By Dayton D. Nordin, Mayis Kirakosyan and Frans de Groen
Many private equity funds are pursuing transactions between affiliated funds or portfolio companies in order to realize the full potential of investments that have been disproportionately impacted by the COVID-19 pandemic. However, if a fund manager is on both sides of the deal there is often a degree of conflict with investors to which the fund owes a fiduciary duty. Investors can be apprehensive about conflicts in such deals because they want to make sure there is no inappropriate shifting of value. To mitigate potential pitfalls, leading private funds are designing a robust governance process built on transparency, communication and independent advice.
General partner (GP)-led transactions
We expect to see a strong uptick in GP-led transactions in 2021, a type of transaction whereby an existing fund sells one or more assets to a continuation vehicle managed by the same sponsor. This structure is attractive because it offers liquidity to investors that wish to exit, while giving the sponsor and rollover investors more time to realize the full potential of their investments. It can help provide much needed breathing room for distressed assets in sectors that have been affected by the pandemic, such as hospitality, energy and transportation. A GP-led deal can also be an attractive option to lock in returns and raise additional capital for investments that have thrived during the pandemic, such as technology and health care assets.
Critical step: Engage all stakeholders often and early and provide complete and accurate communications. Investors prioritize funds that have provided transparent communication during the recent period. Failure to be transparent with limited partners and advisory committees can result in a delayed or canceled transaction.
As the competition for high-quality assets continues to increase and the deal environment remains uncertain, some fund managers are optimizing their existing investments with fund-to-fund transfers. Given the knowledge of the assets, combining portfolio companies allows fund managers to execute a buy-and-build strategy with lower risk. Additionally, the funds realize synergies while building a more efficient, resilient and attractive business to be sold when market conditions are more favorable.
Critical step: Engage an independent financial advisor to perform a valuation and deliver an opinion with respect to the fairness of the transaction from a financial point of view, even if this is not mandated by fund documents or debt covenants. Independent, outside advice and a formal fairness opinion from a reputable firm enhance the transaction process, strengthen the ability to make an informed decision and build a supportive record of governance for the fund manager. This is especially important today given the high level of uncertainty related to asset valuations.
Many portfolio companies will, at some point, require additional financing to stay afloat or make follow-on acquisitions. Distressed assets, however, may experience difficulty obtaining capital at attractive terms because investors are being more selective. In these cases, it may be more practical to raise debt or equity from a different, affiliated fund instead of a third party.
Critical step: Implement procedural safeguards to reduce the risk of challenge, such as forming a special committee of independent directors and seeking approval from disinterested shareholders.
The importance of valuation
Mixed signals, differing opinions and general economic uncertainty may make it very difficult to price acquisitions or exits in the current environment. While we have more clarity than at the start of the pandemic, valuations remain volatile. Relying on prior analyses or other high-level approaches to valuation is no longer an option. In addition, many investors may not be equipped and may not have the time or resources to adequately assess value.
Private funds can navigate transaction complexities with related parties, avoid surprises and increase the likelihood of a successful outcome by focusing on three key steps: engaging all stakeholders often and early; engaging an independent financial advisor; and implementing procedural safeguards. Affiliate transactions can be tricky and require careful balancing of interests. By taking these steps, private funds can achieve their desired objectives, be fully transparent with investors and mitigate risks with minimal disruption.
Dayton D. Nordin, EY US Valuation, Modeling and Economics Leader
Mayis Kirakosyan, EY US Fairness Opinion Practice, Strategy and Transactions
Frans de Groen, EY US Fairness Opinion Practice, Strategy and Transactions
The views reflected in this article are those of the authors and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.