By Patrick Mischo, Office Senior Partner, Allen & Overy Luxembourg
and Codrina Constantinescu, Senior Associate, Allen & Overy Luxembourg
“FUNDS MAY FACE LIQUIDITY ISSUES”, OR “FUNDS WILL FALL OUT OF CARRY”, TO “DEBT IS THE SURPRISE SUBSECTOR THAT WILL SHINE” OR EVEN “THIS YEAR WILL BE A GOOD VINTAGE YEAR” – THESE TYPES OF HEADLINES HAVE BEEN ALTERNATING IN THE PE PRESS SINCE MARCH 2020. WHILE THEY GIVE A MIXED IMPRESSION OF HOW PE FUNDS AND THEIR MANAGERS ARE DEALING WITH THE COVID-19 CRISIS, THEY SHOW THAT THIS YEAR IS A YEAR FULL OF CHALLENGES, BUT ALSO OPPORTUNITIES FOR PE FIRMS. THEY HAVE BEEN REACTING DIFFERENTLY TO THE CRISIS: SOME TOOK A STEP BACK IN Q2 TO LOOK AT THEIR PORTFOLIO AND PROTECT THEIR CURRENT ASSETS, WHILE OTHERS TOOK ADVANTAGE OF THE DISLOCATION AND FOCUSED ON THE COVIDPROOF SECTORS LIKE HEALTHCARE, INFRASTRUCTURE AND TECH.
Since March, assets’ valuations have decreased significantly and exits have been put on hold (except for specific sectors with links to Covid-19, such as healthcare and logistics). Such an environment heavily tests the waterfall and its associated safeguards. The vast majority of Luxembourg funds are well protected by the European model waterfall that pays carried interest very late in the life of the fund. The European model is recognised by the Institutional Limited Partners Association and the like as significantly reducing clawback risks, as opposed to the US deal-by-deal model. The US model may indeed trigger clawback and escrow releases further to the drop in valuations of the assets remaining in the portfolio, as carried may have been paid further to early sales of assets after return of capital contributions and preferred return for those specific assets. Deal-bydeal carried is however rare in Luxembourg fund documents. Another result of the crisis is that the funds that fall out of carry are those that require the most effort from the investment team to recover (and come back even stronger after the pandemic, some executives would say) and performance also depends on the investment strategy and the investment stage of the fund.
A fund that is at the end of its investment period will face more difficulties to restructure and create value for its portfolio companies and investors, considering that commitments are available only for limited purposes (such as follow-ons and management fees) while underlying businesses are often in desperate need of cash. To the extent permitted by the fund documents, GPs waiting for recovery may set up annexes, continuation funds or co-investment vehicles as an alternative to the lack of undrawn capital in their established funds. This solution may benefit their existing investors, as they will be released from paying management fees for long(er) holding periods, while they may decide to participate or not in the continuation fund. In addition, such vehicles may be launched easier than a pooled fund that requires significant fundraising efforts. The Luxembourg market has seen a significant increase in the demand for such vehicles. As a jurisdiction, Luxembourg benefits from a broad toolbox and is well positioned to accommodate GPs and the LPs who believe in their investment philosophy, the quality of their assets, and resilience to the pandemic.
Funds that have launched or are investing in this period may have in front of them a world of opportunities consisting of good and cheap assets that allow them to deploy the large amounts of dry powder in the market (estimated at USD 2.5 trillion in April). In addition, changes to the investment policy (including the geographical focus given the Asian rebound) are easier to implement by such funds based on a constructive discussion with their LPs.
Since certain car makers announced that they will manufacture medical supplies, the boundaries between strategies and brands have started to decrease and now, more than ever, portfolio companies want to be part of the solution to the pandemic and the recovery. ESG has indeed become an important and long-term focus for fund managers and LPs, and – together with reputational issues – influences their decision making. According to Bloomberg, ESG funds have outperformed traditional funds. ESG requirements and investment drivers will become increasingly more relevant in the future, and LPs will be interested in scrutinising the ESG inputs and output of portfolio companies. This trend is not only driven by LPs, but also by the regulatory change: at the EU level, consisting of the adoption of the Disclosure Regulation (EU 2019/2088) and the Taxonomy Regulation (EU 2020/852), and at the international level, by the voluntary ESG obligations and expectations, e.g. UN PRI, UN SDGs, Impact Management Project, and PRIs report on fiduciary duties. Fund managers will focus heavily on ESG implementation and disclosure. ESG may also be an opportunity for first-time funds that currently have difficulties in fundraising as a result of Covid-19. These funds have the advantage of not having to deal with any legacy portfolios and are adaptable to today’s environment by integrating new ESG policies in either pooled funds or deal-by-deal opportunities.
THE VAST MAJORITY OF LUXEMBOURG FUNDS ARE WELL PROTECTED BY
THE EUROPEAN MODEL WATERFALL THAT PAYS CARRIED INTEREST VERY
LATE IN THE LIFE OF THE FUND.
Portfolio companies may also look to the debt funds for alternative funding sources. Debt funds are either financing new deals (direct lending funds) or assisting companies facing difficulties (distressed debt and special situation funds). The recent USD 1bn loan from HPS to Bombardier, or GBP 1.9bn loan from Ares to Ardonagh are opening the way for mega loans from multi-billion dollar private credit platforms. Debt funds offer more flexibility to borrowers and may include unconventional terms (such as loanto- own). Debt funds have the advantage of garnering support from large and/or re-upping LPs.
Portfolio companies have also benefited from financial support and public subsidies in some countries. The funds and their portfolio companies should not expect any increases in taxation in the short term, as public authorities are focused on taking measures to overcome the crisis and stimulate economic growth. However, scrutiny of the taxation of PE funds, their managers and portfolio companies is likely to increase in future. Governments that have piled up significant amounts of debt to support the economy will be looking at increasing tax income in the medium and long term.
As CalPERS CIO recalled at the beginning of the pandemic, “keep calm and carry on” should be the main mantra for the current times that bring opportunities and challenges, but would help shine a new light on resilience, long-term strategies, innovation and a mix of physical and digital.