Terra Firma exit shows rare path to PE liquidity

Last week investors in Terra Firma’s €2.1 billion Deutsche Annington Fund were allocated ordinary shares in portfolio company Deutsche Annington, the fund’s only investment, pro rata to their interests in the fund. The strategy was done mostly as a way of allowing them to cash out from the company at a time of their own choosing, a Terra Firma statement read.

Terra Firma listed Deutsche Annington in July 2013 on the Frankfurt Stock Exchange and held a subsequent sell-down reducing the fund’s holding to 67.3 percent of the company, which owns and rents out German apartments. A source close to the matter said “it’s not practical to sell 67 percent of a €5 billion company in one go. This provides a clean exit, rather than a steady sell-down over time.”

Like many limited partnership agreements, the Deutsche Annington Fund could make distributions in cash or distributions in specie – meaning the company could be handed off to investors in its present form rather than selling it and divvying up the cash proceeds. However distributions in specie remain a rare feature in private equity, making the move notable.

“Normally distributing in specie is limited, at least during the life of the fund, to distributing liquid securities,” said one UK-based fund formation lawyer. He added the only other time GPs distribute non-cash is if a fund’s life expired but some unsold assets remain in the portfolio.

Indeed investors tend not to like receiving assets in specie, said one European insurer. “Most of them [LPs] can’t hold listed shares since these are part of a different allocation (listed stock). As a consequence most LP’s start selling and prices drop due to the high supply of the private equity holders who like to sell.” 

A European fund of funds manager told pfm that his firm includes a clause in its side-letters with GPs saying it wants distributions in cash and not in specie. He sees payments in kind not as a way of providing optionality to investors, but rather as passing the buck. “You are just shoving the problem of selling shares from GP to LP. I expect this to be a wider industry problem as more private equity funds IPO [initial public offerings] their companies.”

Investors may also be concerned that by distributing in kind, the manager receives carried interest on the stock at the value at the time of distribution, whereas market movements may mean that the value received by the investor on realization of the shares is much less, added Cathy Pitt, funds partner at law firm CMS.

But, there are mechanisms to ensure the manager retains some risk, said Pitt, including for example calculating the carry based on the average share price over an agreed period.

However, Terra Firma’s case appears unique with more than 90 percent of investors agreeing to receive the shares which come with a 90 day lock-in period.

One possible reason is that the Deutsche Annington fund was set up to hold a specific entity and investors bought into the fund knowing the entity they were buying as opposed to a typical blind pool.

“I Imagine a lot of investors will know the asset well and may want to continue holding that asset in the long term so it may be in this case investors were much more positive about distribution in specie,” said the UK lawyer. “They may think there is more life left in this investment, given that it has a real estate aspect to it so there may be a good income stream coming off it and therefore the investors like the income stream.”

Shares in Deutsche Annington were trading at €21.04 as of 4:12pm (CEST) on May 27, up 23 percent from their opening trade price of €17.10 back in July.