The coronavirus pandemic is unfolding into a crisis on an unprecedented scale.
Governments globally are taking extraordinary steps to control the virus, protect the health of their citizens and brace their economies for a potential recession that economic data suggest could be the largest since the Great Depression. Few businesses are likely to escape the impact, and in the world of private capital, it is unlikely that funds or their investors will be left unscathed by containment strategies.
In times of intense financial stress, both investors and fund managers need liquidity urgently.
In the context of the current global economic situation, however, the traditional secondary market has limitations. With more LPs considering asset sales, there is a potential risk of a transactional log jam as prospective buyers’ wrestle with estimating fair value and sellers baulk at falling prices.
At the same time, the intense strain faced by managers could also impede typical GP-led deals. Leverage is historically high, both at asset and fund levels, which could lead to heavy write-downs, as well as an increase in the number of portfolio companies requiring follow-on capital. The sharp reduction or even complete halt of company cashflows means the risk of default could be more widespread than what was experienced after 2008. This has the potential to create a situation whereby a few bad assets have the potential to drag down the performance of an otherwise good fund.
The culmination of these factors creates market conditions that dictate the exploration of new structures that can manage both the pressures of liquidity and the ongoing management of constrained assets. The creation of special purpose vehicles (SPV) to house assets requiring a different strategy could allow GPs to take control of the situation, creating long-term value for both themselves and their investors.
The use of SPVs to control liquidity and protect value
At the height of the 2008 global financial crisis, many open-ended funds were gated to restrict redemptions by investors. We see fund managers, such as UK open-ended real estate fund managers, today turning to the same mechanisms to control liquidity requests they will struggle to meet. However, in 2009, many hedge fund managers sought a different solution to control the liquidity available to LPs: SPVs housing assets with a longer liquidity horizon.
The creation of these SPVs, otherwise known as “side pockets”, enabled GPs to carve off and write down non-performing assets and create the longer-term active support they needed. At the same time, the move shielded the main fund from the contagion effect that could drag down overall fund performance.
This structure gave LPs new liquidity options when normal redemption routes were shut. They could sell the side pocket exposure and retain the performing main fund. Also, where needed, they could sell the main fund investment on the secondary market knowing that secondary pricing on the main fund would not be negatively impacted by these underperforming assets.
Today, side pockets are tools that can be applied to closed- and open-ended funds alike, and work for both mainstream and niche strategies – from private equity and credit to asset-backed lending.
Of course, side pockets are not without their own challenges. With economic distress so pervasive, identifying and separating the right companies might not be as easy as it sounds, while further government lockdowns could quickly turn performing companies into non-performing ones. Spinning off non-performing assets will also require GPs to acknowledge issues with assets and require an alteration in their strategy for value maximisation.
As the economic fallout of global containment strategies further unfolds and the resulting stresses on the private capital industry are better understood, it is fair to expect that there will be an increased necessity for non-traditional secondaries requiring more complex processes than seen in the recent past.
However, we also see plenty of appetite within the buying community for more difficult, and less traditional, secondary transactions. This is coming from investors with longer-term horizons who do not require liquidity or redemptions in the short term. Furthermore, there are GPs prepared to get involved in managing non-performing assets, alongside the existing managers, to increase the prospects of recovery.
Moving quickly and decisively will be essential for managing the stress caused by the current crisis. LPs are more sophisticated than ever and increasingly comfortable navigating the secondary market, and GPs are well placed to create liquidity options that leverage this comfort across a wide array of liquidity options.
As history shows us, while it may be difficult, the managers that take proactive steps to protect the fund from the liquidity pressures caused by a small number of non-performing assets – before these assets cause fund-level problems – will see their reputations burnished on other side of this.
Dan Nolan is a managing director in the Secondary Market Advisory practice at the London office of Duff & Phelps. He focuses on intermediating secondaries transactions across private equity, hedge funds and real estate.