Investec: Leverage lends a hand to GP-leds

This article is sponsored by Investec.

The GP-led market has grown significantly in recent years and continues to display resiliency. According to Investec fund solutions specialists Stuart Ingledew and Sharon Thandi, the use of leverage in GP-led secondaries is also increasing as participants get comfortable with the benefits it can bring. They tell Private Equity International that, in light of rising rates and wider macro challenges, GPs remain thoughtful about the use of leverage to ensure all-in costs continue to make sense.

What types of sponsor are pursuing GP-leds and what is their rationale for doing so?

Sharon Thandi: It is a challenging time to exit investments and GPs see a lot of value remaining in their older funds, so they are looking to hold on to their best assets to drive further value. As a result, we are seeing sponsors doing GP-led deals for the first time. Meanwhile, GPs that are familiar with these transactions are repeating the process on the back of positive experiences.

The motivation, therefore, involves a combination of the need to continue to drive value from strong performing assets and the need to generate liquidity for existing LPs to raise a successor fund. We see this not only with upper mid-market and large-cap sponsors but increasingly at the smaller end of the market as well. It is important to emphasise, however, that we haven’t seen any deterioration in the quality of assets involved.

Stuart Ingledew: As Sharon outlined, we continue to see continuation fund transactions involving high-quality assets where the GP wants more time and dry powder to drive further growth. At the moment, there are more deals involving two to four assets, as opposed to single-asset transactions. However, single-asset deals are still coming to market for the right assets.

What are GP attitudes towards leverage and how is it being used in GP-led deals today?

ST: Financing packages are most commonly used to part-fund the purchase price – in other words, reducing that day-one equity funding piece and bridging to the exit of the underlying assets. However, there have been cases where debt is put in place following the closing of the continuation vehicle, with the aim of supporting the growth of the portfolio or single asset in the fund.

More recently, financing has been used as a mechanism for deferring a capital call. In these instances, we see short tenors on the debt, usually due to jurisdictional or tax issues.

SI: The majority of financing packages are structured as term loans, but sometimes there is a need for a revolving credit facility. The manager will look to the RCF as a means of funding bolt-on acquisitions or other liquidity requirements, such as the payment of management fees.

What impact is the more challenging macro backdrop having on this?

SI: Given what is going on in the macroeconomy and the implications for accessing leverage, we may see more GPs looking to supplement underlying debt by putting in place facilities at the fund level, following the inception of the continuation vehicle, in order to optimise their capital structure. There may also be a pricing benefit from raising the financing at the fund level rather than the portfolio level, because, while our facilities’ repayment is likely to come from the underlying assets, we tend to look at these deals with two lenses – the investor pool and the portfolio.

How are terms evolving?

ST: We are seeing lower loan-to-value ratios than we have previously in terms of funding the purchase price and LPs seeking to put more capital to work. There has been an increased requirement from lenders to be able to challenge valuations during the life of the facilities. Tenors, meanwhile, are still out there at three to four years. However, pricing has seen an uplift across the board for fund financing products due to the continued imbalance of supply and demand in the fund finance market.

SI: That valuation piece is important. It has increasingly become a requirement to incorporate that right to challenge into structural protections in the same way we see in NAV financing. These facilities are structured in such a way to ensure you have strong, healthy businesses that are ultimately going to be able to repay the facility.

What are LP attitudes towards the use of leverage?

ST: LPs are generally more accepting today. The evolution has followed the same path that we are seeing with NAV financing. In particular, I think LPs are comfortable with GPs using leverage to part-fund the purchase price, rather than having to fully equitise the transaction on day one.

We are seeing more LPs electing to sell rather than roll their stakes into GP-led secondaries, which is a function of the macroeconomic environment and LPs seeking liquidity, which they are using these deals to access. The dynamics are therefore positive for everyone involved, so long as the price setting and election process is run in the correct and fair way. Typically, we are still seeing a third party involved in that process, ensuring the right protocols are being carried out for all concerned.

SI: Those LPs that haven’t historically liked the use of leverage in continuation vehicles seem to be a lot more accepting where the GP is looking to implement a one-year deferral solution, as they know that their money will go to work after 12 months.

We have seen situations where the lead investor wants to be in control of the tenor of the facility, which in turn controls their deployment. In that situation, the leverage is structured as a one-year rolling facility, with an election each year to either keep that leverage in place, or else draw on capital to repay the facility.

Where we do see pushback from LPs, it typically concerns the waterfall structure and ensuring there is alignment. Investors want to ensure that the GP is taking out leverage for the right reasons.

How competitive is this market and how are players differentiated?

SI: There is a lot less liquidity in the fund finance market generally today and very few players operating in the GP-led secondaries space. Nonetheless, the way we look to differentiate ourselves is with the flexibility of the structures that we can offer depending on the dynamics of the deal. There is no one size that fits all, and we work with the client to seek a solution that is suitable for all parties.

How much growth remains in this specific market?

SI: From a lending perspective, the GP-led secondaries market is only just getting started. You can draw a parallel with NAV financing. That was catalysed by covid and, as LPs became more comfortable with the solution, adoption markedly increased.

I think the use of leverage in GP-led secondaries is now following a similar path with a higher potential for growth given the underlying macro conditions.