How to put pep into the step of aging funds

When private equity funds grow up, they more rarely move out of the house.

As the asset class matures, fund duration has been creeping up, according to industry players. For LPs and GPs, this market dynamic offers an opportunity for some, while testing the patience of others.

“No one wants to own at 14-year-old fund any more, even if you like the manager,” said Brian Gildea, managing director at Hamilton Lane, a big player in the secondary market as well as a major LP.

Currently, buyout funds tracked by Hamilton Lane are fully realized at a median age of 12, he said. But by year 15, about a third of buyout funds still remain unliquidated. Meanwhile, the average hold period of portfolio companies in PE funds has been hovering at record levels for the past few years, Gildea said. In 2014, the median portfolio company hold period came in at 5.5 years, significantly above the historical average of 4.4 years.

“That’s a challenge for the industry,” Gildea said. “[A GP] may have one or two positions left in a fund. Reporting and monitoring are expensive, and LPs are tired of owning them, so they’re using the secondary market. They’re not ending the fund — they’re ending their experience with that fund.”

The secondary market has emerged as one of the major ways GPs can close out aging portfolios, or “tail-end funds,” in the jargon of secondary players.

Setter Capital, a secondary intermediary, said direct secondaries, including end-of-life fund sales, restructurings and recapitalizations, grew by 21 percent to $5.5 billion in the first half of 2015, according to its most recent market report.

More shops are emerging to help the industry with these aging funds. It has created an opportunity for those willing to deal with portfolio companies whose best days are past them.

“It’s an interesting area — secondary buyers are spending more time talking to people about the tails of funds that they have,” said Alan Pardee, managing partner and co-founder of Mercury Capital Advisors.

Players eye end-of-fund opportunities

Some LPs considering an investment in a new fund consider older funds a distraction. So there’s a question in the industry over what you do about those older funds, Pardee said.

It’s not unusual to see 13- to 15-year-old funds, Pardee said. These funds usually have companies that need continuing maintenance and aren’t in a position for exit, he said. However, at some point a fund has held an investment for so long, “it’s time to say goodbye,” Pardee said.

The answer might be to find a secondary buyer to pick up remaining portfolio companies (at a discount), allowing the GP to close out the fund in a direct secondary deal. Direct secondaries differ from traditional secondaries in that the buyer acquires the underlying portfolio companies, rather than an LP’s interest in the fund itself.

Mercury worked with one fundless sponsor on selling a company out of an older portfolio, Pardee said.

“We’re involved with a number [of such sales] and trying to get in the middle of some more of those — to advise the seller — and get involved in some additional sales processes,” he said.

Options for aging funds

Mercury Capital’s Sammartino said healthy GPs with aging funds take a variety of paths.

Existing LPs may sell their interests to a secondary fund, another institutional investor or a fellow existing LP. Sometimes GPs buy out the LP, but that’s not the most common route. U.K. firm Terra Firma reportedly recently offered to buy out LPs in its third fund, which closed on 5.4 billion euros ($5.8 billion) in 2007 and took a major hit when portfolio company EMI Group was seized by its creditor Citi.

Another popular avenue for end-of-fund life is a GP-led fund recapitalization. GPs attract new investors that would be willing to take a secondary stake and possibly provide additional capital. The additional capital can be used for follow-on investments in the existing portfolio or completely new investments. This option is particularly relevant if the GP has not raised a subsequent fund.

“It helps them remain relevant in the market and to continue investing while they strengthen their track record,” Sammartino said. “It could be a bridge to the next fundraise.”

So-called fund restructurings involve the creation of an entirely new fund to hold existing portfolio companies from older funds. The new funds will get a reset investment period, and in some cases the GP will get a new fee stream and another chance to earn carried interest.

Restructurings usually involve new investors buying out existing LPs and capitalizing the new vehicle with fresh funds for add-ons or even new investments.

“It’s a win-win situation for a GP,” Sammartino said. “If they think there is still value left, they can continue to manage the asset on behalf of new investors, with a different view in terms of timing.”

Currently, Mercury Capital is looking at situations where the GP needs approval from existing LPs to extend the life of the fund, she said.

The cost of a tail-end fund depends on the quality of the underlying portfolio, she said.

“The pricing tends to be more attractive than a buyout fund’s portfolio and that’s one reason why GP-led transactions are becoming more popular,” she said.

Looking ahead, Mercury sees a strong pipeline of GP restructurings and GP-led transactions, particularly with infrastructure funds, which contain assets with longer time horizons.

Ardian takes a pass

Mark Benedetti, managing director at Ardian, said the firm has been approached with more than a dozen restructuring offers for aging funds in the past year or two and has chosen not to participate in them.

Assets in tail-end funds that haven’t been exited are usually ones that haven’t performed well, or went through a restructuring or absorbed a downturn in their sector, Benedetti said. It’s difficult to buy these types of assets and make a return absent a price discount, but even then the risk level is high, he said.

“A lot of these fund restructuring deals come to the LPs with two choices: First, sell at a discount, or second, roll your interest into my new funds, commit more capital and reset the carried interest,” Benedetti  said. “We’re not in the business of rewarding poor performance … We’re not interested in doing those deals.”

Instead of taking part in traditional GP restructurings, Ardian has embarked on a “handful” of LP tender offers with healthy GPs, which is yet another option for aging funds. In a tender offer, the GP pre-selects a secondary buyer in an auction and then notifies the entire LP base the proposed buyer is offering a specific price for their interests. LPs can choose to sell or not.

“It gives the LPs the option to say, ‘We’re interested and we’ll sell,’ or ‘We’re not interested,’ and they get to stay where they are, Benedetti said. “We’re not twisting anybody’s arm.”

While Ardian has closed a small number of these LP tender offers, it’s hard to predict if the firm will take part in any in 2016 because those deals typically come out of unique situations.

“We need to find good-quality funds and enter with upside in the future,” Benedetti said. “The price of admission is, it must be high-quality assets with a high-quality GP. You won’t see 20 or 30 LP tender offers a year, like GP restructurings, but they are out there. You have to be in touch with GPs and monitor funds in your portfolio carefully.”

Action Items: See an overview of Hamilton Lane’s secondary practice: http://bit.ly/1IdNoPi

Photo of senior citizen playing air guitar courtesy of ©iStock/Ljupco