Many LPs are facing the issue of higher-than-planned allocations to alternatives; in today’s more mature environment, there are more options than ever before for dealing with this
The public market rout we’ve seen over recent months was not exactly unexpected – markets don’t defy gravity, after all – but its depth may well have caught many investors by surprise. By the end of Q2 2022, for example, the S&P 500 was down by more than 20% in the year to date, while the FTSE 250 was down by nearly 22% year to date in early July. Following a prolonged period of rapid and successful private markets fundraisings and taking into consideration the time lag for GPs to mark portfolio company valuations, this drop in public markets value could cause some potential headaches for investors as they find themselves over-allocated to illiquid alternatives.
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Many LPs now have experience of at least one downturn and are therefore far more sanguine about allocation breaches. This is partly because many have now built in flexibility by setting allocation ranges as opposed to specific targets, which avoids the need for fire sales to gain liquidity at precisely the wrong moment to sell. However, it is also because there is a greater recognition that the current valuation gap between public and private markets could be temporary. Public markets could always recover more quickly than expected (as happened with the COVID period) and even if not, private markets will start to mark down assets over the next few quarters.
As a result, many are waiting to see what happens next. “Cash distributions from private markets were significant in 2021,” says Ralf Schnell, Managing Director, Head of Alternatives, Siemens Fonds Invest. “And this helps with the overshoot we are currently experiencing. We see this as a transition period because public markets react immediately and it takes time for private markets to follow. We are waiting a few quarters to see the extent of the overshoot or rebalancing we will need to address. People are nervous, but the worst thing you could do is to change things now when the picture is not clear.”
Maria Sanz Garcia, Partner and Private Equity Co-Head at YIELCO Investments, says many LPs are doing the same. “We are seeing a large denominator (and nominator) effect currently among many of our clients,” she says. “For investors with, say, a 5% allocation, this could now have risen to 8%. Many have asked their boards for permission to keep this as it is for now so they are not forced to exit their current positions.”
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As in previous downturns, there is always the traditional LP position portfolio sale on the secondary market. This has been somewhat choppy so far this year as a result of public markets volatility and following Russia’s invasion of Ukraine. “Many institutional investors generated strong returns on their private equity portfolio in 2021,” explains Yann Robard, Managing Partner Whitehorse Liquidity Partners. “So strong that they found themselves over-allocated to the asset class as they entered 2022. At the same time, many of these investors' existing GPs were coming back to the fundraising market. This confluence of events left LPs with little capacity to invest in funds in spite of not wishing to ‘skip a fund’ with their existing GPs. A number of investors therefore sought to access the secondary market to free up capacity for new investments in January and February of this year. But as market turbulence hit, the secondary market stalled.”
However, as we move through the year, this may well become a viable option once more as there becomes less uncertainty about valuations. "Many investors seeking liquidity now need to wait until part way through Q3 for their portfolios to be priced off June 30th values to avoid having to sell at optically higher discounts then they are used to,” says Robard. “Private equity valuations need time to catch up with the turbulence in public markets.” In the meantime, he adds, LPs can access liquidity using structured solutions. These enable them to tactically reallocate their portfolios without crystallising a significant discount, timing the market and retaining upside when the recovery emerges.
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There has been such rapid growth in GP-led deals, they now account for roughly half the annual volume of the secondaries market. And while many LPs may opt to roll over into continuation vehicles, these deals can offer LPs valuable liquidity should they need it. And we’re likely to see GP-led deals continue apace. “With increasing market turbulence, more traditional exit routes may well dry up,” says Shane Feeney, Managing Director and Head of Global Secondaries, Northleaf Capital Partners. “It’s likely we will see LPs putting pressure on GPs to look at continuation vehicles as a way of achieving liquidity.”
Ravi Viswanathan, Founder & Managing Partner at NewView Capital agrees, suggests this will be the case for venture capital GPs as well as private equity fund managers.
“Over the last few years, the TVPI and DPI curves were up and to the right because of high volumes of M&A and strong IPO markets. We’re entering a DPI desert. LPs will push for GP-leds, which will gain prominence as secondaries become part and parcel of a VC portfolio management toolkit.”
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This may be a more esoteric solution in private markets for now, but some believe that portfolio securitisation could really come into its own over the coming years as they can offer LPs partial liquidity. Used largely by LPs with more mature programmes, these deals, also known as collateralised fund obligations (CFOs), first emerged in the 2000s, but have developed over time as more data on their performance has become available.
The basic premise is to put together portfolios of LP interests in funds, transfer these to a special purpose vehicle, which then issues tranches of debt.“CFOs can be used as an alternative to a secondary transaction to provide liquidity,” says Domenic Bussanich, Director, Funds and Asset Management at Fitch Ratings. “However, in a CFO you don’t lose exposure to the portfolio because the LP can retain equity.”
“Some LPs are looking at this as they breach their target allocations and want to continue investing over time to achieve vintage year diversification,” adds Jeff Hammer, Senior Managing Director & Global Co-Head of Secondaries, Manulife Investment Management. “Of course, you can sell into the secondaries market, but that hasn’t always been a great trade for sellers. CFOs can serve as an alternative tool to achieve liquidity, recycle capital to future years and, where applicable, remove LP interests from the balance sheet.”
This option can take longer and be more costly than other liquidity routes, but, says Hammer, it becomes easier over time. “It’s possible to establish a long-term repeatable programme and to build relationships with debt investors that may be interested in buying into you as an asset manager.”
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Should LP capital start to become more scarce, it’s highly likely that investors will scrutinise re-ups with even more diligence than has been the case over recent times. Common reasons for not re-upping may well come into sharper focus should the next 12 to 18 months turn out to be turbulent, even if that means access issues in the future. “If we are not convinced about a manager seeking to re-up, we step out,” says Schnell. “If we can’t come back at a later date, we have to accept this. There are always good opportunities in the market.”
And with GPs coming back to market with new funds faster than ever, many LPs are starting to baulk at the concentration issues that can cause, leading some to question whether a re-up is the right decision. “There may be a lot of LPs having two and a half to three unrealised funds managed by the same GP in their portfolio and then they are asked to commit again,” says Verena Kempe, Head of Investment Management at KENFO.
“This will be compounded by the fact that we are likely to see fewer realisations this year versus 2021. LPs need to limit their exposure to each manager to ensure adequate diversification, even where they want to continue successful relationships.”
And finally, ESG may become more of a reason to decline a re-up. “ESG is very important,” says Schnell. “We stepped out of a relationship with a GP that managed one of the most successful funds we’ve ever had in our portfolio. But we didn’t re-up because they wouldn’t give us the side letters we required on ESG.”
