HPE Miami 2023 | Fund Liquidity and Co-Investment Solutions

Key takeaways included:

• We are in the midst of a highly challenging financial landscape, which has presented meaningful hurdles to capital raising. As a result, creative ideas have arisen that provide alternatives and/or complement the more traditional “blind pool” fund model. In particular, there has recently been a proliferation in the continuation fund market. GP-led deals and continuation funds have been used to drive momentum in a fundraiser. Now, these vehicles have become more mainstream standalone products offering high-performing assets that are being managed by established GPs and often are not tied directly to a “blind pool” fundraiser.
• The last decade through the end of 2021 saw strong net cash flows for investors, with limited partners (LPs) receiving significantly more capital distributions than for capital calls on new investments. As exit activity slowed and initial public offering markets closed, this paradigm reversed beginning in 2022 and has resulted in substantial net outflows (approximately an $80 billion swing in net outflows.) While liquidity is at a premium as LPs experience a pronounced “denominator effect,” distributions derived from M&A exit activity have slowed because of a valuation gap between buyers and sellers. This scenario is well suited to solutions that may be achieved via GP-led transactions. Continuation funds, which represent about 85% of GP-led transactions, can be a viable alternative to a full exit for GPs. These structures allow GPs to offer a liquidity option to legacy investors while also providing for incremental capital to be raised to drive further growth of a portfolio company.
• In addition to continuation vehicles, co-investment continues to be a large and growing segment of the GP-led marketplace. The approach to co-investing varies widely. On one end of the spectrum, there are more passive participants—mostly commonly funded LPs—that seek to average down their share of management and incentive fees. These investors frequently come in late when there is full certainty around the transaction details. At the other end of the spectrum, there are those investors that seek to serve as value-added participants, in some cases being involved in the diligence of the asset. In some cases, these groups serve as co-underwriters and/or become involved before there is even clarity on whether an investment will be consummated. Not many LPs or investors are willing or able to sit in the latter seat and, therefore, there can be significant value for this type of active investor.
• Certain GPs are more concerned with how to keep investors involved in the business, either economically or as a contributor to the operations of the business. This is becoming a more complex situation as the cap table gets diversified with more investors, funds come with misaligned time horizons, the use of rollover equity, a longer-dated fund or a controlled investor that’s invested out of a new fund. The animating principle here is how to honor the duty to LPs to maximize value.
• Liquidity alternatives such as continuation funds are available to all private equity funds but there is a particular relevance for healthcare. Some of the most relevant megatrends (value-based care, behavioral health, staffing, etc.) are issues that won’t be confronted for another three or five years, which is the typical holding period for a private equity investment, but are trends that will need solutions for the next 20 to 30 years. The calculus becomes this process of putting priority around generating returns and maximizing value for LPs and then thinking about how that plays into the series of liquidity solutions.
• For healthcare infrastructure, which has extremely long-dated assets, it can be hard to find a good deal where one can add value. When a good opportunity is found, rather than selling a winner, some will want to continue to build that asset. Unlike public companies where the approach is typically to hold onto winners and let them run, with the fundraising cycle in private equity, you must sell your assets earlier in their life. Typically, such sales are of the strongest performing assets as opposed to when assets demonstrate performance return capital. The simple solution is to just have longer-dated funds; however, there is little market appetite from LPs for these longer-scale opportunities. Such lack of interest likely stems from LPs wanting another ability to underwrite the manager after a shorter period of time. The benefit seen in the continuation fund market is that rather than having to determine on day one whether there’s a massive compound over five, 10 or 15 years, you can actually make that decision down the road, say in three, five or even seven years.
• Overall, we are moving toward a more bespoke market, and now more than in previous years, there is no “one-size-fits-all” approach. Tailored solutions in structuring the fundraising and lifecycle of private equity investments are necessary in today’s financial landscape.