Travers Smith's Alternative Insights: Liquidity options for LPs

A regular briefing for the alternative asset management industry.

Private equity had a bumper year last year. Although official data will not be available for a few months, there are already reports that 2021 was a record year for fundraising, investments and exits. That – together with data (and anecdotes) that continue to suggest that private markets are generating outsized returns – means that there are both more opportunities for asset allocators to access the asset class, and more incentives for them to do so. Reports that large institutional investors are increasing allocations to the asset class will no doubt inspire others.

Participants in the private markets have always been quick to innovate and – since there is little in the world of finance that starts with a blank sheet of paper – that often means taking well-established concepts and repurposing them. For LPs who are seeking to ramp up their private markets exposure quickly, or who want some early liquidity without forgoing the future upside in their private equity portfolio – or simply want to raise further capital to meet a large "uncalled" commitment – accessing the mature funds finance market can be an attractive option. For some, it can be an appealing alternative to a secondary sale of a portfolio of fund interests.

The structure is simple, and already familiar to (among others) managers of funds of funds and secondaries funds: move fund interests to a new vehicle and use them as collateral for a loan. The package of LP positions might be a relatively small bundle of interests in similar funds, or a large, well-diversified portfolio. There are a number of lenders keen to provide capital into this market, because it provides them with private markets exposure at a lower cost of capital and with enhanced down-side protection. These lenders are eager to educate larger fund investors, spanning institutions and family offices, on the availability of these products, which offer relatively cheap, often limited recourse, liquidity on the basis of fairly conservative loan-to-value ratios. Several recent deals have underlined the attractions for LPs with existing exposure to the asset class.

Although these transactions seem superficially straightforward, negotiations will focus on some key terms that differ considerably from portfolio-to-portfolio and provider-to-provider. These terms can have important commercial consequences for the borrowing LP and, potentially, the GPs of the underlying funds. For example, what should happen to distributions received from the underlying funds during the life of the loan facility? To what extent should they be automatically applied to pay down the outstanding borrowings, both in performing and non-performing scenarios? Operationally, to what extent does the LP require such amounts to remain available to fund future capital calls into the secured portfolio or, indeed, to acquire new positions? In what circumstances can distributions be paid out to the investor for use elsewhere, provided that the required loan-to-value thresholds are met?

Lenders will clearly want to undertake legal and commercial due diligence on the portfolio interests, and similar considerations will arise to those that apply on a secondary sale in relation to sharing confidential information about the underlying funds with a third party. Lenders will generally want to review the limited partnership agreements and subscription documents and to build eligibility and concentration criteria for continued funding against each position and further borrowing against newly acquired interests.

...For LPs who are seeking to ramp up their private markets exposure quickly, or who want some early liquidity without forgoing the future upside in their private equity portfolio,...accessing the mature funds finance market can be an attractive option...

One important transaction dynamic that needs to be addressed at the outset is the extent to which the underlying fund GPs need to be involved. Often there will need to be a consent, or at least practical cooperation, in order to transfer the LP interests into a special purpose vehicle (an "SPV"), owned or managed by the existing LP and, perhaps, to the LP granting security over the shares in the SPV. But some of the (usually more difficult) questions include: What happens if the facility goes into default? What material investment events in relation to the underlying interests entitle a lender to call in amounts initially lent? Apart from mandatory prepayment provisions, and locking down the secured accounts into which distributions are received preventing any more leakage to the LP (a 'sit and wait' enforcement strategy), lenders usually also want the right to step in and take the keys to the portfolio (either indirectly by taking ownership of the borrower SPV or, in some cases, relying on specific security over each underlying fund interest in order to allow for a piecemeal exit strategy). In either case, the lender would likely sell the portfolio or individual interests in the secondary market. In respect of these enforcement rights, getting the GP's consent at the outset of the financing arrangement may be more difficult. Indeed, GPs are increasingly more aware of these levered structures when drafting the transfer restrictions contained in their underlying LPAs.

Increasing sophistication among the investors in private equity, and growing appetite for exposure to the asset class, is driving market participants to look for ways to mitigate their long-term exposure to an illiquid asset class and to use the assets they hold to drive returns. Of course, when the underlying assets are themselves leveraged, as with private equity or credit funds, some caution is needed. And not all institutional investors will want to – or be able to – take advantage. But at conservative loan-to-value ratios, this looks like an obvious play for some LPs.

For more of our content on alternative asset management, please visit our dedicated online hub.