According to our 2020 GP trends report, the proportion of GPs who believe their next career move will be retirement leapt from 18.8% to 31.4% in the wake of the COVID-19 outbreak. And as the world’s major economies slide ever deeper into recession, it isn’t hard to see why.
Carry distributions are likely to be severely impacted or else wiped out, and so a significant number of senior GPs are wondering if now is the time to bow out.
“The general perception that the current situation will prove more challenging, even more than the Global Financial Crisis, is undoubtedly feeding into an increased interest in retirement. That raises all sorts of questions around how those retiring can benefit from the value they have built up in the management company, as well as how junior partners can raise the money to buy in. This is even more acute if exits are going to be in short supply.” says Jonathan Harvey, Head of Relationship Management in Investec’s Fund Solutions team.
“But, while COVID-19 may be exacerbating the problem, the private equity industry already had issues dealing with succession planning,” Harvey continues. “High buy-in levels and GP commitments can make it very difficult for the next generation to make the financial commitment required to become a partner.”
It is vital, therefore, that GPs looking to build a sustainable succession mechanism can access flexible financing solutions which, enable retiring partners to take money out and, promoted partners to buy in. However, with just under 50% of those surveyed convinced that lenders don’t fully understand their income profile, it is clear that selecting an experienced partner is key.
“We’re able to help private equity professionals solve a lack of liquidity through understanding the way they’re paid and looking at what assets they hold.” says Emily Cvijan from Investec Private Bank. “We’re able to build bespoke mortgage solutions taking multiple properties as security, blending up to four different solutions within the mortgage structure to match the individual’s underlying cash flows. Alternatively, if the client has a managed investment portfolio held with Investec Wealth & Investment, we can lend against the portfolio. In short, we’re able to look holistically at their assets and income profile to help them meet their cash flow needs going forward.”
During times of dislocation, the opportunity to try something new, always becomes more attractive
Jonathan Harvey, Head of Relationship Management, Investec Fund Solutions
A fresh start
Here again, it is vital that GPs are working with experienced partners, who appreciate the rationale for putting a facility in place and are willing to work together with the fund manager to reach a flexible solution. In addition, not all financial partners provide financing lines to first time managers, either because of a lack of track record or an arbitrary threshold on size.
Furthermore, new GPs must not only consider how they will fund their personal commitment but also how they will protect themselves against market risks, such as FX volatility. Analysis of EUR/USD, the most commonly traded currency pair in the world, shows annual swings of between 20% and 30% over the past 19 years.
Between 2010 and 2015, meanwhile, median private equity internal rates of return (IRR) remained flat at around 14%. We are now entering a period where they are likely to fall significantly. It is only too easy to see the potential implications of being caught unhedged, particularly for emerging managers.
“But enhanced risk management can be seen as a drain on capital, deterring smaller or new managers from hedging,” says Michael Slane, Head of Origination at Investec. “Banks typically request collateral – upfront and on an on-going basis – for most types of hedging available to GPs which can create a cash drag. It is also likely that a fund will have to roll hedges and change the delivery date – either moving the contract expiry further out or bringing it in. But rolling positions isn’t that straightforward and it may use up capital.”
“But there are alternatives,” Slane says. “Uncollateralised hedging lines, for example, may be secured against LP commitments, the NAV of the underlying portfolio once initial investments have been made, or future distributions from the fund. Equally, they may be unsecured, uncollateralised lines. By giving headroom on a hedging facility, we don’t need to ask for capital upfront to book the contract and, if those positions become out of the money, we can reduce the chance of calling for variation margin.”
A different future?
“Whilst the data points to an imbalance in the sector, there are certainly shoots of change emerging. For example, organisations like Level 20 are driving positive change within the industry and tenures such as Cheryl Potter’s with the BVCA is not only demonstrative of the progress being made, but also provides women with much needed and very visible role models,” says Cvijan. “But, of course, it takes time and agility for these imbalances to be redressed, which can be a challenge for such an established industry.”
“We know people are planning on leaving the industry and, at the moment, it looks as though the diversity of people coming through is not in keeping with the world we live in,” adds Harvey. “There is more work to be done.”