This article is sponsored by Investec Fund Finance
It is widely considered that we are nearing the top of the cycle. How is the US mid-market responding?
We are in the longest-ever period of economic expansion, yet US stock indices have traded down from recent all-time highs, we are struggling with a trade standoff with China, the yield curve has inverted and the Fed is cutting rates as an economic insurance policy. These factors taken together would suggest that the top of the cycle is near or even in the rear-view mirror, but the unanswerable question is how long this expansion will continue.
In terms of the US mid-market M&A environment, valuations remain high, but multiples have actually been hovering near today’s levels for over five years. Following the Great Recession, acquisition multiples spiked in 2014 and have since remained range-bound.
What the data doesn’t show, however, is that EBITDA adjustments have become more pervasive and substantial – as we have been seeing in the leveraged finance market as well. So, when people are quoting multiples on deals now, they are likely to be based on more substantially adjusted EBITDA than would have been the case five years ago. When you take that into account, entry valuations have continued to climb.
What impact is that having on how sponsors approach value creation?
With high entry valuations and many firms modelling lower multiples at exit, sponsors have to work harder and longer to deliver attractive private equity returns.
We are seeing sponsors deploy larger amounts of capital – relative to initial platform cost – in sophisticated and aggressive buy-and-build strategies.
The objective is often to create companies that both appeal to strategic buyers and have increased organic growth and margins, all of which can have a big impact on multiple expansion at exit. It comes as no surprise then that hold periods are lengthening.
“Until recently, the financing options available to funds low on uncalled capital were generally limited to LP co-investment at the fund level and holdco PIK financing at the individual portfolio company”
Does this mean that the traditional fund structure is unsuitable for modern value creation needs?
Private equity firms operating within traditional fund structures continue to deliver strong investment returns. But the ways in which value is being created now inherently require both more time and more capital throughout the hold period. It is not uncommon for a sponsor to reserve an amount equal to 50 percent or more of the purchase price as development capital.
According to Hamilton Lane data, nearly two-thirds of private equity assets are now taking longer than five years to exit. This extended value creation process has implications for funds themselves. Platform companies acquired in year five of a fund’s life may not be ready to exit until year 12 or beyond. Fund lives are generally extending well beyond the stated 10 years – frequently to 12 years and even to 14 or 15 years.
Managing larger reserves of undrawn capital well beyond the investment period of a fund’s life also poses challenges for private equity managers. Portfolio companies can require even more capital than expected, depleting reserves and putting the firm’s value creation playbook at risk.
So, what financing options do sponsors have when undrawn capital runs low?
Until recently, the financing options available to funds low on uncalled capital were generally limited to LP co-investment at the fund level and holdco PIK financing at the individual portfolio company. These financing solutions have a number of disadvantages.
They deliver permanent or longer-term financing, when a short to medium-term solution is required. They provide funding at the cost of equity, when substantial unused debt capacity exists at the fund level. They require expensive prepayment premia, when debt – if it were available – would provide more reasonable redemption provisions.
We are now offering a bespoke solution, known as NAV Financing. Our capital is structured to match the duration of the financing need rather than being permanent, so it is inherently less expensive. When pricing our capital, we take into account the full equity value of the remaining portfolio of assets, so we offer a more efficient financing solution than has previously been available.
How is the US mid-market responding to this alternative?
When GPs learn about what we at Investec Fund Finance have to offer, the response is often “I have a terrific use for that” or “I wish I had known about that two years ago when I was dealing with XYZ situation”. Generally, our clients are using NAV Financing one of three ways.
The first is to drive further value creation within portfolio companies through accretive M&A or injections of growth equity. The second is to protect a portfolio company experiencing a short-term setback and requiring equity to right-size its debt capital structure. And the third is to accelerate distributions to LPs where value has been created but not yet harvested.
How does NAV financing tie in with GP-led secondaries, another significant development for creating value later in a fund’s life?
We see NAV Financing as an important tool along a continuum of options that GPs have to help them drive value in the later stages of a fund’s lifespan. GP-led secondaries are another of those tools and their use has exploded over the past few years. We think NAV Financing will as well.
Fundamentally, these GP-led secondaries provide new options for LPs in late-life funds. In a GP-led transaction, remaining portfolio companies are rolled into a continuation vehicle. New investors – typically secondary funds – bring fresh capital to drive further value creation in these portfolio companies.
The portfolio continues to be managed by a knowledgeable GP who is incentivised to build value over a finite further timeframe. Existing LPs can either roll their stakes into the continuation vehicle to participate in that potential upside creation or cash out. Investec Fund Finance has become a leader in providing efficient debt financing to these continuation vehicles to help cost-effectively grow value.
How else is the industry innovating in response to this challenge?
We are seeing increased interest from both GPs and LPs in evolving the limited partnership agreement to allow for longer duration investment activity. Probably the most common evolution we see in the LPA has been greater flexibility around recycling provisions, allowing early exits and cumulative fees and expenses to be rolled back into the fund for continued investment activity.
Longer investment periods are becoming less rare. We are seeing six-year investment periods a bit more frequently. There is a lot of talk about longer fund lives, as well. We are seeing funds raised with 12, 15 and even 20-year fund lives, although those maturities remain far from the norm.
What impact would a downturn have on both the demand for finance late in the life of a fund and its availability?
Private equity’s need to drive value doesn’t stop in softer economic conditions. In fact, we know economic downturns can provide compelling opportunities to generate value for those with access to reasonably priced capital. But traditional financing sources often dry up then. So the challenge for private equity is to be creative in finding incremental capital to take full advantage of the opportunities that dislocations can provide.
What other opportunities excite you in the years ahead?
Selling perpetual minority stakes in private equity firms is not new but is seeing accelerated activity. Investec’s fund finance practice was launched more than 12 years ago, providing loans at the management company level. We are extending our longstanding GP expertise to provide efficient debt structures to support minority stake sales. We are also providing a range of GP financing alternatives to private equity managers who are really looking for a less expensive and intrusive alternative to the sale of a permanent stake.
Tom Glover previously held leadership positions in investment and corporate banking at BMO Capital Markets, Merrill Lynch, Deutsche Bank and Goldman Sachs. He is an employee of Investec USA Holdings Corp.