
Tixier said she had originally expected an improvement in IPO activity this year, but it now seems more likely that it will be next year before activity really takes off.
Lamotte agreed, saying that a significant improvement this year was now unlikely as valuations were swinging wildly and was undermining market confidence. “Having a more stabilised market with interest rates dropping slightly could help in general for IPOs in the future,” he said.
Participants:
- Finbarr Browne, chief executive, Schroders Luxembourg
- Camiel de Vries, managing director and head of Benelux & Nordics institutional and wealth, Wellington Management
- Louis Lamotte, managing director, JTC Group
- Stéphane Pesch, chief executive, Luxembourg Private Equity & Venture Capital Association (LPEA)
- Raphaël Remond, deputy chief executive, Northern Trust Luxembourg
- Valerie Tixier, client and market private equity leader, PwC Luxembourg
- Mark Latham, deputy editor, Funds Europe (moderator)
