The world has seen severe dislocation in the public markets with all major stock markets shedding 10-30 percent in the past few weeks due primarily to fears about COVID-19 coronavirus and the slump in oil prices.
We do not believe that this disruption will be limited to the public markets but it will also be felt in the private markets. In the immediate short term, we consider the greatest impact will be on those private funds which are at, or towards, the end of their lives as well as those currently raising capital. In this article, we focus on private funds in the first category. Such funds will no doubt be looking at their portfolio companies (i) with an eye to exits in the next 12-24 months (which may, in certain cases, require a dose of follow-on capital); (ii) at the cusp of an exit by way of an IPO (and some may already be undergoing a pre-IPO capital reorganisation) or private sale (which may be a bilateral transaction or an auction with several bidders); or (iii) already in the process of an exit (which may involve the buyer utilising acquisition finance itself or using its own banking relationships to refinance debt incurred by portfolio companies with other banks or alternative capital lenders).
The market disruption caused, and to be caused, by COVID-19 coronavirus may also adversely impact private funds in the “hold” stage of their lifecycle where they are deploying reserved capital into successive series of funding rounds of their portfolio companies to ensure that (i) the fund does not get diluted with each funding series and (ii) their portfolio companies receive the capital they need to ensure growth per their business plans. As was experienced post the Global Financial Crisis in 2008 (“GFC”), business plans, both at the level of private funds as well as at the level of portfolio companies, had to be revised. Often this involved an extension to the timeline for achieving the target growth level for portfolio companies as well as an upward adjustment to the amount of capital they required. Constrained by fixed lives and fixed capital commitments, private equity funds faced a stark choice: either realise their investments at a sub-optimal time and sub-optimal price or find a way to buy some additional time and raise some fresh capital.
Enter the so-called “annex fund”.
Although they took slightly different forms, several managers formed “annex funds” following the GFC. These were essentially funds specifically designed to provide later-stage follow-on funding to portfolio companies of a particular fund, where that fund had fully drawn down commitments from its investors.
In 2020, managers may well dust off GFC-era “annex fund” technology but unlike 2008, they now have an additional option in the form of a mature and well-oiled private equity secondaries market with plenty of dry powder. We examine below some of the main options available to managers with funds which are fully drawn down but need some additional capital.
The Annex Fund
The “standard” annex fund is typically a new fund vehicle which is offered initially to existing investors on a pro-rata basis. Any spare capacity is then offered to those investors who took up the initial offer and any remaining capacity is then offered to third party investors. All investors (existing and new) buy in at a negotiated valuation (often backed up by an independent valuation report) of the existing portfolio with no preference.
Some key features include:
- Usually there is no management fee (or a substantially reduced management fee) on the annex fund.
- Carried interest is also charged on a reduced basis (e.g. 10 percent) or a standard 20 percent carry only applies after netting any losses, costs and expenses of the original fund against the profits made by the annex fund.
- Transaction fees, monitoring fees and other incremental fees are typically waived as regards the investments in which the annex fund participates.
- Key person, exclusivity and other governance provisions will need to be addressed in the annex fund as well as how conflicts of interest are handled if the original fund LP Advisory Committee and the annex fund LP Advisory Committee are different and have differing interests.
- Returns are typically calculated separately for the annex fund.
- Divestments by both the annex fund and the original fund typically take place at the same time and same terms.
- It is important for managers to convince investors that the add-on capital is not just to prop up ailing portfolio companies and that valuations are fair and transparent.
A less complicated way to raise additional capital would be to offer investors more co-investment opportunities where follow-on capital is required. Where managers have offered ad hoc co-investment opportunities, they may now want to consider implementing a more structured co-investment policy through a “co-investment framework agreement” between them and their investors. Such a framework document would set out clearly, among others, which investors would participate on a priority basis, the nature of their participation as regards fees, carry and other expenses, governance terms and timeframes for co-investment opportunities to be presented and responded to.
Fund extension – With/without opening up an existing fund to new money
Funds that are currently towards the end of their investment periods or their planned lives may well want to consider extending their investment periods to allow for a slower market or to extend their lives to allow for a more orderly realisation of their divestments. Either case may require additional capital to be deployed into portfolio companies as their cash needs may well have changed due to business plans having to be revised (e.g. supplies of raw materials, equipment, services being disrupted or costing more; sales of products or services being adversely affected; staffing costs remaining the same against lower productivity and revenues as staff fall ill or self-isolate). If additional capital is required either for one particular investment or a basket of investments, the manager may consider opening up the fund to new money, whether from existing investors and/or new investors. This is in some ways, similar to raising add-on capital via an annex fund, but it avoids the need to create a separate entity. Unlike 2008, additional capital from a third party new investor in 2020 is much more likely to come from a secondary investor. Read more about the secondary investor option below under the heading – “Secondary Transactions”.
Care should be taken to follow the correct procedures as set out in the fund documents regarding extensions, including seeking investor consents and once approved, the relevant fund documents should be amended and restated to reflect the new terms.
A “strip sale” is typically a fixed percentage of the fund’s portfolio or subset of portfolio companies which are transferred to a new acquisition vehicle to which additional commitments for follow-on funding are made by an entirely new investor (typically a secondary buyer). It is different from an annex fund in the sense that a strip sale is typically treated as a partial disposal by the manager and therefore no investor consent is required. Since the existing fund’s capital is usually fully drawn down or the investment period has expired and therefore no capital can be drawn down, any fresh or additional capital required by a portfolio company or subset of companies would come from the secondary buyer via the new acquisition vehicle in which it (or a syndicate of investors formed by it) is/are the sole investor(s). A disadvantage of strip sales is that if the portfolio companies are further funded by the secondary buyer and not by the existing fund, the existing fund’s investment in such companies will be diluted going forward. This can be mitigated if the proceeds of the strip sale are not distributed by the manager but instead added back to investors’ commitments and made available for re-draw, but this will likely require amendment to the fund documents and investor consent, which may or not be forthcoming. However, it does provide the manager with a mechanism to mitigate the dilution effect. Since strip sales involve only a percentage of existing portfolio companies being sold, the fund will continue to hold the portion not sold by it and this may require an extension of the fund’s life as part of the strip sale transaction if the manager considers that a longer holding period is required than is possible under the existing fund term.
A typical “GP-led secondary” transaction involves the manager establishing a continuation vehicle. This form of fund restructuring involves the existing fund transferring its investments to the continuation fund, typically managed by the same manager. Investors in the existing fund are given the opportunity to elect to cash-out or rollover into the new longer dated continuation fund. Investors who choose to cash-out have their interests purchased out of additional commitments made by investors who rollover, as well as commitments made by a new “secondaries” investor.
GP-led secondary transactions vary greatly in complexity and at their most complex, the following scenario (or variations thereof) is possible:
- Only a sub-set of the existing fund’s investments are transferred to the continuation fund because, for instance, one or more existing investments are not appealing to the secondary investor due to litigation tainting or they no longer have any value (“retained investments”). The retained investments are held within the existing fund.
- To the extent any value is actually received by the existing fund from the retained investments, such proceeds are distributed only to investors who were in the existing fund prior to the secondary transaction.
- Investors who elect to rollover and remain invested in the continuation fund are asked to increase their capital commitments to fund, alongside the new secondary investor, additional capital required by the portfolio companies transferred to the continuation fund as well as to fund completely new investments (a “stapled secondary”) which the manager considers value additive to the existing portfolio company investments (namely, the new investments or “tuck-ins” are considered desirable to enhance the value of existing investments).
Cross trade of investments occur more frequently than people think. Cross trades can take the form of investments being sold and purchased between an early vintage fund and a later vintage fund or between a fund nearing the end of its life and a newly launched fund. A cross trade allows a manager to transfer an asset held within a fund which has either fully drawn its commitments or is nearing the end of its life to another fund which still has capital available for draw down or a long enough life to see the investment through to maturity. Whatever the case, two issues are particularly important.
First, managers should ascertain whether cross trades are subject to affiliate/related party rules applicable to them and their funds. If so, these must be complied with as well as any applicable affiliate to affiliate and conflict of interest provisions in a fund’s governing documents.
Second, managers should not rely on a prior independent valuation of the fair value of the investment(s) being sold and purchased. This may be because such valuation is stale but, more importantly, because such valuation will not reflect transaction specifics and, accordingly, the transaction specific fair value may be materially different from the prior independent valuation. Thought should also be given, in order for the manager to discharge its fiduciary duty of good faith to the funds managed by it and their investors, to whether a transaction fairness opinion is also obtained from an independent financial advisor experienced in such transactions.
Preferred Equity Funds
Some of the approaches described above can be utilised but only through using a “preferred equity” structure. For example, a “preferred annex fund” is a new fund vehicle offered in the same manner as with the standard annex fund described above save that the interests issued by the preferred annex fund carry a high preferred return that is paid in preference to any returns to the investors in the main fund, but typically with the preferred return capped once the fresh capital (whether from existing investors participating in the annex fund or from new investors, typically secondaries funds) has received its full preference.
A typical preferred equity “waterfall” would involve preferred investors receiving all proceeds from investments until they have received their contributed capital plus the preferred return. Thereafter, the existing investors would catch up until they have received their contributed capital plus preferred return (as per the existing fund waterfall) and then both new and old capital would share pro rata at a negotiated split.
Similarly, additional capital raised in conjunction with a fund extension can come in the form of preferred equity. Of course, this could be obtained in the form of bank financing but secondary investors typically offer more flexibility since they don’t require financial and non-financial covenants nor interest and maturity terms.
For many of the solutions discussed above, some form of investor consent or consent from the fund’s LP Advisory Committee (“LPAC”), may be required under a fund’s governing documents. However, even in instances where investor consent is not expressly required under a fund’s governing documents, fund managers may still find it advisable to either consult with LPACs or seek consent from LPACs in order to address and/or alleviate any actual or potential conflicts of interest.
Although COVID-19 coronavirus is a novel new virus which is already showing that it can cause severe disruption in the public markets and is likely to do the same to private markets, we have tools at our disposal which were developed post-GFC as well as more recently which should provide managers with the ability to meet this crisis with more confidence and to produce outcomes for investors which preserve or enhance value.