Whole Fund Liquidity Solutions and Restructurings F EB R UARY 2015 TODAY S SECONDARY MARKET

Transcription

1 Whole Fund Liquidity Solutions and Restructurings F EB R UARY 2015 TODAY S SECONDARY MARKET

2 Today s Secondary Market: Whole Fund Liquidity Solutions and Restructurings In today s secondary private equity market, whole fund liquidity solutions, including fund restructuring transactions, are on the rise as a crucial tool to provide (or accelerate) liquidity to investors. This trend represents a critical shift from the historical approach of funds operating at times many years beyond their stated terms to a proactive strategy to facilitate liquidity for the benefit of all investors. As private equity funds reach the end of their stated lives, the decision to sell remaining portfolio company investments often becomes complicated. Fund managers (General Partners or GPs) maintain ultimate control over the decision to hold or sell. Yet, if they conclude one or more of the investments have the potential for additional value creation, extending the fund s natural term may be desirable to allow the investments to reach their full potential. Still, conflicts may arise among the investor base (Limited Partners or LPs) as some LPs may prefer near-term liquidity, while others may desire further appreciation of the fund s remaining assets, albeit at a longer duration, which can take the fund well beyond its original term. While there are often other contributing causes, these differing objectives can lead to an eventual fund restructuring, a developing transaction niche within the private equity secondary market. While at times opportunistic, fund restructurings have become more prevalent as a tool to resolve the competing demands between GPs and LPs, most commonly for late-in-life funds.

3 A Larger and More Sophisticated Market Today s private equity secondary market is progressing to a state of maturity in the industry, and transaction volume is flourishing, particularly as non-traditional secondary buyers enter the market (including public pension funds and sovereign wealth funds). Some industry experts estimate 2014 deal volume to exceed $40 billion. Secondary transactions in the private equity ecosystem have evolved well beyond their beginnings as simple tools to resolve situations of distress for holders of illiquid investments. During this maturation, transactions have taken on new shapes and forms beyond traditional LP interest trades to include GP spin-outs, direct portfolio divestitures, and public-to-private transactions, among other transaction types. In recent years, whole fund liquidity solutions, including fund restructuring transactions, have emerged as a large and growing segment of the secondary market. While there are many benefits to fund restructurings, in certain circumstances they have received negative press, particularly where a transaction is reported to have adversely affected LPs or created conflicts for the GP (or both). As a nascent sub-segment of the market, fund restructuring deals are in the early stages of acceptability, similar to the early days of the traditional secondary market of the 1980s. As an active secondary buyer, HarbourVest does not believe that a single prescribed approach to a fund restructuring applies in each and every situation. Rather, a successful fund restructuring transaction must address the considerations unique to a particular GP (and, importantly, its corresponding LP base), or risk dissatisfaction among all parties. Experienced buyers of private equity assets, with extensive networks of relationships across both the LP and GP communities, can create fund liquidity solutions designed to benefit LPs and GPs facing complex issues late in a fund s life. These include further extensions, additional capital, or a realignment of incentives (among others). Often, a customized transaction can benefit all parties involved (the LP, the GP, and the secondary buyer), while mitigating many of the downside risks inherent to funds approaching the end of their stated terms. These transactions can also be used opportunistically as organized and efficient liquidity mechanisms for LPs well before the end of a fund s life. A Brief History of the Secondary Market The emergence of secondary transactions began in the early 1980s. Over the past decade, the increased acceptability of secondary transactions has driven the market s staggering growth. Secondary transactions are now considered strategic tools used by both investors and fund managers to navigate the constraints of an illiquid asset class. Given the growth of the market, an increasing number of secondary transactions are far from traditional and include sophisticated terms and features well beyond a simple LP interest trade. Transactions today are designed to allow sellers of private equity to accomplish multiple objectives that often extend well beyond price optimization. During and just after the global financial crisis (GFC), distressed sellers used the secondary market to generate much needed liquidity while reducing unfunded obligations. In more recent years, investors have turned to the secondary market as a solution to resolve a broader range of issues, such as shifting portfolio weightings among venture and buyout strategies, managing geographic or vintage year exposure, consolidating the number of manager relationships, or reducing exposure to the asset class altogether. Today, the universe of sellers includes a more diverse cross-section of institutional investors, including endowments, public pensions, and notably, financial institutions responding to post-gfc regulations that limit their private equity allocations. Sellers now have access to a greater number of buyers than has ever been the case. Whole Fund Liquidity Solutions and Restructurings 1

4 Private Equity Market Driving Restructuring Dealflow Large amount of capital raised from 2002 to 2007 Despite its substantial growth since the early 2000s, the secondary market shows few signs of slowing, largely due to the overwhelming amount of capital raised by private equity funds prior to the GFC. From 2002 to 2007, over 3,100 buyout and venture funds raised $1.1 trillion. The enormous amount of capital raised during this time period is now a key driver for the supply of potential secondary market opportunities, particularly as investors and fund managers alike look to resolve lingering issues borne out of the GFC. Nearly 1,100 funds raised prior to 2006 have $184 billion of unrealized value.* Many of these funds have minimal remaining value and are likely to run off naturally. Based on recent estimates from secondary marketing intermediary Credit Suisse, 364 (33%) of these funds still hold in excess of $100 million of unrealized value. Of these funds, nearly 70 are managed by GPs that have not raised capital since 2008, representing an estimated $25 billion market opportunity. Long-Term Challenges Fuel the Secondary Market Elongated hold periods for GPs can lead to extended fund lives Many fund managers endured elongated holding periods for their investments as portfolio companies took longer than expected to return to pre-gfc operating levels, a result of the pace at which some GPs invested capital prior to the crisis, coupled with the market struggles of the 2008 to 2009 time period. These elongated holding periods are a key driver for the need for fund restructurings. Given the substantial capital raised between 2006 and 2008, the market is expected to continue to grow. While the aggregate market opportunity is estimated to total $184 billion today, it is expected to grow to $337 billion by 2017 as late 2000s vintage funds approach the ends of their stated lives. However, it is important to note that this data does not include the supply of potential funds that may pursue a liquidity solution opportunistically in advance of the end of the fund s stated life. From 2002 to 2007, over 3,100 buyout and venture funds raised $1.1 trillion. ESTIMATED END-OF-LIFE RESTRUCTURING OPPORTUNITIES PROJECTED MARKET OPPORTUNITY $billions (NAV) $350 $300 $250 $200 $150 $100 $50 $ FUNDRAISING $billions $350 $300 $250 $200 $150 $184 billion Pre-2006 Vintage Funds $163 billion Funds with >$100 million of NAV $25 billion GPs that have not raised capital since ,098 funds 364 funds 68 funds Number of Funds Number of Funds * Preqin_Special_Report_Private_Equity_Secondary_Market_ June_2014.pdf Private Equity s Long Tail Considerations For Private Equity Managers And Investors Facing Fund Life Extensions January 2015; Credit Suisse Private Fund Group, acting through Credit Suisse Securities (USA) LLC $100 $50 $ HarbourVest Partners

5 Transaction Overview HarbourVest believes that fund managers who seek extensions to their fund s stated life, or investment period, which can consequently lead to a future restructuring opportunity, generally fall into one of two categories: End-of-Life Transaction Many restructurings in the market to date have typically involved funds rapidly approaching the end of their stated lives (end-oflife transaction). These funds can have portfolios that struggled to achieve liquidity for a range of company-specific or broader market-related reasons. For example, this may be a trend among funds raised in the early 2000s. These fund managers typically anticipated exiting portfolio companies during a timeframe that eventually became the GFC. During this period, depressed valuations and limited financing options constrained liquidity opportunities. Many of these funds emerged from the GFC beyond the standard fund term with, at times, significant remaining portfolio NAV. Given meaningful remaining portfolio exposure and/or potentially misaligned incentives, many of these funds present potential restructuring opportunities. Mid-life Transaction While many restructurings closed to date have involved late-in-life funds, HabourVest believes the potential market opportunity is not limited to end-of-life transactions. Many funds that have yet to reach the end of their stated lives but for a range of reasons might require a realignment of incentives or additional time or capital in order to realize full value from their investments could benefit from a restructuring transaction. Today, this could apply to funds raised prior to 2007 that deployed capital during the private equity bubble in advance of the GFC. These funds may feature a sizable portfolio of assets that were often over-leveraged or significantly underperformed during the recession. As a result, many managers have waited for a recovery in performance before pursuing an exit although the end of the fund s life is rapidly approaching. In some circumstances, these funds are posting net internal rates of return (IRRs) below the preferred return hurdle, creating a potential misalignment of incentives. These GPs may have a low probability of generating carried interest and could elongate portfolio company holding periods for the sake of continuing management fees even if there is little probability of additional equity value creation. Funds in this scenario may benefit from a restructuring to realign incentives and provide additional time (or capital) to maximize portfolio values. WHAT CREATES THE NEED FOR FUND RESTRUCTURINGS? End-of-Life Funds: Early 2000s Fundraise Fundraising Investment Period <2000 Start of Global Financial Crisis Poor Liquidity Environment Extended holding period exceeds life of fund Opportunistic Funds: Pre-Crisis Fundraise Fundraising Fast Investment Pace Slow Investment Pace Large portfolio of underperforming assets with delayed exits Extended investment period; additional time required to create value Whole Fund Liquidity Solutions and Restructurings 3

6 Competitive Fundraising In the post-crisis environment, fundraising has been increasingly difficult. Less capital has been invested into private equity while LPs are becoming more selective, making larger bets with fewer, but high quality GPs. Many GPs that had strong franchises a decade ago are now facing the challenges of a diminishing capital base. FUNDRAISING FOR PRIVATE EQUITY* $billions $1,200 $1,000 $800 $600 $400 $200 $0 $1, Source: Prequin and Credit Suisse $ Some fund managers, particularly those with recent subpar performance, or those that lack a true point of differentiation among their peers, have encountered difficulty in raising a subsequent fund in this more competitive fundraising marketplace. Even fund managers with good performance, and potentially valuable underlying portfolios, have fallen victim to the increased GP selectivity in the marketplace. As funds move into years 10 and beyond, management fees may begin to dwindle. If the GP still holds meaningful asset exposure going into extension periods, and without a subsequent successful fundraise or alternate source of revenue, it may face the added challenge of operating the franchise. This dynamic is hastened if the funds are poised to generate little incremental carried interest, as the economic incentives dissipate. A solution to this conflict may be provided through a mechanism that allows the GP to operate the fund (and franchise) under potentially realigned incentives (if needed) while allowing all LPs the option to seek liquidity. Fund restructurings are therefore often considered when current LPs have little interest in supporting a GP s franchise going forward, or when they desire liquidity to redeploy capital elsewhere in their investment portfolios. Alternatively, restructurings may benefit funds raised just in advance of the crisis that deployed capital at a more measured pace. With a slower investment pace and substantial undrawn capital going into the GFC, many of these GPs were unwilling to invest during a highly uncertain time in the market. Many managers sought extensions to their investment periods in order to deploy the remaining undrawn commitments. As some eventually built potentially valuable portfolios in the years immediately following the crisis, their funds may require additional time beyond the stated fund life to realize full value. The existence of funds within these categorizations have resulted in GPs seeking either investment period or fund life extensions in order to achieve the ultimate objectives stated to LPs at the formation of the fund. However, the elongated holding periods may require even more time beyond the formal extensions and, in some cases, additional capital, at a time when some LPs desire immediate or short-term liquidity. It is this conflict, among others, that creates the need for a fund restructuring. Opportunistic Transaction While elongated holding or investment periods can lead to an eventual end-of-life or mid-life transaction, it is important to note that there is a rising trend of opportunistic transactions. These can involve funds that have performed well, with strong underlying portfolios and realized performance. In these deals, GPs can facilitate an efficient and organized liquidity solution for all LPs, providing a mechanism to lock in a strong IRR by choosing to accelerate liquidity. This can be particularly attractive if the transaction is taking place at a strong point in the cycle. Depending on the transaction structure, this liquidity solution may be more economically attractive than a natural run-off (with multiple portfolio company exits) as there could be material exit fee savings. Finally, opportunistic transactions can be used by brand-name GPs who have raised successor funds but are aiming to provide a liquidity solution to the limited number of LPs who have not continued to support the franchise. * Buyout and venture funds 4 HarbourVest Partners

7 GP-led and LP-driven transaction There is no single factor at the heart of the decision to pursue a fund restructuring. Idiosyncratic motivations to pursue a restructuring GPs may be motivated to restructure a fund, rather than manage it out, in pursuit of several objectives. These can, but not always, include: Improve the basic economics, including new management fees, to maintain the firm s operations Negotiate a new carried interest arrangement so that the existing portfolio has an increased probability of generating carry Extract more value from the portfolio by providing additional time for growth and/or additional capital to support portfolio companies Extract more value from a whole portfolio sale rather than single company sales, with a single transaction delivering lower transaction costs and a quicker return of cash to LPs Attract primary capital to help jump start the next fundraise Differentiate themselves among the GP universe by offering an accelerated liquidity mechanism to LPs LP motivations to exit Meanwhile, LPs may have their own motivations to exit a fund through a restructuring transaction. While these motivations may underlie the reasoning for any sale, a fund level liquidity solution provides an organized mechanism through which all LPs can make the decision to sell en masse through an efficient one-stop process. Motivations can include: Reducing exposure to the asset class to meet regulatory changes, particularly among financial institutions Adjusting or rebalancing portfolios as liquidity and market values fluctuate Exiting manager relationships that are no longer core nor expected to be supported going forward Rebalancing portfolios to meet internal requirements, such as the number of GP relationships, exposure to a particular sector or investment strategy, or fluctuating allocation targets Accelerating liquidity to lock in an attractive IRR Traditional versus Customized Whole Fund Liquidity Solution With a long history of secondary investing and executing complex transactions, the HarbourVest secondary team has evaluated a broad spectrum of fund restructuring transactions over its history. While a traditional fund restructuring can succeed in certain unique circumstances, a customized whole fund liquidity solution tailored to the unique demands of all counterparties has proven more successful in our recent transaction experience. In general, a fund restructuring of any kind features a number of benefits and considerations for each participant, which may include the following: BENEFITS GPs LPs Secondary Buyers Second chance at carry if existing fund is not expected to generate carry New fee stream Runway for portfolio company growth Greater timing flexibility for portfolio company exits Potentially reduced exit fees Differentiate themselves as facilitators of accelerated liquidity Immediate liquidity Potentially lock in strong IRR Exit from hard to monetize or underperforming assets Exit from non-core manager relationships If selling, potential to monetize at a premium to traditional secondary sale given transaction scale and buyer s potential ability to restructure GP economics and stabilize franchise If rolling, potential to experience reduced risk/ uncertainty through incentive realignment, extended duration, and capital availability Potential opportunity to deploy substantial capital Potential upside with extended investment holding period Complexity can limit competition Restructuring of GP economic terms, possibly below market standards CONSIDERATIONS Conflict of interest Reputational risk Theoretical liability depending on structure and ultimate LP or LPAC approval Advisor engagement and fee payment Time intensive process Potentially overreaching transaction waivers (i.e. waiver of GP conflict) Potential price dilution if GP requires buyer to commit blind pool capital Limited negotiating leverage / options if a forced seller (i.e. LPs who are closed end funds such as fund-of-funds) LP pricing demands may result in unresolvable bid-ask spread Time intensive, complex process Uncertain investment size based on unknown LP up-take at outset Reputational risk with LPs Today s Secondary Market: Whole Fund Liquidity Solutions and Restructurings 5

8 Traditional fund restructuring does not always provide flexibility to all LPs In a traditional fund restructuring transaction, the GP generally seeks a secondary buyer to purchase up to 100% of the remaining assets in the fund through a new vehicle, intended to be managed by the incumbent GP. An intermediary is usually involved to validate that the GP is acting as a good fiduciary to LPs and has fully price tested the market. Once a lead buyer has been selected through an organized process (commonly an auction), this buyer then may provide a cash price at which LPs can exit their investment in the fund, as well as a rollover option, which would allow LPs to exchange their stake in the existing fund for a stake in the new vehicle (SPV), in order to retain exposure to the portfolio going forward albeit at different terms. At closing, the existing assets are moved into the new vehicle, which is managed by the original GP, and often given new management fee and carry economics, along with an extended fund life. In these transactions, LPs are typically required to either sell their interest or exchange it for a stake in the new/restructured vehicle. In such circumstances, LPs may not receive the choice to remain invested as is and have the GP fulfill its existing obligations under the original LPA. TRADITIONAL FUND RESTRUCTURING Before After Selling LPs Rollover LPs Rollover LPs Secondary Buyer CASH SPV Interests CASH Existing Fund Cash and SPV Interests SPV Portfolio Portfolio 6 HarbourVest Partners

9 LP-specific considerations and questions In any restructuring, a specific set of concerns must be addressed to satisfy the LPs, the most important constituency in any such transaction. As LPs evaluate the options in any restructuring deal, these critical questions must be answered: Conflict of Interest: Given that the GP can technically be both the buyer and seller, is the conflict acceptable/ waiveable? Are the transaction consents reasonable? Optionality: Are LPs provided enough options (including a status quo option) that requires the GP to fulfill its obligations under the original LPA? Price Maximization: Did the GP obtain adequate price discovery to ensure LPs are offered the highest possible price? Did the GP require the buyer to make a blind pool commitment, which may have diluted the price LPs are offered in conjunction with the restructuring? Fees: Does the advisor work for the GP or the fund? Who bears the advisor s fee? Transparency to LPs is key As fund restructurings have become more common, LPs can be constrained when evaluating several potential options (or transactions) simultaneously. Many institutional private equity programs operate using a buy and hold strategy, and a portion of the LP universe is not adequately resourced to evaluate the complexities of a restructuring or the benefits and considerations associated with each possible decision. High levels of access and transparency are required from the GP (and the intermediary) in order to ensure that LPs are fully aware of all key factors affecting any transaction. Additionally, many investors must attain relevant internal approvals to enable a transaction and as such, should be provided adequate time to reach a formal decision. In HarbourVest s experience, a successful transaction will address these LP-specific concerns favorably and with consideration for all counterparties. Resolving these issues is a central theme to what HarbourVest considers a customized whole fund liquidity solution. WHOLE FUND LIQUIDITY SOLUTION Selling LPs Before After CASH Secondary Buyer Rollover LPs Rollover LPs SPV CASH Existing Fund Existing Fund Portfolio Portfolio Whole Fund Liquidity Solutions and Restructurings 7

10 Flexible whole fund liquidity solution At its core, a customized whole fund liquidity solution should provide the utmost flexibility to meet objectives for both LPs and GP. In such a transaction, a secondary buyer creates a custom solution to provide liquidity for LPs who require it, while potentially allowing other LPs to remain invested under the terms of the original LPA. The whole fund liquidity solution can address multiple concerns: An organized exit mechanism reduces conflict among the GP and LPs. The GP s basic economics remain the same with existing LPs, while the customized solution can facilitate additional capital for the GP to realize full value from their portfolio companies. LPs can choose liquidity or to remain invested under the original LPA terms. The resources required to develop this type of transaction are considerable, particularly in the context of transacting directly with multiple LPs, leaving it as a pursuit for only the most sophisticated secondary buyers. Advantages of a whole fund liquidity solution ADVANTAGES GPs Potentially extend life of fund subject to support of all LPs Potential for new economic terms via secondary buyer of LP interests Possibility of additional capital to realize full potential of remaining assets LPs Potential broad range of choice: Immediate liquidity Remain in fund at terms agreed in original LPA Potential rollover at buyer terms No conflict waivers or time intensive transaction consents Full price discovery if agent was engaged Secondary Buyers Opportunity to create custom solution to acquire compelling assets Helps GP and LPs achieve all objectives Structures deal with GP to determine new economics for new investors only, while protecting status quo seeking LPs A fine balance must be struck when delivering a solution that works for all participants in a restructuring transaction. This requires considering the needs of the portfolio and of each LP, as well as the goals of the GP. In our experience, a successful fund restructuring should provide LPs with both the option to achieve liquidity or to remain invested in a fund with minimal to no dilution. We believe that LPs should ideally be provided an option that preserves the deal agreed upon in the fund s original LPA if desired. In one example, a special purpose vehicle (SPV) could tender for all LP interests in the fund, allowing the secondary buyer to transact directly with the LPs, providing a high degree of transparency at the outset. Upon consummation of LP interest purchases, the secondary buyer may pledge additional capital to the SPV to provide support for operating companies as needed. Additionally, the buyer could restructure economics (new fees or incentive based payments) at the SPV level only. In this case, the GP would receive no incremental economics from any (original) remaining LPs, as the original fund remains intact and holds the same portfolio company assets that it did prior to the transaction. Multiple Paths to Success The private equity fund restructuring market is nascent, much like the secondary market in the 1980s. While it is still only a small part of the broader secondary market, there are significant drivers behind its future development. The inherent conflicts that underlie each potential transaction can create roadblocks to the market s ongoing development. As more funds reach the end of their stated lives and move into extension periods, we expect the opportunities for whole fund liquidity solutions to grow, as will the creativity required to meet the demands of investors and managers alike. With a focus on more solution-driven transactions, this sub-segment of the market may reach the level of acceptability the traditional secondary market receives today, particularly as more brand-name GPs use fund liquidity solutions as a more organized and efficient means to accelerate liquidity for LPs. The traditional private equity secondary market was intended to resolve issues unique to an illiquid asset class. As the private equity ecosystem has evolved, the needs and circumstances of GPs and LPs have become more complex. A fund restructuring, or customized liquidity solution, is another tool for investors to achieve liquidity in an ever-changing asset class. As whole fund liquidity solutions become commonly accepted within the secondary market, LPs may develop a broader infrastructure to guide their evaluation of transactions and ultimately better inform their decisions. 8 HarbourVest Partners

11 HarbourVest Partners, LLC is an independent private markets specialist, partnering with investors to provide investment programs and customized solutions focused on venture capital, buyout, mezzanine debt, and credit through primary fund investments, secondary purchases, and direct co-investments. HarbourVest has more than 300 employees, including 80 investment professionals, deployed in Asia, Europe, Latin America, and the U.S. During more than 30 years of investing in private markets, the team has committed more than $25 billion to newly-formed funds, completed over $11 billion in secondary purchases, and invested $4 billion directly in operating companies. HarbourVest partners with pension funds, endowments, foundations, and financial institutions throughout the U.S., Canada, Europe, Australia, Latin America, and Japan to provide complete private market solutions. This material does not constitute an offer or solicitation for any fund sponsored by HarbourVest Partners, LLC ( HarbourVest ) or its affiliates, or any investment services provided by HarbourVest. No sale will be made in any jurisdiction in which the offer, solicitation, or sale is not authorized or to any person to whom it is unlawful to make the offer, solicitation or sale. Unless otherwise specified, all information is current at the time of issue. Unless otherwise noted, HarbourVest is the source of all data. Any opinions expressed are those of HarbourVest and are not a statement of fact. The opinions expressed do not constitute investment advice and are subject to change. Past performance is not a guarantee of future success and there can be no assurance that investors in funds will achieve the returns discussed herein. Investments in private funds, involve significant risks, including loss of the entire investment. Before deciding to invest in a fund, prospective investors should pay particular attention to the risk factors contained in the fund documents. Investors should have the financial ability and willingness to accept the risk characteristics of an investment in a fund. Certain information contained herein constitutes forward-looking statements, which can be identified by the use of terms such as may, will, should, expect, anticipate, project, estimate, in-tend, continue, or believe (or the negatives thereof) or other variations thereof. Due to various risks and uncertainties, including those discussed above, actual events or results or actual performance may differ materially from those reflected or contemplated in such forward-looking statements. As a result, investors should not rely on such forward-looking statements in making an investment decision. HarbourVest Partners (U.K.) Limited, 8th Floor, Berkeley Square House, Berkeley Square, London W1J 6DB registered in England and Wales number Authorized and regulated by the Financial Conduct Authority. HarbourVest Partners (Asia) Limited (BAD993) which is licensed for Type 1 (Dealing in Securities) and Type 9 (Asset Management) regulated activities in Hong Kong. Beijing Bogotá Boston Hong Kong London Tokyo HarbourVest Partners