Private Equity Liquidity Solutions in the Time of Coronavirus
June 23, 2020
Financing operations during a period of reduced revenues has been a challenge for many companies during the COVID-19 pandemic – including companies that are part of a private equity portfolio.
Steps that private equity fund managers can take to manage portfolio financing needs and preserve financial flexibility were the focus of the recent IAA webinar Private Equity Managers and the COVID-19 Liquidity Crunch. The session featured Andrew M. Ahern, Ramya S. Tiller, and Andrew C. Rearick, partners from the law firm Debevoise & Plimpton, an IAA Associate Member.
Ahern noted that financing additional liquidity needs during the current crisis will likely be easiest for newer private equity funds that still have “dry powder.” These funds are able to draw down capital from investors to fund follow-on investments.
More mature funds may need to consider other options, including external financing. In order from least disruptive to requiring the most change, these options are: amending the partnership agreement, establishing a NAV financing facility, issuing structured or preferred equity, and restructuring the fund. The speakers discussed the pros and cons of each of these options.
Amend partnership agreement. As a first step, private equity managers might consider finding additional sources of capital within the fund by amending the partnership agreement.
For example, an amendment might increase flexibility in the fund’s recycling provisions, allowing cash generated by one portfolio holding to be redirected to another portfolio company rather than being distributed to investors.
Ahern explained that these amendments tend to be relatively straightforward. They generally don’t require unanimous consents for adoption, they don’t require investors to increase commitments, and they maintain current sharing percentages.
Alternatively, the partnership agreement might be revised to permit the sponsor to set up another vehicle – sometimes called a sidecar, annex or overflow fund – that allows limited partners or unaffiliated third parties to voluntarily make additional investments in the fund. Because these arrangements are voluntary, they are easy to put in place, though sponsors need to be attentive to valuation issues and to potential conflicts related to carried interest.
NAV facility. Sponsors might also consider accessing external capital by borrowing using the portfolio investments as collateral through a NAV facility from a bank.
These facilities tend to charge relatively low interest rates. In addition, putting a NAV facility in place generally doesn’t require investor consent or a change to the partnership agreement.
A recording of of Private Equity Managers and the COVID-19 Liquidity Crunch – and presentation slides from the webinar – are available on the Webinars section of the IAA website.
Another positive: NAV facilities don’t disrupt the underlying portfolio. However, noted Tiller, not all portfolio companies may be included in the borrowing base. Sponsors need to continually monitor whether portfolio companies are meeting the detailed eligibility criteria, in order to avoid an unexpected mandatory paydown of NAV financing.
On the other hand, establishing a NAV facility can’t be done quickly, especially for new borrowers. “Even in the best of times, a NAV facility takes more time,” cautioned Tiller. “In the current situation, it’s just going to take a lot longer for people to understand and get comfortable with the assets.”
Structured or preferred equity. An alternative source of external financing is through the issuance of structured or preferred equity. “In many ways, this looks like leverage,” noted Ahern, “except that it’s structured in the form of preferred equity, and it’s coming from a secondary investor, as opposed to a bank.”
He noted that, historically, this financing mechanism has been used to accelerate distributions in older funds. However, Ahern believes that, in the current environment, it could become “more interesting as a means of increasing capital.”
Fund restructuring. For sponsors willing to contemplate a complete change to the existing partnership arrangement, a fund restructuring is an option. In these transactions, the existing fund sells all or part of the portfolio companies to a new vehicle established by the sponsor and funded by a secondary buyer. A restructuring can be a liquidity solution if the secondary buyer agrees to commit additional capital beyond the portfolio purchase price.
Because of the potential for conflicts, general partners considering restructuring transactions must be prepared to have a “robust process,” noted Ahern. This process is required to find the highest price for limited partners who have decided to cash out and to structure rollover transactions for the LPs who are maintaining their interest.
Whether a restructuring is appropriate for a particular fund will “entirely depend on circumstances,” Rearick observed. The question to ask, he said, is, “How much runway do you need for the future?” since restructurings can be used to extend the term of a fund.
TAGS: Coronavirus, COVID-19, Private Equity, Private Funds, Takeaways, Columns