This article is sponsored by Akin Gump Strauss Hauer & Feld
How do you think the fallout from covid-19 is going to impact the market for secondaries and GP-led restructurings?
Mary Lavelle: There has already been a clear slowdown in secondaries activity. Processes that were in train have either rushed toward completion or – in most cases – been put on hold. People hope those will come back to life at year end, but that remains to be seen.
We are not expecting many new GP-led fund restructurings and tender offer processes to kick off in the near term, save in very limited circumstances. We are only seeing new processes where there is a real driver to get something done, either because of a liquidity need or because the parties are willing to take a punt on price.
Pricing is currently one of the key issues – being able to come up with a price for assets that both buyers and sellers can get comfortable with is proving difficult. People are waiting to see how recent events will impact valuations. Things are so unpredictable that most people will still want to wait for Q2 valuations before they will properly consider new deals; general expectations are that things will not resume until the second half.
When the GP-led market does come back, though, it could come back with a vengeance. There is a lot of dry powder in the market and we expect a lot of opportunities to snap up assets at good prices. Some sellers are also going to have to offload attractive portfolios, particularly where their portfolios are suffering from the denominator effect. Together, these factors could make for an extremely active 2021.
Trey Muldrow: What we are witnessing in this segment of the market, as well as in M&A generally, is confusion about the proper valuation of assets. Valuations have dramatically changed over the past few months. As this recalibration occurs, there is also an absence of certainty about future performance. Accordingly, it is a difficult time to deploy capital with confidence. Nevertheless, there remains a fundamental desire to transact.
The LP liquidity solutions market has developed significantly in the last decade, with the inclusion of several more sophisticated and creative participants. In addition, we are witnessing many sponsors develop a broader awareness of the benefits of secondaries deals and general liquidity options available at the fund level. We believe there are more conversations discussing these options than were happening previously. This could result in more transactional opportunities for parties to evaluate over the next several months.
How do you see the market addressing pricing issues?
ML: We are already seeing buyers and sellers putting a strong focus on price protections and thinking more creatively. There are a few options, the first being a simple price renegotiation. In deals not yet signed that were underway prior to the escalation of covid-19, parties have gone back to the negotiating table. In future deals, we may see that right becoming explicitly provided for between signing and closing. The traditional time lag between setting pricing and completing deals can be months, and that does not work in this environment.
Another option is an earn-out type clause that can offer some protection to both buyers and sellers, and that is something people are already thinking about. Equally, we could see a new focus on the timing of entry into binding documents which fix a price, and perhaps an attempt to minimize the gap between signing and completion. Material adverse change, or MAC, clauses are another option – they can give buyers the right to walk away and so are effectively used as an opportunity to revisit price.
The gap between buyer and seller pricing expectations may not be all bad news to GPs in the GP-led restructuring context, as a lower price effectively allows GPs to more quickly achieve carried interest in the new fund. It is worth noting, however, that that fact simply serves to exacerbate the conflicts of interests issues that GPs must address in restructuring assets into a new fund.
TM: Many transactional lawyers are going back and dusting off a lot of the deal concepts that were highly utilized during the great financial crisis. During that period, a purchase price expectation gap between buyers and sellers impeded deal activity. We can revisit tried and tested methods of dealing with this, such as earn-outs, price adjustments and other M&A technology. Accordingly, we are evaluating and refining these tools because we believe the market will be amenable to bridging the gap to enable transactions.
What are your views on material adverse change or material adverse effect clauses? Are they useful?
TM: MAE/MAC clauses can be used for a couple of purposes. One relates to disclosure in respect of the assets or business being acquired. Currently the focus is on using these clauses for termination purposes. In one legal case, a party was permitted to walk away from a transaction based upon the MAE/MAC clause.
“People are putting on their thinking caps and looking at creative ways to come up with long-term solutions … we expect to see more innovation in the GP-led space” Trey Muldrow
I’m not sure we are going to see many more legal cases on this, but the clauses do provide a tool for discussing the certainty of closing and conditions for termination. I think people will continue to use and include MAE/MAC clauses as a termination event, but that leads to tremendous negotiation over the clause terms. Prior to covid-19, the MAC clause was negotiated on the edges of a deal unless something specific to a company required a more tailored approach. Now, much more attention is being paid to wording, carve-outs, systemic risk and industry risk.
I suspect these clauses will become more bespoke and people will develop clear understandings of their parameters. They will likely be heavily negotiated so neither side can really take advantage of them, eliciting a price/termination negotiation among the parties.
Doubling down on diligence
Will single-asset deals still be an option for GPs?
ML: We expect the number of single-asset deals to dramatically decrease in this environment. 2019 was a good year for single-asset deals, with volume more than doubling year over year, but there has always been a nervousness about concentration risk with these deals; secondaries buyers are used to diversified portfolios. That nervousness is now hugely exacerbated by market and valuation volatility.
If these deals are to happen, one would expect buyers to focus a lot more on diligence, leading to longer execution times. Diligence on single-asset deals is typically more comparable to traditional M&A deals. In a lockdown environment, diligence is even harder to do, making these deals less appealing. An alternative to stronger diligence is to seek representation and warranty insurance. However, we have heard of insurers carving out covid-19 from those policies.
TM: There could be other seller categories considering liquidity transactions during this disruption. Credit funds, for example, could be forced to take control equity positions in post-bankruptcy companies looking to engage in single-asset deals. These funds are not natural holders of equity. As a result, credit fund holders could be another transactional opportunity over the next 12 to 24 months. The credit funds may look at this market as a liquidity alternative to holding onto the respective equity assets for an extended period.
What role do you see for preferred equity in the GP-led space?
ML: Preferred equity can be a neat alternative for people at the moment in terms of providing liquidity. People are talking about it a lot and we are seeing people explore this possibility in all sorts of contexts. We have heard that preferred equity providers are seeing increased dealflow as a result.
“Pricing is currently one of the key issues – being able to come up with a price … that both buyers and sellers can get comfortable with is proving difficult” Mary Lavelle
One benefit of preferred equity is that it allows people to access additional capital without having to sell assets. Sellers don’t have to give up potential future upside, and that is potentially very relevant here, given that we are living in a time where GPs need liquidity but may have an expectation that assets will bounce back at some point in the future and, in some cases, may be high performing again. For sellers who do not want to sacrifice potential long-term upside for short-term liquidity, this is a good solution. Another really key benefit of preferred equity as compared to traditional GP-led restructurings is that as a GP, you avoid the challenge of having to resolve conflicts of interest issues which can be challenging when restructuring assets into a new, affiliated fund vehicle.
These deals are also a lot quicker to execute and more flexible compared to other GP-led and debt financing options. They are renowned for flexibility because a fixed maturity is not required, and there can be fewer financial covenants. Additionally, the liquidity can be used for a wide range of needs.
It will be interesting to see whether other forms of borrowing will be used on an increasing basis as well, such as NAV (asset-backed) facilities.
TM: There may also be a broader category of sponsors looking at this market for whom preferred equity offers an opportunity. There are several GPs who were looking, at the beginning of 2020, at a robust market that was going to allow them to sell portfolio companies and return capital to LPs. This opportunity window has closed. These GPs may need capital to financially support the portfolio companies. The preferred market is opening up to these GPs as a financial alternative to inject capital into the fund as a bridge until the exits can be achieved.
Everyone has had to react, and now people are putting on their thinking caps and looking at creative ways to come up with long-term solutions. We are aware of people raising funds to deploy capital specifically around these creative solutions, so we expect to see more innovation in the GP-led space.