Newer GPs that showed strong fundraising growth in recent years are now victims of their own success as exits sputter.
Market volatility caused by the war in Ukraine, high inflation and rising interest rates have curtailed the opportunities available to exit existing investments. That means relative newcomers unable to put up realized carry are having to borrow in order to meet their own fund commitments, fund finance sources tell Private Funds CFO.
Hark Capital founder and managing partner Doug Cruikshank says that GPs are subject to “exit velocity.” An environment in which GPs can raise funds quickly, as they had done in previous years, combined with a longer timeline for harvesting carry, results in a situation that is “almost like a denominator effect” for GPs, Cruikshank says. (He caveats that Hark doesn’t focus on GP lending solutions.)
Exit volume progressively dropped over the first three quarters of 2022, affiliate title PE Hub reported in December. The data, which was provided by Refinitiv, showed there were 295 exits in Q1, 283 in Q2 and 228 in Q3. Volume was more than in the same three-quarter period in 2020 – overlapping with pandemic lockdowns – but less than during the equivalent periods in 2018 and 2019.
Delayed exits are particularly bad for newer GPs because they aren’t getting cashflows as reliably as their established peers.
“It’s more acute for them because first of all, they’ve raised fewer funds and they’re smaller,” says Tom Glover, an operating adviser with BC Partners.
This affects newer sponsors in two ways, Glover adds. First, their management fees are smaller – and those cashflows are smaller relative to the GPs’ expenses, which haven’t been completely defrayed. Second, they are not getting cumulative liquidity yet from previous funds.
The timing for when GPs receive carry, or the type of waterfall they use, is also a significant factor.
Glover says that GPs using European waterfalls, in which they get their proceeds all at once during the fund’s wind-up, are at higher risk than those getting it back on a deal-by-deal basis, or American waterfalls.
Waterfall type varies by sponsor, Glover explains, with North American private equity firms typically using the American style and PE firms elsewhere typically going with the European one. However, he notes that sponsors across other private capital asset classes – real estate, private credit and infrastructure – tend to go with European style even if they are based in North America.
A survey of PE funds by law firm Paul, Weiss, Rifkind, Wharton & Garrison found that 90 percent use an American waterfall, with only 10 percent using a European waterfall. The report, released in December, had a sample of around 50 funds that were raised recently.
Paul, Weiss also found that the most common GP commitment amount is 3-5 percent (55 percent), followed by 1-2 percent (28 percent).
Look to cashflows
GPs have a menu of options when it comes to the collateral they can put up for a GP credit, but lenders view some as riskier than others.
The choices can include management fees, both from new and existing funds; GPs’ new and existing commitments, plus their related distributions; and their current and future carry.
Generally, sources say that management fees are the least risky, commitments and linked distributions are in the middle, and carry has the highest risk, though there are caveats that can reduce or increase the risk of each.
GPs may have limits on whether they can collateralize their commitments, Zac Barnett, co-founder at Fund Finance Partners, notes.
“Oftentimes in the subscription facility docs, there will be restrictions on a pledge of the limited partners’ equity interest,” he says, adding that GPs’ commitments are typically treated as LP equity commitments in partnership agreements.
Subscription lines can also preclude pledging the commitments, Barnett adds.
An important caveat is that sponsors shouldn’t expect carry alone to suffice – it is usually only a piece of a packaged financing, Barnett says.
Carry is attractive to lenders as collateral, since it represents a successful GP’s largest fee source, and it can align sponsors’ and lenders’ interests.
But vested carry is preferable since it’s not vulnerable to LP clawbacks.
“If it’s not vested, lenders are going to have a hard time underwriting it,” Barnett says.
GP principals have an additional option to get financing wrapped up: provide personal guarantees.
The guarantees come with tradeoffs, Glover says. Principals that use them can get lower interest rates to fund commitments, but they’re putting their own wealth at risk as added collateral. If they choose not to offer guarantees – it’s a “non-recourse” option – then the cost of financing will be higher, but their assets won’t be at risk.