As a lack of liquidity in the markets has slowed fund exits, secondaries transactions are reaching record highs, with LPs looking for an alternative route to liquidity. A significant portion of secondaries transactions can be attributed to the rise in continuation funds. Continuation funds are principally GP-led secondary transactions, which result in one fund managed by a GP transferring portfolio assets to a new continuation fund that is managed by the same GP.
These funds provide an extension to the period for which the GP can hold assets beyond the life of the original fund, and typically aim to provide LPs with a choice of exiting or rolling their exposure to such assets via the continuation fund. The LPs in the original fund that elect to exit are cashed out using proceeds contributed to the continuation fund by the incoming LPs, who often include a specialist secondaries fund as the lead new investor.
However, LP-led secondaries, where investors sell their existing stakes in a fund to new investors (often with approval, but otherwise little input, from the GP), are also on the rise. But what factors have contributed to this striking growth?
Lack of traditional exits
Slower-than-hoped interest rate cuts and a stalled volume of IPOs and private market deals – both traditional exit routes for GPs – have led to a large backlog of unsold assets held by funds. In situations where GPs are holding on to portfolio investments for longer, seeking to extend the life of funds beyond their original terms and transferring assets into liquidation trusts, a secondary sale can provide LPs with a return of capital, and more flexibility in their investment programme.
Liquidity needs
As LPs struggle to realise their investments, concerns over exits have grown, and the alternative sources of liquidity proposed by GPs are being tested by LPs and regulators alike. Institutional investors, in particular, have increasingly demanded a return of capital. LPs often need to rebalance their holdings to ensure their allocation percentages are compliant with internal policies and to commit capital to new vintage launches. Secondary transactions offer an early exit opportunity for LPs looking to realise profit and obtain a return on their capital early.
De-risking portfolios
In uncertain economic times LPs are also focusing on de-risking their portfolios. Secondary transactions enable them to offload underperforming or non-core investments, reducing risk exposure.
Hesitation with GP-led solutions
GPs that are unable to sell underlying assets or raise new capital have sought to use financing products, such as NAV lending facilities, to fund distributions out of debt. GPs may use NAV financing because it can result in a quicker, less complex process than a full exit process, and may initially result in capital being returned to LPs based on the established NAV of the fund’s portfolio rather than realised (and discounted) sale proceeds in a tough market.
However, LPs have increasingly questioned its efficacy as it can result in LPs being required to hold and return distributions to repay the facility in the event that the assets are not ultimately realised at NAV. Similarly, questions have been raised over GPs’ use of dividend recapitalisations to return capital to investors. This model involves GPs issuing debt over the underlying assets of a fund, allowing GPs to return capital to investors but weakening the financial position of those underlying assets.
Distributions in-kind
A common provision in closed-ended fund agreements permits GPs to distribute assets in-kind to LPs on a winding-up. In the absence of another viable form of exit, or where GPs are time-constrained during the liquidation period of a fund’s term, GPs may enforce this provision and distribute shares in investment holding companies or interests in underlying assets themselves. For LPs that cannot, or do not want to, hold direct assets, a secondary sale offers a way to cash out in advance of that risk materialising.
Final thoughts, and further options
On a related note, the lack of market liquidity, and the fact that many funds are looking to target a new class of investors in private wealth clients, is resulting in a significant uptick in the use of evergreen funds – structures traditionally available for liquid asset classes but increasingly used by funds in credit, real estate and private assets more generally. While the lack of liquidity in the underlying assets, and the difficulty in valuing those assets on a monthly basis, poses risks in using such structures, limited redemption cycles may provide the right path for investors who are in need of urgent liquidity and want to avoid a direct sale.
By Panos Katsambas, Partner and Global Co-Lead of the Financial Industry Group, and Matthew Evans, Counsel, Reed Smith
