Some private fund investors may have practical or regulatory requirements to reduce their allocation to alternative investments, particularly where a reduction in the value of their public market investments have left them over-weighted in alternative investments. This was one of the features of the previous global financial crisis.
In addition, investors may default on capital call obligations for a number of reasons, including investors’ own liquidity crises or simple disorganisation due to physical displacement of investor personnel.
Managers may therefore experience an increase in transfer requests from fund investors and, ahead of any increase in transfer requests, the manager may wish to focus on the transfer provisions in each fund’s governing documents such as rights of first refusal or legal opinion requirements that need to be complied with, and any tax or regulatory issues such as PTP restrictions.
For funds of funds with capital to deploy, the focus may be on waiting for the next round of fund reporting to consider whether they wish to increase their acquisition volumes. Given the level of uncertainty in the wider economy, we may see increased use of creative pricing structures agreed between selling private fund investors and fund of funds buyers. These can include purchase price deferrals – where the buyer agrees to pay a higher price in exchange for payment at a later date – and earn outs.
An alternative way of describing earn out mechanisms would be “anti-embarrassment”. What we saw in the last recession, and occasionally since, is sellers wanting some potential upside when selling at a large discount. These can be structured in many different ways but effectively the buyer and seller share some of the return from an LP position; for example, after the buyer has received a certain specified return, the seller and the buyer share the upside.
Some managers may also require additional liquidity to support their portfolio companies, particularly if more liquidity is required than is available in their funds and any increase in portfolio company debt would require some increase of portfolio equity.
Such transactions were already becoming more prevalent in the market, and the current climate will almost certainly create additional opportunities to implement them.
There exists now an increased amount of funds of funds, pension funds and sovereign wealth funds that are interested in providing capital in such circumstances, either through a side car fund, preferred equity structure or other GP-led transaction. As such, fund managers may be well-served to explore GP-led secondaries transactions such as preferred equity infusions, continuation vehicles and tender offers by third parties to provide alternative paths to liquidity for existing investors.
Of course, any transactions should be structured carefully with counsel to ensure compliance with relevant contractual documents and legal and regulatory requirements.
The authors of this article are Ira Kustin, Duncan Woollard, Adam Brown and Ed Harris from law firm Paul Hastings.