A Dry Well of Liquidity
The liquidity crunch in private equity has sparked a record surge in secondary market opportunities, with unprecedented demand amid slowing investor inflows and stalled exits, according to Goldman Sachs Asset Management.
The Goldman team said that a distribution drought of a cyclical nature is hitting managers hard as in the first half of 2024 distributions were at about 9% of net asset value as opposed to 29% of asset value in 2021. Private equity funds distributed more than $700 billion following a flurry of exits in 2021, the team pointed out in a new report, Distribution Drought: The Quest for Liquidity in Private Markets.
Despite the fact that distributions have slowed, most LPs are still under-allocated to private market strategies. Consequently, they are not seeking liquidity to alleviate excess allocation constraints, and many are actually increasing their allocations.
Therefore, although distributions are essential for cash flow management and asset allocation, they may be particularly crucial in affirming performance for mid-life funds in the current environment. It may be argued that many LPs now value distributions as much for validating existing holding valuations as for liquidity, noted Goldman.
Dan Murphy, head of portfolio solutions for alternatives capital formation at Goldman Sachs, identifies a trifecta of impediments to traditional exit routes, including elevated borrowing costs, paralyzed public markets, and a historic reversal in which holding valuations now outstrip potential exit prices — a phenomenon not seen in a decade.
“Buy-and-Build”
The report noted that many GPs have made “buy-and-build” a fundamental aspect of their overall approach. In the U.S., add-on deals have increased to over three-quarters from less than half of all leveraged buyouts during the post-GFC period. Goldman Sachs has seen the buy-and-build strategy gain traction in infrastructure, where asset owners have seen the benefits of scale in capital-intensive areas.
One example is regional buy-and-builds of specialty healthcare practices, according to the report, which do not fit neatly in larger hospital systems, and often become too large for practitioners to acquire. In large-cap core infrastructure, the size of assets inherently limits the pool of potential acquirers.
“As the number of add-ons increases, often both the size and complexity of the business increases as well, limiting the number of viable owners of the asset,” Murphy wrote. “Other financial sponsors have become an increasingly important exit route for these businesses.”
Consequently, Goldman Sachs observes that financial sponsors, rather than public markets, have emerged as the primary exit strategy for platforms with numerous add-on transactions, facilitating the increase in secondary buyouts where one general partner (GP) divests an asset to another GP.
The market for limited partner (LP) secondaries has experienced significant growth. In an H2 Market Update, BlackRock indicated that widespread acceptance of the secondary market by both LPs and GPs had resulted in a new volume record of $140 billion, exceeding the prior high of $132 billion established in 2021.
Multiple pension systems have publicly presented secondaries. This month, the $77 billion Pennsylvania Public School Employees’ Retirement System said that its investment office personnel divested 13 private equity firms on the secondary market. The total net asset value of the transaction, which concluded on September 30, was $822 million.
GPs and LPs are more inclined to retain assets for extended periods due to evolving fund structures and the proliferation of continuation funds. Goldman Sachs said these, and other mid-stack capital solutions are being offered as interest rates and private equity valuations begin to vacillate, placing them between debt and equity.
Interim Liquidity Demand
There is a growing trend among GPs to pursue interim liquidity through dividend recapitalizations, which Goldman Sachs anticipates will see record volumes this year. The strategy, which entails the acquisition of additional debt to distribute special dividends to shareholders, has become a critical instrument for private equity firms as they navigate the current market constraints.
“Some of these developments will be long-lasting and have wide-ranging implications for how GPs approach investments at entrance and exit, as well as how LPs consider liquidity,” Murphy wrote.
Goldman Sachs observed that general partners evaluate liquidity decisions across entire fund families, rather than solely individual assets. Fund economics, carried interest treatment, and partner compensation are all factors that influence the manner in which managers approach specific portfolio exits. LPs must understand these factors to accurately assess proposed transactions.