Majority of LPs require further education on NAV financing – Capstone survey

GPs are more likely to use NAV financing and preferred equity this year despite more than half of LPs believing them to be poor liquidity tools, according to data from Capstone Partners.

The firm’s Liquidity Solutions Survey 2023 found that 54 percent of LP respondents see NAV financing and preferred equity as a poor way to generate liquidity. Minority or dividend recapitalization and GP-led secondaries are much preferred, with 61 percent and 57 percent of investors believing them to be good ways to generate liquidity, respectively.

Regardless, NAV financing and preferred equity have been used by 12 percent of managers in the past, and 14 percent plan to use them in 2024. GP-leds were used by 21 percent of managers previously, with 28 percent planning to use them this year; minority or dividend recaps were used by 30 percent and will be used by 28 percent in the year ahead.

Affiliate title Private Equity International’s  most recent LP Perspectives Study found that LPs have mixed views on the merits of NAV loans. The share of LPs who believe restrictions around GPs’ use of NAV loans in fund documentation are ‘very important’ climbed from 19 percent to 25 percent from the 2023 survey.

One quirk of NAV loans that is cause for concern among LPs is their recallable nature – a development PEI examined in November. Some LPs find it problematic to receive distributions that may have to be paid back: receiving recallable distributions means they can’t use the capital for other purposes, as it must be kept on hand in the unlikely event it is recalled.

The Capstone report found that GPs are finding more varied ways to provide liquidity to their LPs in a difficult exit and fundraising environment. This trend has accelerated since the covid-19 pandemic and continued apace last year.

“Liquidity tools are a creative financing source,” Steve Standbridge, managing partner and president of Capstone Partners, a Mizuho company, told PEI. “In this allocation-constrained market, the LPs have indicated a desire for more liquidity, so GPs have been working with their advisers for ways to provide liquidity outside of a full sale of a business.”

Capstone’s report also found some discrepancies between managers and investors regarding the use of these tools. GPs and LPs have different motivations for using the products, with LPs stating the main objective of GP-led secondaries is to provide liquidity to LPs. However, 75 percent of North American GPs and 50 percent of Asia-Pacific GPs view providing additional capital for growth or significant acquisitions as the main reason.

Additionally, around half of LPs do not consider their GPs to be transparent in their use of liquidity tools. The report also found that investors are at vastly different stages in their understanding of alternative liquidity and financing techniques.

This discord underscores the need for effective communication between LPs and GPs in 2024, Standbridge said. “Whenever a new financial product is introduced into a market, there are always going to be people – who are probably at an information disadvantage – wondering if someone is trying to take advantage of them. It’s natural. As more people start using new financing techniques, the market becomes more transparent and efficient and it becomes more apparent that these new structures can be beneficial to all constituents.”

He added: “It’s important with these liquidity options that communication and transparency is emphasized. The GPs that are the best communicators understand that managing investors is a critical part of their business, and they have to take a long-term approach.”

The survey also found that an ongoing lack of liquidity in the market is driving increased interest in longer-term funds. Some 12 percent of GPs are planning to launch a fund with a 12–15 year lifespan in future, and 28 percent of LPs said they are ready to invest in such funds. For LPs that already expect to see their GPs launching such a fund, 40 percent would be ready to invest.

Standbridge told PEI that the majority of GPs “would love to have some form of longer-term or permanent capital, as most don’t enjoy fundraising every three to five years.” Progress has been hampered by LPs being less willing to invest in such vehicles – however, that readiness is now increasing, he added.

“The willingness to look at longer-term funds will continue to increase, although I think it will vary by type of investor: foundations and endowments generally take a long-term view. They tend to be less concerned about quick turns of capital… Pension funds and insurance companies vary depending on forward liquidity needs. Funds of funds tend to like more liquidity sooner as they have to raise their own funds and their LPs want to see capital being returned. Family offices are opportunistic and their interests depend on family and estate dynamics.”

The more widespread availability of liquidity tools is one reason behind growing LP appetites for longer-term funds, although it will not change the dynamic of private equity as a whole, Standbridge noted.

“The increase in longer-term funds will be a slow drip. Investors will manage duration and will be selective… I think as long as the industry keeps providing new ways for LPs to achieve liquidity outside of a final wind-down of a fund, they will be more open to making longer-term commitments.”