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Friday Letter: The trouble with fund restructurings

Repairing pre-crisis partnerships is a $100bn market, but the technical challenges are considerable and best practice remains a work-in-progress

‘An illiquid asset class is becoming easier to exit,’ the Financial Times proclaimed last week. Its Lex column went on to say that “when life gives Wall Street lemons’” it repurposes them into new asset classes, and suggested that was occurring in private equity “now secondary funds have emerged” to buy LP interests.

While a few of our editors shared a chuckle over the paper’s framing the strategy as new, its subsequent observation that today’s booming secondaries market may challenge returns – “the easy money may have already been made” – was bang on.

Talk to secondaries buyers active today – from dedicated fund managers to large institutional investors – and you’ll find few remain focused solely on purchasing portfolios of LP interests.

It’s still the industry’s bread and butter – accounting for 75 percent of last year’s $42 billion in deal volume, by Cogent’s estimate – but most secondaries investors have expanded to offer other ‘liquidity solutions’ du jour, like restructuring pre-GFC era funds alongside incumbent managers. These are higher-risk, more complex and time-consuming deals to complete, but they can potentially deliver superior returns (as well as more meaningful fees for advisors).

“We have seen more of those transactions come to fruition recently, partly driven by the secondary market looking for good pools of assets,” Michael Halford, UK head of investment funds for law firm King & Wood Mallesons, tells PEI in an interview for its upcoming legal special.

The rise of fund restructurings – and whether that’s in fact an emerging asset class – was one of the topics discussed by private equity veterans this week in Miami, where alternatives-focused investment bank Hycroft Advisors held an invite-only conference exploring private equity innovation at the investment as well as fund/industry level.

Discussion wasn’t so much focused on the investment rationale for restructurings – ‘it’s a market worth over $100 billion by anyone’s numbers’, was a statement that went unchallenged – but on the need to develop best practice.

‘There’s an absence of precedent,” one fund manager said, noting LPACs weren’t set up to function like independent boards of public companies. Nor are most LPs resourced appropriately to evaluate restructuring proposals, which vary greatly from one deal to the next. “It’s evolving, how [LPs] process these opportunities,” another GP said. “They know what they don’t like … but they don’t know what they like.”

An example of something firmly in the ‘don’t like’ camp: GPs trying to use a fund recap to avoid a clawback situation.

“Pitchforks come out,” one secondaries manager said of LP reaction to such proposals. He recalled a recent restructuring process that had only 20 percent of the fund’s LPs tender “because they were so irate about the clawback issue”.

As such conflicts are sorted through, and lessons learned from the handful of restructuring deals that have closed – or indeed failed to complete – the market continues to shift focus from poorly-performing ‘zombie’ funds and others with ‘red flags’ to GPs with solid track records but some legitimately lingering assets.

That said, as was highlighted in Miami, the way forward is by no means straightforward. How to get valuations right with disparate groups of investors, devising a set of meaningful choices for LPs in each deal and determining whether or not variables like staples or resetting of GP economics should be permitted are just a few of the questions for which there isn’t a cookie-cutter answer.

Whether or not this area of secondaries activity constitutes a new asset class, what’s exciting is the increasing number of highly intelligent pools of capital seeking out the best possible solutions to one of the asset class’ historic limitations. Watch this space.

PEI’s forthcoming legal supplement will address the topic of fund restructuring, among others, as will a dedicated PEI book authored by industry practitioners. Get in touch to register your interest at cslondon@peimedia.com.