This was supposed to be the year when the cork from the ketchup bottle flew to the other end of the room and we all swam in a deep pool of M&A transactions. Little did we know about Liberation Day and the ability of one man to upset the markets. So far this has been a miserable M&A year on both sides of the pond. All this comes after an extended period of deal drought. It has been estimated that in Europe alone there are around 1000 Private Equity (“PE”) owned companies with reported valuations more than EUR 1 billion that under normal market cycles should have been sold a long time ago. The number of “overdue” PE exits in the US is also staggering.

The J-curve and the lost liquidity of PE investments

The PE J-curve describes how in the early years PE funds show negative returns and cash flows (deal and management fees and investments made) and then in the later years both turn positive as the investee company portfolio appreciates in value and cash is released in exits. During the last years the J-curve has crashed due to lack of exits, leaving fund investors (“LPs”) with minimal or net negative cash flows from their PE investments. As a result, many LPs, including both institutional investors and family offices, find themselves overcommitted to PE and in search of liquidity. This also makes it hard for the general partners (“GPs”) to raise new closed-end funds from the LPs.

Creative solutions

In order to provide liquidity to the LPs, the PE houses have come up with new ways of making deals. GPs have raised fund level loans secured by the value of the fund’s investments (NAV lending) and distributed cash heir LPs. This creates an additional layer of debt on top of the acquisition and working capital loans in each of the investee companies. All good–unless the valuations are off.

A substantial number of PE investee companies have been sold to continuation vehicles (“CV”), i.e. a new PE fund managed by the same GP. In a properly executed CV transaction, the valuation and the terms of the transaction are validated by one or several new professional investors, the existing LPs have a choice of selling for cash or rolling into the CV, and conflicting interests are represented by independent advisers.

Historically, LPs in need of liquidity have sold their PE commitments in a secondary market. Now the discounts to the values reported by the funds at the secondary transactions are quite steep. A new option for the LPs has been to seek bank financing secured against their LP investments in hope of the funds returning cash in the upcoming but now postponed M&A deal frenzy. This naturally creates yet an additional layer of debt. 

And finally, GPs are increasingly seeking fund commitments from wealthy individuals and family offices that are not cash strapped for the above reasons, as they have not been previously offered this asset class in a substantial way.  

What does this all mean?

The good news is that these new solutions bring liquidity to the market during the difficult deal drought. The adviser community, especially those that can handle transactions that combine elements of Fund Formation and M&A in a creative way, has plenty of mandates. As always, unless prudent deal practices are adhered to, we risk creating market bubbles.