For our Guest Blog slot this month, we spoke to Kirkland & Ellis’ Ted Cardos and Jacqueline Eaves about the market impacts of COVID-19 and increasing fund investment capacity in the current environment.
Here’s what they said:
During this period of market volatility, many funds are looking to access additional capital for investments that have urgent and substantial liquidity needs. This is especially pertinent for funds with fully drawn capital commitments.
Assuming the fund has exhausted its remaining capital (including recycling or co-investment capacity) and an amendment process to extend is unattractive, the first port of call may be to consider raising an annex fund; a supplemental, distinct pool of capital typically raised from existing investors. Raising an annex fund has the advantage of being simpler than an asset level GP-led restructuring, and new capital can be structured as preferred equity, debt or other form of rescue capital to mitigate valuation issues. However, management fees and carried interest are generally modest compared to blind-pool funds, given the circumstances in which they are usually raised. Sponsors will also need to check existing fund restrictions on raising such a vehicle, including successor fund limits, key man restrictions and deal allocation protocols as well as conflicts. If time is of the essence, sponsors should consider if this impacts who can invest and whether full regulatory approval, including an AIFMD marketing passport, is required.
It is also fairly common for an annex fund raise to be led by a third party, typically a secondary investor, which can accelerate the process as they are used to diligencing and pricing such transactions and give the sponsor certainty through an underwrite which can then be syndicated to existing investors.
There are also well-established sub-fund alternatives, namely equity recapitalisations, preferred equity and NAV facilities. These options can be designed to support one or more fund assets.
An equity recapitalisation is a relatively straight-forward option, which generally can be completed without the need for LP approval, but can take some time (and due diligence) to put in place, and may be less appealing for investors than some of the more innovative alternatives.
Preferred equity is very flexible (it can actually be plugged in to almost any level of the fund structure) and is quick to put in place (as it requires relatively few documents and in most cases does not require investor approval), but can be comparatively expensive capital. It also defers distributions that would otherwise be made to existing investors, albeit for the benefit of providing emergency finance as well as retaining equity upside. The preferred equity provider may also require a minimum return, and other restrictions to protect their investment.
A NAV facility, being a fixed term debt financing secured against the equity value of the portfolio, is especially relevant where there is a substantial and diverse asset base, at lower LTVs. Although generally cheaper than preferred equity, NAV facilities are a liability on the balance sheet, and include more substantive debt-like terms. In addition, there may be prohibitive structural obstacles to putting a NAV facility in place. The specifics of the fund structure and the principal commercial drivers should be analysed carefully to determine which (if any) of these options may be most suitable.
Sponsors should also consider the broader investment ecosystem; each of the sub-fund options can be adapted to offer participation to existing investors.
An alternative option is a GP-led restructuring, which has evolved significantly from a solution for tail-end, “zombie funds” around the Global Financial Crisis, to a popular structure utilised by many blue-chip sponsors. In a nutshell, a sponsor establishes a continuation fund and transfers one, a portion, or all of the assets of the existing fund to the continuation fund, giving LPs the opportunity to sell (and exit) or roll into the continuation fund. It is a versatile option, which can be useful in a range of scenarios, such as to (i) reflect a longer hold period (ii) facilitate additional capital requirements (iii) provide investor liquidity options (iv) realign sponsor economics and/or (iv) facilitate continuing investor participation a single asset within a tailored vehicle.
As these transactions involve multiple assets and moving parts, sponsors should expect the process to take at least a few months to diligence, structure and effect including tax implications of any structural changes, AIFMD and passport restrictions and portfolio transfer issues. As the GP is effectively on both the buy- and sell-side of the transaction, sponsors should anticipate that an LP advisory committee waiver of the GP conflict will be required. The key challenge for these transactions in the current market is pricing, although evolving valuation mechanics and a tentative return of LPs to the market, coupled with looming deployment targets, point to more buoyant activity in the second half of 2020.
In each case, in addition to the technical viability of any of these options, fiduciary duties and economic rationale should be considered carefully. Given the macro-economic context, there is potential for detailed scrutiny after-the-fact. Now, more than ever, sponsors should seek out the very best legal and commercial advice before settling on any strategy.
Ted Cardos and Jacqueline Eaves are partners in Kirkland’s Investment Funds Group focusing on liquidity solutions transactions.
Ted Cardos is a private funds partner in the London office of Kirkland & Ellis International LLP. Ted’s practice primarily involves structuring, negotiating and documenting complex business transactions in the private funds secondary market, including traditional portfolio sales, structured secondaries, synthetic secondaries, stapled secondary offerings, preferred equity and fund recapitalizations. Ted also advises private funds in connection with direct co-investments and other transactional matters.
Jacqueline Eaves is an investment funds partner in the London office of Kirkland & Ellis International LLP. Jacqueline advises private investment funds on a range of complex business transactions in the secondary market, including traditional portfolio sales, structured secondaries and direct co-investments. Jacqueline also has extensive experience of a broad range of corporate transactions, including mergers and acquisitions, joint ventures and corporate advisory matters.
About Kirkland & Ellis
Kirkland & Ellis is a global leader in providing sophisticated advice to investment fund sponsors, institutional investors and other market participants in the alternative investment fund space. Kirkland offers clients the unsurpassed resources of a large, integrated, multidisciplinary, global team located across offices in the United States, Europe and Asia-Pacific. With more than 400 dedicated Investment Funds attorneys, few firms approach the breadth, depth and scope of Kirkland’s experience in investment funds legal services. Since January 2017, Kirkland has advised over 540 funds with total capital commitments in excess of $870 billion.
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