More GPs opt for alternative exit routes but LPs face a steep learning curve

More GPs opt for alternative exit routes but LPs face a steep learning curve

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General partners, who manage private equity funds, are increasingly exploring alternative exit routes to provide liquidity to their investors, or limited partners (LPs). However, LPs, particularly the Asia-focused ones, face a steep learning curve.

LPs in Asia are less accustomed to unconventional exit paths such as GP-led secondaries, NAV financing, GP stakes, or dividend recapitalisation than their peers in the West.

In the LP-GP space, liquidity plays a critical role as LPs must get good returns from prior funds to maintain their investment momentum, recycle cash, and participate in future vintages.

To ensure this, global GPs have been widely adopting alternative liquidity strategies, particularly since 2018-19, said Lloyd Bradbury, Managing Director and Head of Asia-Pacific Private Capital Advisory at Greenhill & Co. Asia Limited, an independent investment bank. “Among the 20 largest GPs globally, many have utilised at least one of these [alternative exit] tools, if not multiple. Some GPs have even executed four or five continuation funds over the last five years,” Bradbury added.

Asia, in comparison, is around five years behind the US and Europe in adopting alternative exit strategies, with COVID-19 playing a big role in this lag.

Nevertheless, experts point to an increase in the number of continuation funds and other forms of liquidity in the region. “There are a handful of mid-market buyout GPs in Southeast Asia, who I think are doing a nice job,” said Bradbury. However, “these tools are reserved for top-tier GPs and the best assets. Not every GP, fund, or asset will be suitable for a continuation fund, strip sale, preferred equity, or similar options.”

Cautious LPs

A survey by Mizuho-owned global placement agent Capstone Partners early this year showed that LPs remain cautious about non-traditional exit options.

The Liquidity Options Survey 2023 of over 500 global GPs and LPs found that alternative liquidity and financing techniques such as NAV financing, GP-led secondaries via continuation funds, and minority or dividend recapitalisation are being adopted at a fast rate.

Minority or dividend recapitalisation—where new debt is incurred to repay existing shareholders—was utilised by 30% of GPs in the past, with a similar proportion planning to use it in the year ahead, according to the survey.

Meanwhile, GP-led secondary transactions were undertaken by 21% of the respondents, with 28% planning to utilise them this year as well. Here, a GP sells one or more portfolio companies from a fund to a new investment vehicle—the continuation fund—managed by the same GP and set up in negotiation with a new set of LPs. 

NAV financing was utilised by 12% of surveyed GPs previously, with 14% intending to employ it in the upcoming year. In NAV-based financing, a lender provides capital to a fund or vehicle that owns an underlying portfolio of diversified companies. 

However, GP stakes, although used by 11% in the past, are less favoured, with only 5% planning to use them in the future, according to the survey. The term ‘GP stake’ refers to acquiring a minority (10-25%) equity stake in private equity firms.

Industry experts say one approach that has been prevalent in the APAC region is GP-led secondaries often facilitated through continuation vehicles. The region has also seen some NAV financing though it isn’t typically accessible to venture-focused managers in APAC.

“NAV financing is expensive. The incremental cost is almost the required return on equity. So, if it provides liquidity, it does not mean that it is in the interest of the investors or the GP,” said Alexandre Schmitz, CEO of A2Z Private Capital, an Asia-centric boutique investment bank.

The Capstone survey also found that many LPs do not believe their GPs are transparent in their choice of liquidity tools.

Moreover, there are differing expectations. For LPs, the primary objective of GP secondaries is to provide liquidity, according to the survey. However, 75% of North American GPs and 50% of APAC-based GPs see it as a tool to raise additional capital. 

Need to communicate

Eric Marchand, managing partner of Collyer Capital, a Singapore-based boutique fund manager, stressed the need for tripartite discussions where GPs, buyers, and LPs can openly communicate about the transaction. “By being transparent about the potential advantages and drawbacks of using a specific deal construct, GP, LP and buyer communication may lead to better understanding of the various risks involved,” said Marchand.

Providing equal access to information to the sell-side and buy-side LPs during a GP-led secondary transaction is essential for maintaining trust and integrity, believes Bradbury. Transparency and robustness around price-setting are also critical.

“For example, we have seen situations where GPs have sold a strip of an asset to another GP, a sovereign wealth fund or pension fund to set a ‘true’ third party price, and then do a GP-led deal at that same valuation,” added Bradbury.

Kerrine Koh, Managing Director and Head of Southeast Asia, Hamilton Lane says LPs should have more confidence in the possibility that they can execute a sale at their end.

As an investor, Hamilton Lane now asks questions about the intention and structuring of a deal, among other details, said Koh. It looks for options that allow investors to decide whether to participate in a continuation vehicle or opt for liquidity without rolling into a new fund.

“There are other forms of liquidity like NAV financing, which we are less sanguine about. While liquidity is crucial, it shouldn’t lead us to pursue strategies that might not align with investors’ best interests,” said Koh.

Ensuring alignment

“As an investor in continuation funds, we always assess as an incoming LP whether there is considerable alignment of interests between the GP and us,” says Yuliang Chen, Founding Partner, Bee Alternatives Limited.

Chen explained that this could be in the form of a meaningful GP commitment into the said fund, or accepting tiered carried interest structures, where the carried interest percentages scale up or down, depending on how high or how low the actual financial return turns out to be.

For secondary buyers, this could be a strong demonstration of the GP’s conviction in the success of the continuation fund, and could also motivate the GP through economics.

“As part of the GP’s fiduciary duty, LPs can request GPs to engage third-party advisors to provide independent valuation reports or manage the whole process of the GP-led transaction. This ensures transparency and confirms that all acquisitions and transaction terms are conducted at arm’s length, mitigating potential conflicts of interest,” said Chen.

Bradbury points to the use of fairness opinions (a report regarding the fairness of a major financial action like a merger or takeover that an investment banker or an analyst may provide for a fee). However, these are not mandatory in Asia as they are in the US, but they can be adopted to provide further assurance and transparency to LPs involved in these transactions. 

For secondary buyers, it’s crucial to ensure that their involvement isn’t solely to meet GP expectations. They are investors aiming to generate returns, so they should verify whether GPs intend to actively manage the continuation fund or if they are mainly looking to offload their exposure.

“2024, I think will be an interesting year. I don’t think it’s going to be dramatically different from 2023 or 2022. But we’re seeing more interest in India, this year, some selective interest in Southeast Asia, and continued interest in developed markets in Asia-Pacific like Australia, Japan, South Korea,” said Bradbury

Edited by: Pramod Mathew

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