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Recent market trends in the Canadian private equity (PE) landscape indicate a growing appetite for sponsor-led liquidity solutions amid challenging market conditions. There has been a notable increase in secondary transactions and alternative exit strategies as sponsors seek to unlock value and provide liquidity to investors. While traditional exit routes such as initial public offerings (IPOs) have become less viable due to market volatility and regulatory uncertainties, sponsor-led solutions offer greater flexibility and efficiency in achieving liquidity objectives. Secondary market transactions, including fund restructurings, tender offers, and strip sales, have emerged as preferred alternatives, enabling sponsors to optimize portfolio performance and generate returns for investors.
These trends underscore the importance of agility and innovation in navigating the evolving private equity landscape, with sponsors leveraging strategic partnerships and sophisticated financial instruments to maximize value and mitigate risks.
This article explores several potential alternatives that sponsors may employ to meet increasing demands to address the liquidity needs of the fund, investors and portfolio companies.
Fund restructuring
A fundamental aspect of PE funds is their limited lifespan. However, liquidating PE assets at the expiry of the fund’s term, usually within a 10-year timeframe, may not always be an optimal strategy, especially in a challenging macroeconomic environment. In such circumstances, a sponsor-led solution would be to create a continuation fund to acquire one or more portfolio companies from the existing fund. Under this structure, sponsors can retain control over managing the fund’s assets for an extended period until these assets achieve their maximum potential.
Continuation funds typically have a shorter term than the existing fund (e.g., 2-6 years). Furthermore, the investors of the existing fund generally will have the following options when the continuation fund is established:
- Selling their interest in the existing fund and receiving a pro-rata share of the cash purchase price for the transfer of the assets to the continuation fund,
- Rolling over their interest into the continuation fund, or
- Occasionally, a combination of the previous options.
In the rollover option, investors may be allowed to roll over their interest on either a reset or a status quo basis. On a reset basis, the investor participates in the continuation fund on updated economic terms, which could involve lower management fees and higher carried interest rates. In return for the favourable economic terms under the reset basis, the sponsor would seek to lock in its carried interest earned in managing the existing fund to date. On a status quo basis, investors continue to participate in the continuation fund on substantially the same economic terms (i.e., same management fees and carried interest and no crystallization of carried interest on the transferred assets).
Numerous factors must be carefully considered when forming a continuation fund, including tax implications and structural complexities. However, a critical aspect is to address the sponsor’s conflict of interest, ensuring it complies with its fiduciary obligations to investors. To mitigate the conflict of interest risk, the sponsor can undertake measures such as seeking a fairness opinion from an independent valuation expert and providing adequate disclosure to all investors with respect to the terms of the restructuring process.
Historically, continuation funds have not been widely utilized in Canada. However, in recent years, there has been a growing trend towards their adoption, offering investors the flexibility to either withdraw from their investment in the portfolio company or remain invested by rolling into the continuation fund.
Tender offers
Sponsors may also consider organizing a secondary sale process directly to facilitate liquidity for existing investors, allowing them to either maintain their interests in the existing fund or sell their interest to a secondary buyer.
Compared to a fund restructuring, a tender offer represents a simpler alternative, as it does not involve establishing a continuation fund, alleviating the sponsor from the complications of investor negotiations and expenses associated with a continuation fund transaction. Additionally, a tender offer may prove particularly advantageous when the secondary buyer commits to subscribe for a “stapled” interest in another fund being raised by the sponsor.
Strip sales
In a strip sale, the sponsor partially sells the fund’s portfolio company investments at a price negotiated with the secondary buyer. Buyers in these transactions typically consist of other PE funds that do not intend to acquire a controlling stake in the underlying assets. These sales offer partial liquidity in a well-performing portfolio without surrendering complete control of the underlying assets. However, it implies that the existing fund will surrender a percentage of the potential appreciation of the assets.
Similarly, sponsors considering strip sales should carefully review conflict of interest issues and financing arrangements of the portfolio companies
Preferred equity options
Another sponsor-led liquidity strategy is preferred equity options, which allow a new investor to inject additional capital into the fund, in exchange for which the new investor receives priority over the distributions from the assets held by the fund.
This type of mechanism is typically structured by transferring the assets to a newly established special-purpose vehicle, which issues preferred shares to the new investor. Alternatively, the sponsor may also admit the new investor to the fund and issue a preferred interest to such investor.
This strategy offers the benefit of providing liquidity to existing investors while contributing extra capital to the fund. Nonetheless, these transactions may require an amendment to the fund documentation to allow the issuance of preferred equity, typically requiring a higher level of consent from the limited partners.
Net asset value (NAV) loans
Fund finance has traditionally consisted of subscription facilities, in which credit facilities are secured by the uncalled capital commitments of the limited partners. However, NAV loans have recently emerged as an attractive alternative to provide liquidity for funds when market conditions render asset sales difficult.
NAV loans, generally used for later-staged funds, allow sponsors to borrow against the value of their portfolio holdings, offering them flexible and efficient access to extra capital while avoiding potential discounts associated with other secondary market deals. NAV loans appeal to sponsors aiming to accelerate distributions to investors and finance add-on investors without requiring additional capital calls.
In NAV loan arrangements, lenders typically have recourse to the fund’s portfolio investments, with the borrowing base calculated on the net asset value of the fund’s portfolio assets. However, securing NAV loans will generally require a comprehensive due diligence review of the fund, the limited partners, and the portfolio assets. In this regard, reviewing the fund’s organizational documents is crucial to ascertain the feasibility of NAV finance. If the fund’s organizational documents do not expressly contemplate NAV borrowings, sponsors must carefully interpret the respective borrowing provisions and determine the need for amendments or investor consent.
The current economic landscape continues to favour NAV loans, and sponsors should stay attuned to the evolving fund documentation and legal considerations surrounding these types of arrangements.
Risk management and mitigation strategies
Effective risk management is paramount in sponsor-led liquidity transactions to safeguard investor interests and preserve value. Key risk factors include valuation uncertainties, conflicts of interest, regulatory compliance, and market volatility, which require proactive mitigation strategies.
Valuation uncertainties:
Sponsors considering sponsor-led liquidity solutions must grapple with valuation uncertainties, particularly in volatile market conditions. The valuation of portfolio assets can fluctuate significantly, impacting the attractiveness and feasibility of liquidity options. To mitigate this risk, sponsors should employ robust valuation methodologies, leveraging industry best practices and engaging qualified valuation experts to ensure transparency and accuracy in the valuation process. Additionally, sponsors should conduct thorough due diligence on portfolio assets, scrutinizing financial performance, market dynamics, and potential risk factors to inform valuation assessments.
Conflicts of interest:
Sponsor-led liquidity transactions inherently involve conflicts of interest, as sponsors seek to balance the interests of various stakeholders, including investors, portfolio companies, and themselves. To effectively manage conflicts of interest, sponsors should implement rigorous governance structures and adopt transparent communication practices throughout the transaction process. This may involve establishing independent committees or hiring third-party advisors to oversee the transaction and ensure fairness and impartiality. Moreover, sponsors should adhere to fiduciary duties and regulatory requirements, prioritizing the best interests of investors and maintaining integrity and ethical standards in decision-making.
Financial and operational risks:
Sponsor-led liquidity solutions entail inherent financial and operational risks, including potential disruptions to portfolio company operations, adverse market conditions, and unforeseen liabilities. Sponsors should conduct comprehensive risk assessments and scenario analyses to identify and mitigate potential risks, developing contingency plans and risk mitigation strategies to safeguard against adverse outcomes. This may involve stress-testing liquidity options under various market scenarios, assessing the impact of financial covenants and performance metrics on portfolio assets, and implementing robust risk monitoring and management frameworks to proactively address emerging risks.
Investor relations and transparency:
Maintaining strong investor relations and transparency is essential for fostering trust and confidence among stakeholders throughout the sponsor-led liquidity process. Sponsors should communicate openly and transparently with investors, providing timely updates and disclosures regarding transaction developments, risks, and potential outcomes. This includes facilitating meaningful dialogue and engagement with investors, addressing concerns and inquiries promptly, and soliciting feedback to inform decision-making. By prioritizing investor relations and transparency, sponsors can mitigate concerns regarding conflicts of interest and enhance investor confidence in the transaction process.
By addressing these key risk management and mitigation strategies, sponsors can navigate the complexities of sponsor-led liquidity solutions with greater confidence and resilience, effectively managing risks and maximizing value for all stakeholders involved.
Conclusion
Determining the optimal liquidity alternative will depend on various factors associated with the existing market condition, interest rates and the fund’s valuation. Sponsors are encouraged to evaluate the different liquidity options available carefully, considering the fund’s investment strategy and the provisions outlined in its organizational documents and portfolio-level agreements. Moreover, in structuring sponsor-led transactions, sponsors must navigate other critical considerations including the previously described risk management and mitigation strategies, and skillful negotiation of the economic terms of the proposed transaction.
Looking ahead, we anticipate sustained growth in sponsor-led solutions in the United States and Canada, as the need to maximize liquidity in today’s market remains a top priority for sponsors and investors. Through strategic planning and execution, sponsors will be well-positioned to achieve optimal results.
Please reach out to a member of Miller Thomson’s Private Equity group should you require structuring assistance.
