According to data from Preqin as of Q3 2023, the pace of fund closings is in sharp decline compared to 2022 despite a recent uptick in the capital amount raised. However, the upward trend is attributed mainly to the benefit of large mega fund managers, such as CVC, who recently closed a record-breaking deal worth 26 billion euros. To illustrate this, 46% of the total fundraising amount over Q3 2023 were collected by the 15 biggest funds reaching a final close through such quarter. At the other end of the spectrum, a long tail of smaller/mid-market managers struggle to hit their target in a crowded market with the highest number of funds the market has seen in the last 5 years (over 4000).

Evidently, a consolidation is underway, with most of the capital falling into the hands of a smaller number of GPs who are responsible for the larger proportion of the total capital amount raised. Cash-strapped limited partners squeezed by a slump in distributions due to the difficult exit environment are favouring established GPs relationships with a proven track record. Finding innovative and bespoke solutions to offer liquidity to investors is taking centre stage with “dry powder” (uncalled capital) reaching an all-time high of USD 2.59 trillion by December 2023 (according to S&P Global Intelligence).

In this contribution, we will discuss macro trends and solutions developed by fund managers in order to counter the exit and fundraising shortfalls. We will particularly emphasise how these trends and solutions apply to today’s market and traditional fund terms.

1. Innovative solutions to fill in the liquidity gap

Both global dealmaking (M&A) and IPO activity have been fairly slow over the last 18 months leading to the private equity industry entering 2024 with a record of unspent investor cash. According to Bain & Co, the number of private equity transactions over Q4 2023 was near a decade low. Overall exit value fell 26.6% from the previous quarter and 74.1% from the peak reached in Q4 2021. This has left GPs with a staggering number of portfolio companies to exit. As a domino effect, the exit deadlock also affects the fundraising of any new vintage – LPs for the most part are first expecting some distributions on prior investments before considering to re-commit to the next fund. To counter this, GPs who were forced to hold onto their assets for much longer than anticipated spent much of the last two years strategising over bespoke solutions to bring cash back to investors, hence the recent surge of secondaries transactions (whether GP or LP-led) and of other innovative financing tools (net asset value (NAV) facilities) which, at times, may give rise to conflict of interest.

1.1. GP and LP-led secondaries

Private equity secondaries transactions have been on a sharp rise and can be broken down into two categories, “GP-led” and “LP-led” transactions. GP-led secondaries typically take the form of continuation funds launched by fund sponsors to hold onto profitable assets owned by funds nearing their term. Two main drivers are behind this trend, first the GP belief that there is still strong upward potential to maximise profits on certain asset(s) on a go forward basis and second the need to offer liquidity solutions to investors. In a typical continuation fund, one or more asset(s) of a fund getting closer to its term are transferred to a new vehicle managed by the same sponsor. Investors in the existing fund are then offered the option to either sell or “roll” their interest into the continuation fund (i.e., remain invested in the underlying assets). New investors will then provide fresh capital to the continuation fund allowing it to provide liquidity to the existing fund investors who have elected to cash out/sell their interest. The continuation funds terms come in different shapes and forms often reflecting asset specific nuances. Amid sluggish IPO and M&A market, continuation funds enjoy a very strong momentum. To illustrate this, the percentage of GP-led in PE distributions nearly doubled in 2023 (representing around 9% of total PE distributions according to Baird). The flipside of this however is the growing LP sentiment that this market has become fairly mature, over-crowded even in some respect, thereby incentivising sponsors to focus their GP-led transactions on “trophy assets” to stand out from the competition. Conflict aspects also very much take centre stage in any continuation fund transaction as assets move over between two funds managed by the same sponsor. Absent specific circumstances (such as a competitive M&A auction process or a third party investing alongside the continuation fund), limited partners will expect the pricing for the acquisition to be supported by a third-party fairness or valuation opinion. The U.S. Securities and Exchange Commission (SEC) made it a requirement for similar transactions in the United States – whilst there is no such formal requirement in the European Union (EU), the practice has very much evolved towards requiring LP Advisory Committee consent (LPAC) and a third-party valuation on pricing. In tandem with the SEC rules (which led to revisions of the Investment Advisers Act of 1940), the main industry body representing LPs interest (Institutional Limited Partners Association, ILPA) also published some guidelines advocating for increased transparency (and third-party valuation) when embarking in a continuation fund project. The purpose is very much to ensure that these transactions among related parties are conducted in a fair and transparent manner. What were initially best practices (LPAC consent, third party valuation) are now becoming industry standards to shield LPs against potential GP abuses.

While GP-led transactions are a great complement to LP-led secondaries, they are not a substitute for it. LPs need to constantly rebalance their portfolio across the large number of funds invested. The drivers to engage into LP secondaries are generally threefold (1) overallocation concerns due to constant volatility in the public market leaving PE allocation meaningfully above targets, (2) the slower pace of distributions and (3) the desire to maintain diversification across vintage years and to free up capital for “re-up” transactions in successor funds and for fresh investment in funds launched by other (and sometimes difficult to access) managers. In the private equity space, LP-led secondaries are typically lower duration investments with a relatively quick return that helps mitigating the J-curve effects. It’s not unheard of that a buyer might step into a LP-led transaction and get its capital back in short order because the manager sells the asset on an accelerated basis. Middle vintage years have proven particularly attractive as they are fully funded, just entered their harvesting period and perceived as offering attractive valuation prospects. Regarding pricing, LP-led transactions typically conclude at a “discount to NAV” sometimes reduced by a “premium” when a quick return is expected.

1.2. NAV facilities

More than ever in a slow exit environment, NAV facilities are emerging as a strategic liquidity management tool. NAV facilities allow funds to borrow based on the value of their portfolio investments, providing them efficient access to additional capital. NAV facilities typically take the form of term or revolving loan facilities granted by lenders to the fund (or its SPV(s)). The security package generally includes one of the following securities (and often a combination thereof): a pledge over the equity interests in the SPV(s) and/or or portfolio companies, a pledge over the bank account(s) on which portfolio investment distributions or payments are to be received by the Fund and/or the SPV and/or security interests over the distribution claims/receivables owed by the portfolio investments. NAV facilities can serve a variety of purposes particularly for late-stage funds or funds confronted to a liquidity shortfall. They are often used by funds with little undrawn commitments left or which are past their investment period and need extra firepower to fund “add-on” transactions. Here, NAV financings backed by the fund’s portfolio are particularly attractive as they come in at a lower price than asset level financing. A more recent trend is the greater use of NAV facilities to counter the slump of distributions. As noted above, GPs are under pressure to monetise returns to their LPs and NAV facilities can be used to accelerate distributions, drive up IRRs and retain the asset much longer to maximise the upside potential and delay the exit until market conditions improve. This benefits both GPs and LPs but some LPs have voiced concerns that funding distributions through NAV facilities is somewhat artificial particularly when such distributions are “recallable” (and therefore cannot be immediately redeployed for new investments). Nearly every LPA of a private equity fund has a recall provision allowing the GP to call back distributions (usually with some limits in terms of recallable amount and timeframe). Views are mixed in the LP community regarding the merits of NAV facilities. Some are put off by the mere recallable nature of distributions, other are more lenient and of the view that the benefits of NAV facilities outweigh their flaws. GPs can argue that recallable provisions apply in the same fashion to any type of distributions regardless of whether these are funded by an exit or by drawing funds under a NAV facility. Also, the GP right to recall distributions is generally contingent on some restrictions in LPAs which are more stringent than those applying to its right to draw uncalled capital. Regardless of this debate, the NAV financing market which represents around EUR 100 billion to date is on an undisputable upward trend. It is projected by certain players to triple in size by 2025.

2. Drilling down to the fund terms

Not only did turbulent market conditions prompt GPs to develop liquidity solutions to counter the exit and fundraising shortfalls, they have also given LPs the upper hand when negotiating with GPs. This is particularly the case in the small to mid-market segment where teams track records are either in their nascent phase or less established. For significant GPs, the launching of a new vintage of their flagship fund is no longer always accompanied by a sharp increase of the fund size. Fund size tend to be stagnant and many GPs ended up recalibrating their target fund size downwards. The current trend is expected to last, noting Preqin expects 2021 fundraising levels to only return by 2028, albeit with a steady year on year growth from 2025 onwards. In this tense fundraising environment, GPs have developed solutions and adapted their funds terms to secure commitments. Trends of consolidation, broader strategies, and retail market expansion are on the horizon for the PE industry which has shown resilience in the current market downturn.

2.1. Fundraising period

The slow pace of fundraising has been accompanied by the need for GPs to extend fundraising periods (also called marketing or closing periods). Flexibility for rolling closes has become key as GPs are no longer systematically able to hold significant first closes. For new funds (including new vintages), GPs tend to review carefully their standard fundraising period clauses to ensure that they will have sufficient time to raise capital (e.g., by stating that such period should initially last 18 months rather than 12) or by introducing clauses enabling GPs to easily extend the duration of such period should the initial timeframe become too short (e.g., at the discretion of the GP or with LPAC consent). A combination of both a longer initial closing period and extension rights is increasingly common. Another trend is that fundraising periods are now marked by smaller but numerous closings (rolling closes) with GPs aiming at securing capital commitments as soon as investors negotiations and onboarding are completed.

2.2. Fees

From the face of the fund documents, both management fee and carried interest levels did not undergo any major shift, the mean management fee staying below 2% in most cases (except for growth strategies) and the industry-standard of 20% carry remaining largely prevalent. This said, it is without doubt that management fees and carry are being highly negotiated by means of side letters, especially by anchor/large-ticket investors and other first closers.

3.3. Co-investments

Co-investments are increasingly being used as a tool to attract investors as these generally come with a low fee structure which (often) combines no management fee with no carry entitlement for the sponsor GPs. GPs are trying to secure “stapled commitments” where a co-investment piece is offered to LPs who commit as well to the flagship main fund on the market. Co-investment is also an area where small and mid-size managers can stand out in their efforts to lure LPs away from the largest PE managers. It is increasingly difficult for LPs in the largest fundraise to be offered co-investment rights as these are snapped up by the largest LPs. Anyone not falling in that bracket is more likely to get traction with smaller/mid-market GPs to meet their desire to allocate capital to co-investment opportunities. Priority allocation of co-investment incentives to first closers and large ticket investors has now become a regular theme in side letter negotiations.

3.4. Investment period and fund term

If an investment period usually runs over 3 to 5 years after the first or the final closing, having the possibility to extend such period when the market is undergoing a downturn may be key for GPs, so that they may deploy capital when evaluations have decreased and when borrowings are on better terms. Indeed, following the investment period, drawdown capabilities are usually limited to follow-on investments (or also sometimes to investments under consideration upon the end of the investment period), expenses and giveback obligations. Typically, an extension requires the consent from a majority in interests of LPs, or from the LPAC. Noting the term of a typical PE closed-ended fund imply the dissolution of the fund and the realisation of remaining assets, GPs also tend to have the possibility to extend the term (e.g., at the GP’s discretion for a year extension and by majority in interests of LP or LPAC consent for a 2nd year extension) to ensure an exit in good market conditions. In a market downturn, we note LPs will be more likely to grant these extensions. For new fund launches, GPs are looking to provide for a longer investment period and fund term from the outset in the fund documents, or at least for extension mechanisms such as those highlighted above.

2.5. Clawback

which require a GP to return to the fund the surplus of carried interest it has received. This might be the case for funds having sold assets at great market conditions (and having allocated carried interest accordingly) while subsequent assets are realised mid-way through a market downturn (and at a lower upside). The clawback is generally measured at the term of the fund during the liquidation phase. In addition to escrow provisions “freezing” a portion of the allocated carried interest on a bank account for a certain period of time, some LPs have started to negotiate interim clawbacks pushing for calculation at interim points (typically at the end of the investment period with the latest NAV of the unrealised portfolio as reference point). The clawback obligation is therefore triggered upon each interim calculation and not only at the term when all assets have been disposed of. GPs may counter this by arguing that interim clawback calculation based on unrealised value is not appropriate.

3. Some macro trends – consolidation, broader strategies and retail market expansion on the horizon

3.1. Consolidation

Tougher market conditions combined with growing compliance and regulatory costs and a maturing industry is putting smaller, single asset managers under pressure. A consolidation trend is underway with many market players expecting it to accelerate. Fundraising is dominated by large market players who are themselves on the look-out for opportunities to expand their footprint to new strategies or regions. A few marquee deals closed in 2023, such as the EQT/Baring Private Equity Asia tie-up or the acquisition by CVC of the Dutch infrastructure powerhouse DIF Capital Partners. In contrast, many smaller private equity managers have found the process of attracting new investors particularly difficult and strategic alliances with bigger outfits is seen as a solution to future proof their business. Somewhat less drastic, joint ventures between emerging/less established GPs are not unheard of and “GP stakes” deals are also the rise. GP stakes are transactions whereby a strategic partner takes a minority stake in a GP management company. The strategic partner is typically either a GP stake fund or an anchor investor already invested in funds managed by the sponsor GP. The benefits for the GP stakes investor are twofold, building up direct exposure to the management fee streams and betting on the upside potential of the equity stake acquired. For the sponsor GP, the expertise, knowledge and established network of the GP stake investor are generally the drivers to embark on such a deal.

3.2. Private Credit Push

Many private equity houses stepped up efforts to expand their footprint in private credit. Higher interest rates and a downward pressure on valuations had a massive knock-on effect on buyout transactions which were near a decade low as we entered 2024. This prompted many GPs to pivot away from buyout and re-focus on strategies more insulated from the current inflationary pressures, such as infrastructure and private credit. Private debt funds come in many different shapes and forms but they often involve floating rate loans which are particularly attractive as the income they generate increase with rising interest rates. Borrowers on their end are on the look-out for alternative lending sources and private debt funds are ideally equipped to fill in the void. What’s more, the risk return profile is particularly appealing to investors. They cannot expect the same windfall which buyout funds managed to deliver over the last decade of low interest environment (around 18 per cent according to Adam Street Partners). By comparison, the expected return for private debt funds is more in the low teens, albeit with less risk and some downside protection with a security package over the borrower’s assets. The private credit growth is not in its nascent phase, quite the reverse as it has been growing steadily over the last 5 years and the future looks even brighter. Preqin indeed expects the asset class to close to double the 2022 figure of USD 1.8 trillion by 2028. Loan-originating funds will however need to adapt to the proposed regulatory framework under AIFMD 2, which has just been adopted and should be effective in 2026. Indeed, for funds whose investment strategy is mainly to originate loans or where the notional value of the funds’ originated loans represents at least 50% of NAV, it is notably proposed to require such funds to be closed-ended (albeit with some possible caveats), to retain 5% of the notional value of loans originated and subsequently transferred, to impose leverage limits, and to prohibit origination of loans exceeding more than 20% of the capital of the funds to single borrower of certain categories (financial undertakings AIFs, UCITS).

3.3. Retail market expansion

Much has been said about the democratisation of the private assets industry which is well under way and expected to accelerate with the modernised European Long-Term Investment Fund (ELTIF) 2.0 regime, which applies 10 January 2024. The ELTIF label optionally comes with a marketing passport to EU retail investors which has garnered strong momentum, particularly among the largest asset managers. The horizon is also expected to brighten for products with a semi-liquid profile following the publication by the European Commission on 6 March 2024 of its proposed amendments to the draft technical standards prepared by the European Securities and Markets Authorities (ESMA) noting that ESMA’s proposal “does not sufficiently cater for the individual characteristics of different ELTIFs”. The contemplated changes of the European Commission should notably address the concern of the industry on the redemption terms and size of the required liquidity pocket as initially set out within ESMA’s proposed RTS. The European Commission has indeed suggested to remove the 12-month prior notice period for redemptions from open-ended ELTIFs, and to lower the minimum percentage of liquid assets to be retained as a liquidity pocket from 40% in the highest scenario to 25%. The proposed RTS amendments should therefore be welcomed by the industry and could potentially pave the way for a rise of launches of open-ended products under the ELTIF 2.0 label. ESMA should now review the contemplated changes suggested by the European Commission.  In all cases, it is undisputable that a strong uptick of launches of closed-ended ELTIFs should materialise in the months and years to come. The above concerns are not applicable to these, and the regulatory framework is now there for such products to take off. In Luxembourg, undertakings for collective investments under Part II of the Luxembourg law of 17 December 2010 (Part II UCIs), which are well suited to open-ended strategies, have strongly resurfaced, notably thanks to the modernisation of the Luxembourg’s fund toolbox with the Law of 21 July 2023. Going forward we also expect umbrella Part II UCIs to get momentum as this structure can deploy multiple sub-funds, some with the ELTIF wrapper (and others not), thereby allowing to combine closed-ended and open-ended strategies under the same roof. The shift from the traditional institutional investor base towards high-net-worth individuals and semi-retail investors which has marked 2023 will likely accelerate this year. Market demand, particularly emanating from third party intermediaries (such as private banks) is strong. A flurry of feeder vehicles and/or access funds have been established by those intermediaries as a workaround to the regulatory and operational complexities that come with tapping into the semi-retail market. Another key component to the democratisation of private assets is very much centred on “tech” related solutions which accompany this trend. Platforms, tokenisation and digital infrastructure solutions more widely (such as distributed ledger technology, DLT) are emerging at a steady pace to accompany this trend. Challenges accompanying the democratisation movement should not be overlooked and are expected to keep GPs and the PE ecosystem busy in the years to come (adjust sales and distribution strategy, revamp operational process, education of distributors and end-investors).

With 2024 now fully underway, a look in the rear mirror demonstrates how resilient the private equity industry has been to face head on unprecedented headwinds marked by higher borrowing costs, lower valuations and geopolitical pressures after a decade of strong growth. Innovative solutions were designed as workarounds to deliver liquidity and maximise the upside potential of portfolio assets. The LP community has been largely amenable to the surge of GP-led transactions even if it meant delayed exits and has used the current environment to negotiate further fund terms with GPs. The pendulum has definitely swinged in favour of investors. As we head into 2024, we expect GPs to face increased pressure from LPs to close exit transactions. This largely comes down to coming to terms with the re-pricing expected by buyers of PE assets and some early signs of sellers starting to capitulate have emerged. A surge of M&A and IPO activity is what it will take for the industry to gradually get back to normal.