Fund restructurings have become a common occurrence in the secondaries market. Jeff Hammer and Paul Sanabria, managing directors and co-heads of the illiquid financial assets practice at Houlihan Lokey, explain what makes a GP a good candidate for a fund restructuring and how to ensure that LPs are getting the best possible deal.
How large is the universe of general partners that are suitable for restructuring?
Hammer: There is significant disagreement over the size of the pool of funds that are ripe for restructuring. Various researchers have identified over $100 billion in assets in partnerships that are candidates; others have said that the universe is even larger, while more sceptical observers contend that even $100 billion is overstated.
A large part of this disagreement stems from the fact that it can be difficult to identify restructuring situations. A fund with stranded assets managed by a GP who seems to be sitting on them is not necessarily a good candidate for restructuring. A GP that seems to be implementing stalling tactics may in fact be acting prudently to liquidate investments at the right time and in the right environment.
That said, the past three years have seen enormous growth in the number of GP-led restructurings. What started out as a trickle of one-off, highly-negotiated deals has become a regular flow of transactions using increasingly standardised techniques.
What are some of the circumstances that make a fund a good candidate for a restructuring?
Sanabria: As the market has developed, it has become clear that several distinct criteria render a fund a better or worse candidate for a restructuring transaction.
First, the fund’s assets have to be fundamentally attractive and appropriately valued. Investments that are declining, out of fashion or volatile can create execution difficulty. Investments that are carried at unreasonable values are also problematic.
Second, the GP has to be able to demonstrate some form of continuity and forward momentum. Incoming investors need to be sure that a core team is focused on maximising the value of the existing investments for a defined period of time.
Third, GPs subject to a clawback liability present challenges. A clawback occurs when the GP receives early distributions that are greater than those to which the GP is ultimately entitled. Current LPs are reluctant to forgive this liability since this is expected to be monetised over time. A clawback can become a contentious issue during a transaction, as pricing will indeed reflect the status of the clawback solution.
What kinds of restructuring are the most common these days?
Hammer: The most common fund restructuring is a fund recapitalisation. In these transactions, a potential anchor investor prices a portfolio in an older fund. The winning price sets a transfer value for the assets, enabling existing limited partners to cash out at that price or to roll into a new fund with new terms. In some cases, existing LPs are offered a “status quo” option, allowing them to continue with the same terms as the old fund.
Sometimes the new fund terms require investors to allocate new capital to the GP for new investments. Dry powder is typically accorded to GPs that have convinced investors that they are good stewards of capital as well as effective value-maximisers for existing investments.
What fund terms do you find are the most common in restructuring transactions?
Hammer: New terms are common to virtually all restructurings. It is fairly common for new management fees to be higher than the existing fund where fees may have scaled down due to fund maturity. The new investors typically ensure that the GP has sufficient economics to manage the fund but not generate a profit.
Investors are much more focused on the GP realising value through carried interest. Importantly, new investors are generally willing to reset the carried interest to the transfer price that was established in the competitive process. However, it is common for the new fund to have governance provisions that allow investors greater influence over liquidation terms and timing as part of a package of improved investor rights.
What terms can ensure LPs are getting a fair deal?
Sanabria: The way to accomplish this goal is to present the LPs with reasonable options. A transaction is generally deemed fair if the LPs can stay invested in the assets or cash out their position at a fair price set through a competitive process. Staying invested in the assets could mean rolling over their exposure in the old fund into an equivalent position in the new fund or it could mean staying invested in the assets on the same terms and conditions as the original fund. However, the “status quo” option can have a chilling effect on the ability to execute a transaction given the “free rider” effect – whether to include it depends upon the facts and circumstances of the specific situation.
In addition, a fairness opinion by an independent advisor on the consideration paid by the new investors can be sought. In fact, this has been done in the large majority of restructuring transactions.
How do existing LPs typically respond to a restructuring?
Sanabria: The best way to characterise the response is that LPs show an abundance of caution. While the popular perception is that investors simply want to gain liquidity quickly, the LP decision is much more nuanced than a simple emotional yearning to break free from a long-dated fund. The LP does not want to feel taken advantage of, so while the offered price is important, so too is the process by which the deal is structured and the new governance rights employed.