Interviews

If necessity really is the mother of invention, then perhaps that goes some way to explain the expansion in financing alternatives being adopted by private equity managers to help navigate the challenges of the past 12 months which will remain with us for some time.

While inflation has been at its highest level for forty years there are signs that may be abating slowly. However, interest rates show no such signs of reversing, economic growth remains subdued, we still face continued supply chain disruptions and unfortunately we are no closer to an end to the Russo-Ukrainian war.

More recently we have seen events in the banking sector not witnessed since 2008.  While it is generally agreed that regulators moved quickly and decisively to avoid potential contagion it does demonstrate that the current global outlook remains volatile.

With this challenging and unpredictable backdrop, it is no wonder that investors are once again having to reassess their options around capital and liquidity for both their portfolio company interests and at a fund level.  While the above circumstances may be ‘current’, the need for private equity managers to navigate challenging markets is not new.

For example, during the GFC, many GPs were forced to dispose of assets at ‘fire sale’ prices or wait until the recovery was completed and end up holding assets for much longer than anticipated. The material negative impact on IRR and, to some extent, money multiples are a feature of those pre-GFC fund vintages.

The question we and others in the industry are now asking is whether the current, albeit very different, economic environment will cause such outcomes to resurface given the material decline in key industry metrics around deployments, exits and fundraising during 2022.

In an increasingly crowded private equity market, with GPs jostling for scarce investor capital, those with a proven track record for capital growth and strong fund IRRs are likely to succeed in continuing to attract investors.

Understandably therefore, GPs are closely monitoring their overall fund performance metrics, particularly as the strategy of ‘holding winners for longer’ becomes a more widely accepted industry approach. The use of subscription finance is now firmly embedded across the industry and allows mangers to call investor capital less often and only after deals have been completed so there is no risk of calling capital unnecessarily.  In addition to the practical advantages, this also improves the performance metrics, particularly IRR.

Similarly, dividend recaps have long been a popular tool to avoid selling and simultaneously realising partial value for investors. However, this time around PE managers may be unable to execute such recaps at a company level due to tightening debt markets or a reluctance to add leverage at this point in the cycle.

As a result, during the past twelve months, NAV Finance providers have seen increased demand to provide fund level financing given the greater scale and flexibility this funding provides without having an impact on the underlying portfolios.

NAV lenders have also provided greater levels of growth capital to help managers grow their existing portfolios and take advantage of attractive follow-on investment opportunities in a dislocated M&A market. A recent report from EY suggests that 60% of PE deals in 2022 were bolt on acquisitions – partially reflecting the likelihood to hold performing assets for longer and therefore an opportunity to invest additional capital into those strong businesses.

These trends have also led to the dominance of continuation vehicles within the secondary market, which also allow the manager to adopt a ‘hold winners for longer’ strategy, and like, NAV Finance, we would expect to see the rate of adoption increasing as industry awareness accelerates. This larger pool of options available to private equity GPs are already helping investors weather the storm, and we would not expect to see such marked underperformance in IRR outcomes compared to previous vintages that we identified at the time of the GFC. For managers with conviction in their assets and with confidence of less challenging macro conditions ahead, the compromises of the past may not be necessary this time.

Despite the warnings from American writer and futurist Alvin Toffler that too much choice can be debilitating to global businesses, it is not unreasonable to conclude that the greater array of financial management tools should only be beneficial for private equity managers, funds and investors.