This Year, Expect LPs to Dial up the Pressure for Capital Returns

Patience is a virtue—and one that private equity limited partners have demonstrated fairly well since merger and acquisition activity began to retreat in 2022, locking up their money for the past couple of years. But it seems that patience has finally run out. No longer content to wait for ideal market conditions, LPs are pressuring PE managers to sell off portfolio holdings to finally recapture some equity.

“A lot of sponsors have been sitting on assets for quite a few years. And a lot of them have not wanted to sell because of valuation concerns. But their LPs are now really looking to get capital back and have it deployed elsewhere or with new asset managers,” says Chris Sheaffer, a partner at Reed Smith. “We’re hearing that they are putting a lot more pressure to get that capital back sooner rather than later, even if it means that LPs are not going to get the returns that were originally projected when the fund was initially raised.”

Faced with the consequences of the denominator effect where the private equity portion of investment portfolios were suddenly overweight, LPs are actively resetting allocations and seeking ways to rebalance their portfolios. As a result, fundraising among PE firms remains challenging, particularly for smaller and younger fund managers. As LPs reset their allocations, many are reducing the overall amount they are allocating to private equity overall, forcing them to decide whether to spread the investments they maintain within the asset class among multiple managers or to make more concentrated bets with individual GPs.

Meanwhile, private equity firms are embarking on fundraising campaigns for new funds, providing additional leverage for LPs who are beginning to strongarm managers into more aggressively pursuing exit opportunities. “In select cases, where a GP is starting to raise their next fund, LPs are going to be much more successful in urging those GPs to exit opportunities,” says Sash Rentala, a partner and head of financial sponsors at Solomon Partners Securities. He noted that in such situations GPs will likely need to accept lower valuations given the difficulty of executing deals in the current market environment.

LPs are also stepping up calls for greater transparency, with mixed results. While industry experts says that transparency has been increasing across the board, assisted by heightened regulatory requirements on this front, fluctuations in interest rates and a general lack of clarity regarding future market conditions has made it difficult for GPs to be as transparent as they might want to be.

LPs’ Drive for Diversification

In cases where LPs realize they must stay the course, however, the secondary market has been a major source of activity. Many PE firms have been offering continuation funds. “GPs are definitely looking at more ways that they can generate earlier liquidity options for their investors, particularly in this fundraising environment where raising a successor fund is more challenging. More than two-thirds of the LPs that we surveyed said they had been offered a chance to invest in a GP-led secondary or remain in a continuation fund over the past 12 months,” says Meghan McAlpine, a senior director of strategy and product marketing at SS&C Intralinks, citing recent research by the firm. She noted that when it comes to non-traditional leveraged buyout (LBO) deals there has also been a visible increase in the number of secondary funds and add-on acquisitions within the middle market.

More than two-thirds of the LPs that we surveyed said they had been offered a chance to invest in a GP-led secondary or remain in a continuation fund over the past 12 months.

Meghan McAlpine

SS&C Intralinks

When LPs are making new private equity allocations they are writing smaller checks than they historically have, according to industry experts, with investments going largely to seasoned asset managers with long-proven track records of success and stable returns. There has also been a shift in the assets that are attracting investments, away from LBO deals and towards less traditional investment vehicles such as private credit funds, secondary funds and real estate. Private credit has proven particularly attractive, with unlevered deals yielding around 15% in returns without the volatility of other investments.

“We have seen a pickup in real estate and infrastructure investment over the last year,” says Brian Forman, a partner with Morrison Cohen and chair of the firm’s investment funds and advisors practice, adding that even those strategies are not immune to the slow fundraising environment, with many missing their targets. “Continuation funds remain very popular. We have seen clients pursuing them on multiple occasions…they are spoken of regularly. Discussion about NAV (net asset value) lending is also very common,” says Forman, noting that while he has yet to see many people utilize this type of funding, he expects that could change in 2024, particularly if interest rates begin to decline.

GPs’ Response

The LP community’s desire for greater diversification has not been lost on GPs, who have been actively broadening their offerings. “GPs, particularly in the middle market, are expanding into other diversified asset classes. More traditional middle-market PE funds are expanding into credit and want to have that credit option,” says Nicole Macarchuk, a partner in Dechert’s corporate and securities group, which focuses on private equity, private credit and M&A. “They are turning to some of their LPs where they have long-term relationships to potentially start or stake new direct lending, new private credit, new real estate, infrastructure or other new  investment strategies that they may want to diversify.”

Related content: Private Credit’s Rise Continues—But Not Because of SVB

“GPs are looking to find ways to bridge the gap either on valuation or raising capital for new deals, which makes continuation funds an attractive tool to do so, although we’re starting to see more positivity on take private and go to market transaction in that regard,” says Macarchuk, adding that GPs are becoming more creative with private credit offerings to create value for LPs.

That shift is supported by Coller Capital’s latest Global Private Equity Barometer report, which found that 44% of private equity investors expect to raise their private credit allocations over the next 12 months. Similarly, co-investment deals, which are becoming more commonplace, are also more attractive to investors, according to Coller Capital’s findings. Many PE managers have also altered their focus to profitability within their portfolio companies versus growth.

One major driver of the shift to less traditional PE deals has been paltry M&A activity. In the wake of an ongoing disconnect between buyers and sellers regarding company valuations, the number of M&A exits for PE firms has been minimal, with roughly 75% of sell-side deals in 2023 failing to come to fruition, according to Macarchuk. Pitchbook data shows there were only 170 middle-market deals completed in Q3 2023, down nearly 75% from 2021 when there were around 600 exits per quarter and still well below pre-pandemic activity levels in 2019 when there were an average 300 to 350 deals completed per quarter.

Exit Routes

Absent traditional M&A exits, GPs have been forced to seek alternate sources of revenue for investors. Of the deals that have been getting done, it is primarily the portfolio companies that attracted investments in 2019 and 2020 that are proving most successful so far.

Despite an ongoing disconnect between buyers and sellers regarding valuations, many fund managers are finally deciding it is time to unload assets they have been sitting on long beyond traditional holding periods, even if that means taking a loss to get some of these companies off their books and return something to investors. One result of this has been an overall shift in GPs’ focus for portfolio companies to profitability versus growth.

“A lot of sponsors said, ‘we’re going to take our foot off the growth accelerator and focus a little more on profitability so that we have sufficient resources to get us through a downturn in the market.’ And several of them have actually been successful at cutting down burn rate, making some of these companies break even or close to break even,” says Rafael Castro, a partner at Hark Capital, which specializes in NAV lending.

Similarly, much in the way that the lingering absence of exits has forced some fund managers to sell portfolio companies at a loss, Castro says it has driven others to embrace financing options such as NAV loans that they may have previously eschewed. “Both LPs and GPs are now starting to get a little bit more sophisticated with regards to NAV loans and realize that not all use of proceeds are created equal… LPs are generally supportive of using a NAV loan for defending the value of a portfolio company or to grow it via acquisitions, but are a lot more circumspect with regards to using a NAV loan to dividend capital back to investors,” says Castro.

Related content: NAV Lending Ramps in Popularity, but Questions Remain

While the ongoing valuation disconnect between sellers and buyers remains a major factor holding up M&A activity, there is widespread agreement that sellers’ expectations will begin to get more realistic this year. Private equity attorneys note that there was a wave of activity in the fourth quarter of 2023 as investment banks began the processes of readying portfolio companies for deals.

“For the assets that have been sitting out there for a while, there has to be a reset of expectations on valuation, both on the LP and sponsor side,” says Reed Smith’s Sheaffer. Adds David Hayes, a partner in Reed Smith’s corporate group: “We’re starting to see more willingness of our clients to make earlier exits in portfolios for smaller returns when it makes sense…while there hasn’t been a meeting of the minds between buyers and sellers yet, I am optimistic that 2024 will be more encouraging because of a more stable interest rate environment.”

Britt Erica Tunick is an award-winning journalist with extensive experience writing about the financial industry and alternative investing.

Middle Market Growth is produced by the Association for Corporate Growth. To learn more about the organization and how to become a member, visit www.acg.org.