Simpson Thacher & Bartlett: Liquidity Alternatives for Private Funds in a Post COVID-19 World
By Peter Gilman, Jennifer Levitt & Michael Wolitzer
Market developments since the onset of COVID-19 have created new and enhanced capital opportunities for private fund sponsors. With regard to short and medium term needs of existing portfolio companies, innovative financing techniques and alternative liquidity solutions have developed or evolved to satisfy these needs. This includes both debt and equity alternatives raised at the fund level (or otherwise above the portfolio company level). Further, as sponsors consider exit opportunities from investments, the exponential growth of GP-led secondaries and the availability of related continuation funds has created a new source of longer term capital for sponsors, while allowing LPs the option of current liquidity. Related to that, many sponsors have opted to sell portfolio companies to special purpose acquisition companies (“SPACs”), which often allows them to continue on as an equity participant in the combined enterprise. SPACs also have been raised by the funds or the sponsors themselves as further dedicated capital to deploy into investments.
Portfolio Liquidity Needs and Techniques
Private fund sponsors have long utilized various liquidity alternatives to supplement capital received from investors and other traditional sources. Effective use of these alternatives can significantly improve a fund sponsor’s ability to weather a liquidity crisis and provide stability at both the fund and portfolio levels. While the initial onset of the COVID-19 pandemic brought uncertainty and new liquidity challenges to U.S. private fund sponsors, many fund sponsors were able to effectively utilize a number of liquidity alternatives─reflecting a combination of innovation in the space and retooling of traditional techniques─to both support their existing portfolios and proactively capitalize on new opportunities in an ever-changing PE environment. Even as the climate stabilized, sponsors have continued to use these techniques more strategically to fund additional capital needs.
In the attached materials, we examine a number of these alternatives and recent trends, which include:
- Preferred equity financings: Issuance of preferred equity interests at or below the fund level that receive priority distributions at a negotiated rate or multiple.
- NAV-based facilities: Debt facility secured by equity interests and/or rights to cash flows from all or a subset of a fund’s investments. Some alternative providers may be willing to offer hybrid debt/equity or unsecured facilities.
- Subscription facilities: Revolving credit facility secured by the uncalled capital commitments of private fund investors. Can also be used to support and/or bridge holding and portfolio company financings and are likely to be the primary source of supplemental capital early in the life of a private fund.
- Hybrid facilities: Combine components of NAV-based and subscription facilities. While standalone subscription facilities are often the most economically attractive early in the life of a fund, sponsors have increasingly looked to utilize hybrid facilities earlier in a fund’s life. • Warehouse financings: May be used to acquire one or more investments prior to a fund closing on investors and being able to use capital contributions or a subscription facility to do so. Generally more expensive and shorter-term than other financing alternatives.
- Fund document amendments: With the support of investors, fund terms may be modified to extend fundraising periods, investment periods or the term of a fund or increase a fund’s ability to “recycle” or reinvest investment proceeds, make new or follow-on investments or engage in other capital raising strategies.
- GP-led secondaries: Raise a continuation vehicle to purchase one or more investments of an existing fund. This benefits the existing fund by exiting the relevant investment(s), but allows the sponsor to continue to manage such investment(s) until an optimal time for exit at a later date, while affording investors the choice of receiving liquidity or holding interests on a long-term basis.
- Annex/top-up funds: May be raised as a supplemental fund to finance a private fund’s existing or new investments, which may take the form of a preferred instrument.
- Dislocation/event-driven funds: Form and raise a new fund focused on investing in volatile, distressed or other “dislocated” assets.
GP-Leds
In addition to providing liquidity to investors, GP-led secondaries are part of a larger trend away from the private equity industry’s traditional shorter-term investment holding periods (approximately five years) toward a longer holding period, as evidenced by the rise of continuation funds alongside, and as a complement to, GP-led secondaries. In these scenarios, sponsors transfer assets to a continuation fund, typically managed by the same GP, rather than selling the assets outright. In this way, sales to continuation funds effectively serve as fund restructurings, providing the sponsor with a longer time horizon in which to hold the asset and create value, while avoiding the need for exercising fund extension options in order to do so and providing liquidity to those investors that desire it. This trend is also evidenced by the rise of longer-term, “core” or “permanent” capital vehicles, designed to hold investments for an extended period of time or even indefinitely.
Moreover, GP-led secondaries serve as an additional avenue to exit investments. As discussed above, sponsors may form continuation vehicles to hold selected assets (or may raise co-investment capital alongside a successor fund that is buying an investment from a prior fund). Secondary fund sponsors are launching designated funds formed for the specific purpose of investing in GP-led transactions.
SPACs
Since publication of the below materials, we have also seen fund sponsors increasingly utilize business combinations with a SPAC (“de-SPAC transactions”) to exit a portfolio investment as a liquidity tool. Selling investments to a SPAC can be a way for private fund sponsors to not only exit an investment, but extend its tenure engaged in created value. In some cases, a sponsor may create liquidity while also retaining upside in the relevant investment by rolling a portion of their ownership of the relevant investment into common equity in the SPAC.
Funds and sponsors may also raise SPACs in their own right in order to diversify their holdings, broaden their investment strategies and expand their capital base beyond traditional sources. By raising a SPAC, fund sponsors gain access to a pool of capital that can be deployed in ways that may not fit the sponsor’s existing vehicles or limited partner restrictions or that would otherwise be restricted by fund documents. In addition, SPACs allow private fund sponsors to raise large pools of capital from public markets, representing an expansion of traditional capital sources. It may be noted that recent regulatory scrutiny of SPACs combined with cooling market receptivity may reduce the prominence of this technique in the future.
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Please find Simpson Thacher & Bartlett LLP’s full chapter on liquidity alternatives, first published in Global Legal Insights’ Fund Finance 2021 (5th ed. 2021), here (article appears after table of contents): Liquidity Alternatives for Private Funds in a COVID-19 World: A U.S. Perspective
Please contact Melissa Mao at melissa.mao@stblaw.com for additional information.
