The Private Equity Liquidity Crisis

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Last week, I had the joy of attending the Privatize Private Markets Summit in Frankfurt. I had the chance to chat with numerous peers in the wealth management industry, all looking to tackle one key questions: Should we include alternative assets in our client portfolios - and if so, how?

Frequent readers know that I am carefully optimistic about private equity as a whole, but somewhat sceptical of the ‘democratization’ of private assets. While prior encounters with mass affluent-oriented wealth management firms and their attempts at including alternatives had made me sceptical, I was positively surprised by my peers present at the conference. Many of them, like us, were thinking of how alternatives can be part of a client’s overall asset allocation. Not just a opportunity to upsell an individual fund, but as a potential building block that can increase expected returns, reduce risk, and/or add diversification to a traditional liquid portfolio.

Yet many of my peers (like I!) had concerns about the overall market. Are those retail-oriented products like evergreen funds or ELTIFs really a good long-term product, or just exit liquidity for institutional investors? And what happens once an eventual market correction also affects ‘volatility-laundered’ alternatives - do clients really understand the (liquidity) risks involved in semi-liquid funds?

So today, we want to dive a bit deeper into PE’s ‘liquidity crisis’: Why are there no exits happening? How are GPs trying to tackle those issues through all sorts of financial engineering? And should I as an investor in PE be worried about it? Let’s get started.

The PE Liquidity Crisis: Where are the exits?

The numbers are clear. Despite an ongoing recovery in exits, and a re-opened IPO market, PE investors are seeing record lows in the distributions that they receive from their buyout investments.

For me, there’s a number of reasons at play (don’t see this as an exhaustive list):

• The economic environment continues to be challenging. While public market indices keep on hitting new highs driven by Mag 7 and the AI hype, the ‘real’ economy such as industrial firms or chemicals companies are struggling. Whether its tariffs, geopolitics, or supply chain challenges, uncertainty is high.
  

• Interest rates are falling, but elevated. Long gone are the days of EUR high yield financings below 3% - banks are cautious, and the numerous private credit funds want to see double-digit interest rates for their financings, significantly cutting back the number of feasible deals.
  

• Entry valuations are high relative to current levels. Many of the deals that should start to hit exit channels were bought at high prices of ‘19-21. While economic fundamentals, in some cases, might be decent, the decline in non-tech valuations (although investors are also much more cautious here than in 2021) is making exits at current levels unattractive - especially to the GPs given their (lack of) carry.
  

• Fund-level fundraising is tough. One would think that GPs would be incentivized to sell - after all, more DPI might make them look more attractive in regards to raising their successor fund. But unless they can sell for a great price (which is unlikely for average assets), selling might also mean that they lose some of the cost basis on which their management fee is charged, unless they already have a new fund that can charge management fee. A classic chicken-egg-situation.

Either way, the overall trend is clear: Investors have committed substantially to private equity, venture capital, and comparable asset classes, and are not receiving the degree of distributions that would be required to maintain (or even grow) their fund portfolio. As one family officer with an established portfolio (15+ years of investing) told me at a dinner during SuperReturn earlier this year: “Before 2022, we had significantly more distributions than capital calls and were struggling to reinvest. These days, we’re not even sure if they’ll cover the capital calls.”

Liquidity Solution #1: Continuation Vehicles

You might think that a lack of traditional exits simply means that there is no way for GPs to realize liquidity from their funds. But in that, you are mistaken - there’s few problems that a GP won’t try to solve through some creative financial engineering.

The most-discussed method these days is a so-called continuation vehicle (CVs). In a CV, a GP takes one or multiple assets from their current funds to transfer to a newly set-up fund. But rather than an exit to another GP, where the buying GP would take over management of the portfolio company, the current GP continues to act as manager of this new fund. LPs have the choice whether they want to sell at the given price (typically a slight discount to the current NAV of the underlying assets), or if they want to ‘roll’ their investment, i.e. become an investor in the CV. Investors that want to sell are typically replaced by co-investment or specialized “GP-led secondaries” funds. 

In theory, CVs are a great vehicle for GPs and LPs alike. For LPs, they are given the flexibility between receiving liquidity or staying invested in a proven asset. For GPs, they can retain well-known assets with more ‘room to grow’ and grow their AUM without having to increase their fund size.

Yet practically, CVs are somewhat controversial. The “discount to NAV” pricing method is challenged by the intransparency of how those NAVs are set to begin with - often also influenced by the GPs. GPs can often also boost their management fee on said asset, and crystalize some of their carry without an actual liquidity event. For LPs, they are forced to accept higher fees or sell an asset that has room to grow - and of course, they might wonder if an exit to an external party (like another fund or strategic investor) would realize a higher price.

In regards to the liquidity crisis, CV are indeed a method for LPs to get a bit of liquidity - despite the real issues associated with this somewhat new type of vehicle. I am cautiously optimistic that CVs could be a good investment opportunity for LPs. GPs are incentivized to grow carry and management fee, but likely won’t choose an CV over an attractive exit for an asset that they don’t actually want to hold on for longer. One recent Evercore study quoted by Bloomberg even showed that CVs in vintages between 2018 and 2023 outperformed traditional buyout funds.

Nevertheless, the aforementioned challenges around NAV pricing and higher fees remain. I also wonder if fundraising in secondary funds has a role to play: A lot of money has flown into diversified secondary funds, which struggle to compete for ‘traditional’ LP secondaries and instead need to deploy substantial amounts in the CVs as the second-best (?) alternative.

As so often, my verdict is still out.

Liquidity Solution #2: Fund-Level Solutions

At the level of individual portfolio companies, an outright sale or sale to a CV are likely the most common and most meaningful ways to create liquidity for investors. To a smaller degree, we’ve seen some dividend recaps, i.e. portfolio companies taking on new debt to distribute to the fund and thus its LPs.

But what if all options at the portfolio company level are exhausted? Once again, creative GPs still find ways to create liquidity.

First, so-called NAV loans. Rather than borrowing money at the asset level (i.e. a leveraged buyout in which the company takes on debt used to buy out prior investors), the fund itself takes on debt at the fund level. Given the absence of planned cashflows besides exit and perhaps a distribution, the loan is instead secured by the assets (i.e. the portfolio companies) of the fund itself.

NAV loans are not necessarily new. One notable user of such facilities is software buyout firm HgCapital, taking on an average of 8% per fund as debt. Yet while HgCapital (by my knowledge!) has used this as an option to make additional (and/or relatively cheaper) investments into companies, GPs these days use NAV commitments to make earlier distributions to LPs.

While I like the idea of how Hg uses NAV loans, I am more sceptical of NAV loans as a liquidity solution. According to law firm Proskauer, NAV facilities see spread that range between ~530 bps (for 5-10% LTV) to almost 1000 bps (for >50% LTV). Even for the highest-performing GPs, that is a substantial figure that needs to be covered by the returns created by holding the asset for longer - while introducing substantial downside risk. Unless LPs are in dire need of liquidity, interest rates are likely in excess of the returns that an average fund might realistically return these days.

Second, strip sales. Admittedly much more nascent than CVs and NAV loans. Rather than selling individual assets of a fund, a fund simply sells a share of all their assets to another party (although in some cases, that other party could be a CV run by the same manager). While still somewhat rare, we’ve seen strip sales in practice, for example a strip sale in which Goldman Sachs sold a share of a portfolio of private credit loans to secondaries shop Pantheon, or a number of proposed (but admittedly not sure if confirmed) strip sale by Blackstone in the nascent GP secondaries space.

Third and least, there’s the humble LP Secondary - or in other words, an LP selling their investment in a fund to another buyer. Especially for end-of-life funds (think a fund in year 12+, or a fund of funds with a number of residual interests), ‘structured’ LP secondaries have become more common. Think of them like tender offers for LPs - rather than holding on to a economically irrelevant but still work-creating fund, they can sell their stake at a discount to a secondaries fund that is happy to retain it as ‘free option’.

The Counterpoint: Are our worries justified?

Often in life, disappointment comes from a misalignment between expectation and reality. We can apply that to our liquidity crisis in private equity: If we were expecting our fund program to reach break-even in years 5-7, and still are yet to get close to a balance between capital calls and distributions, its perhaps justified to be a little bit disappointed - especially when you were a bit more aggressive in your overall liquidity planning, as many family offices and affluent individuals were in the last years. (I hope you at least had that liquidity invested in public equities rather than less risky cash and bonds and can at least be happy by a few years of strong performance.)

But when it comes to the private equity liquidity crisis, I sometimes wonder: Should we really be worried, or is it maybe a blessing in disguise?

In our view, one of the main benefits of long-term-oriented asset classes such as private equity or venture capital is their ability to compound over the long term. It’s not unheard of for a well-performing asset in PE or VC to compound its value at 15% to 20% p.a. Taking PE’s 5-year holding period and a bit of napkin math, we’d see an equity ticket compound over the typical 5-year hold period from 100€ to 200€ or even 250€. But it’s those later years where the math really starts to work in your favor - wait another two years, and your 200€ might almost double again to 260€ or even 360€ (admittedly, before fees). Extend that to 10 or even 15 years (as sometimes the case for VC), and the number goes up even further.

You entrusted your GP with your commitment because you found them to be a good steward of your wealth. So if they say that right now is not the best time to sell, even though the underlying performance is performing well - shouldn’t you trust them? Shouldn’t you see this as an opportunity to hold onto a well-performing asset for longer? After all, unless they’re really compounding at attractive rates, a GP’s hurdle rate (which luckily most GPs have not managed to abolish just yet) will run against them - further incentivizing them to either boost the company’s growth, or to sell before their carry melts away. I always like to say that PE has ‘positive market timing’ - you can always expect a GP to sell when they stand to make the biggest financial return for themselves.

Of course there’s many good arguments that go perfectly against this line of reasoning. There’s GPs marking up assets (sometimes through use of CVs) to book values that are many not fully in touch with reality - but that boost their marks to raise their successor funds. Ways to hold assets for longer, such as CVs, clearly have their issues, such as the step-up in fees, or paper realization of carry. And there might simply be some GPs who don’t sell because their success came from the rising tide of the last decade of low interest rates, and less so from their actual performance.

So look at this like my recent explanation into what investors get wrong about semi-liquid private equity funds: Private equity is a long-term investment, so don’t be surprised when it really takes a long term to work out. If you’re confident into the managers you picked, and as long as the underlying financials of their portfolio companies are working out, perhaps there is less reason to worry than one might think. And if you’re not confident in your fund picks, or even the asset class as a whole - maybe you should rethink your approach.

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