60 Seconds with Sixpoint: How Do You Earn Extra Credit With Your LPs?
The record peak in fundraising and M&A activity has come to an end. Managers who might have been racing towards their final close now find themselves getting lost in the crowd. Other sponsors intending to hold a “single final close” with overwhelming demand are watching LPs push back or cancel their commitments entirely. The reasons for this slow down are myriad and mostly obvious. Despite the uptick in public markets, private equity is a lagging market and followers market at the same time. Investors are unsure what Q2 (and even Q3 marks) might look like. Without the immediate pressure to make a decision some LPs can now take their time to assess each fund and better compare managers who might not have otherwise been open and in the market at the same time. Among the biggest impediments, is exits and distributions. Return of capital is thought of as the grease that keeps the wheel of fundraising going, a necessary catalyst for any LP considering a commitment. LPs also rely on distributions to fund new allocations and GPs need commitments to fund new deals. Unfortunately, as a result of the economic disruption, GPs will face the most challenging exit environment in recent history.
Not only are public market valuations in free-fall, but credit spreads have also widened as leverage has become less available. As a result, some managers are exploring NAV-based loans which are loans to one or more underlying portfolio companies backed by a total fund guarantee. In a few cases, we have seen sponsors attempt to use the NAV-loan as a means of providing a distribution to their LPs. While there are a number of valid uses for the NAV-based loan; we don’t believe that this is one of them. LPs likely won’t give you full credit towards DPI for a recap of this type. Instead, consider a single asset recapitalization or continuation fund. In such circumstances, you can sell your trophy assets (or fallen angels) to a continuation vehicle providing more time and capital for the asset to mature. Existing LPs can choose to exit or roll and participate in the new funding and the entire transaction is a tax-free event. We often get asked the question from sponsors considering such a transaction: will LPs give me ‘full credit’ for a single asset just as they would a traditional M&A exit or an IPO? The answer may surprise you. First, taking a company public and holding on to restricted shares subject to the more volatile fluctuations of the market may be the least appealing to outside LPs. A sponsor-to-sponsor or strategic trade sale is certainly the easiest to understand but not always the best route depending on what you are trying to accomplish. If your LPs are seeking liquidity sooner than you think is prudent to exit, then a single asset recap (or continuation vehicle) may be right for you.
Structured properly, investors will view the single asset recap as a true exit and count all proceeds in your DPI calculation. A single asset recap has all of the qualities and characteristics of any other exit. As the manager, you are likely to hire an advisor to run a competitive process to demonstrate a sound market check. A well-run process should yield multiple bids with a competitive set of terms and an ultimate purchase that should be relatively close to any of the other exit scenarios. The new LP or LPs (aka the buyers) now own the asset but simply rehire you to manage the asset going forward.
The trend toward single asset recaps began well before COVID. Sponsors recognized that it didn’t always make sense to sell their best companies at the very point of inflection. Post-COVID, the trend has only accelerated with the M&A markets all but shut down and the evolving profile of a typical continuation vehicle candidate. Sponsors no longer have to rely on single asset recaps to “clean up” the last remaining asset in an older vintage fund. Today, the equity recap is a tool with its own set of buyers, market dynamics, structural characteristics and price discovery that should stand alongside the traditional M&A and IPO route as a potential source of liquidity for managers at any point in the investment cycle and in any environment.