Exit This Way
INTRODUCTION
Evolving Investor preferences and changing market sentiment result in an abundance of new exit options in the real estate sector. Whether you believe specific sectors are overvalued or undervalued, real estate funds have posted strong performance over the past twelve months, especially those with an overweight to industrial or multifamily. The strong performance and increased competitiveness for stabilized assets leads Investors to explore portfolio sales or early exits to realize gains. The profits from the realizations are accretive for Investors and investment managers, but both parties are left to raise and deploy additional funds quickly, now in a rising interest rate environment. Additionally, Investors recognize that these holdings could offer additional upside to Investors in a longer duration vehicle, providing continued competitive performance and stable cash flow. Additionally, large portfolios may command premiums compared to individual sales, particularly in high performing sectors. Because of these trends, recapitalization efforts are increasing, and recapitalizations are more acceptable to once-weary Investors who recognize there is opportunity to both realize returns and hold assets in a continuation vehicle managed by trusted partners. This report discusses alternative exit options and highlights the importance of running a transparent, institutional process along the way.
WHAT IS RECAPITALIZATION?
Fund recapitalization or restructuring alternatives are common in the private equity asset class and becoming more prevalent in the real estate sector. According to Brian DiSalvo, Capital Advisor from Park Madison Partners, “GP-led recapitalizations (i.e., direct secondaries) are one of the fastest-growing corners of the real estate market today. Since the Global Financial Crisis (GFC), these transactions have evolved from a relative novelty to a widely accepted approach to monetize investments and generate liquidity. Direct secondaries now constitute a substantial majority of overall real estate secondary trades. As the market has matured, several investment managers have launched dedicated secondary vehicles to capture this burgeoning new source of deal flow, thereby increasing overall market liquidity and efficiency.”
The below chart demonstrates the growth of direct secondaries since 2013 according to Park Madison data. In 2021, Park Madison estimated $13.8 billion of total secondaries transaction volume, with direct secondaries representing approximately 87% of that total.
A continuation vehicle (or recapitalization) provides for a new structure, a new Investor base and the ongoing management of assets. Investors are provided the ability to either sell their portion of the fund to a new secondary Investor or to stay invested in the fund. Fund recapitalizations can occur before the fund term expires or at the end of the fund's life if the investment manager believes there to be an upside to the assets on a go-forward basis. There are several types of fund recapitalizations that we will dive into throughout this piece, the most common being the traditional full or partial sale of the portfolio. The options will create both advantages and disadvantages for the Limited Partner (LP) and General Partner (GP). Therefore, every investment manager will need to weigh the pros and cons of each recapitalization to determine which alternative best aligns with their strategy and objectives, all while considering the potential impacts on Investors. Alliance Global Advisors (Alliance) has guided several firms through this process and is well equipped to provide suggestions and guidance to execute a smooth transition of Investors in and out of the fund.
TYPES OF FUND RECAPITALIZATION
Several different recapitalization options are available, and none are a “one-size-fits-all” solution. In this section, we will investigate dividend recapitalization, GP-led tender process and a continuation fund. Each of these options has its pros and cons, with the flexibility to make slight alterations to meet the goals of the Investor and investment manager. Before providing an overview of each individual alternative, we have highlighted some commonalities they share. According to Brian DiSalvo from Park Madison, “the most important consideration for GPs considering a recapitalization is their fiduciary obligations to existing LPs.” Additionally, the recapitalization process will need to be efficient and transparent for all Investors, whether they are exiting the fund or not. Firms will need to begin socializing their recapitalization plan as soon as possible and gauge Investor feedback. Clear expectations around identifying and mitigating conflicts that may arise will be imperative in a successful recapitalization. In addition, GPs will need to consider their rationale and motivations for a potential transaction and formally present this to the LPAC/LPs to solicit formal guidance on process mechanics and process steps. Except for a full or partial portfolio sale, every recapitalization alternative will most likely require new terms for managing the vehicle and new economics for the GP.
According to Brian DiSalvo for Park Madison, “there are specific fact patterns that recapitalization advisors look for when assessing whether or not a recapitalization will result in the best execution and ultimately be successful. Examples include:
Exit timing mismatch – For a number of reasons (market conditions, business plan progress, etc.), the projected time to exit an investment may differ from the investment vehicle life or LP expectations
Business plan considerations – Additional upside potential remains that the GP is well-positioned to execute/capture
Property encumbrances – Prohibitive debt, tax obligations, or other legal considerations prevent an outright sale (e.g., lockouts, litigation, property tax trigger, etc.)
Investor liquidity – LPs have liquidity needs which the GP wishes to accommodate without selling the asset outright”
CONTINUATION FUND
A continuation fund is the rollover of assets to a new vehicle with an extended hold period. The rollover can incorporate any number of the existing fund assets that the continuation fund will acquire. The continuation fund can take several shapes, including a closed-end vehicle, club, open-end vehicle or separately managed account. Regarding open-end commingled funds (OECFs), nine out of 14 recent OECF launches included seed assets ranging from a few properties previously held in older vintage closed-end funds or on the GP’s balance sheet to large seed portfolios purchased to decrease the blind pool risk of the founders’ round Investor. Existing Investors are often given the ability to roll over their stake to the new continuation fund if chosen, but not required. This transaction will allow the GP to continue managing the assets and potentially extract future value given the extended hold period. Like the GP-led tender process, there is an extensive conflict of interest incorporated in the valuation of the assets and the investment manager should pursue the use of third-party valuation firms. With the new capital entering the continuation fund, the GP will benefit from acquiring new assets. The ability to acquire new assets could allow the investment manager to cater to the needs related to the risk/return profile new Investors are seeking.
Another form of continuation vehicle exists when Investors choose to shift from separately managed accounts to funds. In these circumstances, Investors may contribute separately managed account assets to an OECF in lieu of shares in the fund, and they are often rewarded by the GP through a significant fee break for this contribution.
DIVIDEND RECAPITALIZATION
Dividend recapitalization, less common in the private real estate sector, is a practice used to pay Investors a special dividend to help them recoup a portion of their investment. This action is a type of leveraged recapitalization that takes the form of issuing new, higher loan to value (LTV) loans on the assets in the portfolio and using the additional capital for the dividend. This special dividend decreases the Investors' risk and impacts the assets' capital structure as well as reduces the overall credit quality of the fund and/or GP. This is due to the increase of debt and decrease of equity in the portfolio. The process is often used in private equity to allow an Investor to exit an investment, recover an initial investment or avoid using earned profits for dividends. A dividend recapitalization is not always the best decision, and in some instances, cannot be considered at all due to leverage constraints. Before pursuing this transaction, several variables to consider include existing leverage, Investors' appetite for leverage and the effect it will have on net operating cash flows.
GP-LED TENDER PROCESS
A GP-led tender process is an increasingly popular recapitalization alternative in the private equity world. This transaction has many practical uses in real estate that would allow secondary Investors to assume another LP’s share of a fund that offers low-risk cash flows. This transaction takes the shape of the GP tendering all or a portion of an existing LP’s interests to a new buyer that may be a current Investor. This is a beneficial transaction when one or more Investors are pushing for the sale of assets to recoup some of their investment. It will allow the Investors to fully or partially exit the fund and a new Investor who wants the investment manager to continue to manage the fund to enter. Valuation of an exiting LP’s interest is critical, and the investment manager should take steps to ensure that it obtains fair market value.
INVESTOR CONSIDERATIONS
It is imperative for GPs to run a transparent and institutional process when pursuing alternative exit scenarios. Existing Fund Investors and their Consultants will seek to understand the exit options considered by the GP and request access to the models associated with various exit scenarios. In addition, Investors must have confidence that a fair, competitive value is paid for their existing holdings. A substantiation of value by at least one independent third party will likely be required. If questions remain, the Limited Partner Advisory Committee (LPAC) may seek to appoint its own third party to conduct an analysis. Conflicts of interest arising from “affiliate transactions” must also be mitigated to ensure that the GP is acting in the best interest of existing Investors throughout this process. The process and time it may take to obtain required approvals should not be overlooked.
CONCLUSION
In addition to traditional exit options (asset sale, partial portfolio sale or full portfolio sale), there are now many alternative options to consider. Each option will require a great deal of due diligence and extensive communication from the GP to ensure all parties in the transaction are satisfied and that a fair and transparent process is in place. An alternative exit may provide a unique solution for both LPs and GPs in this environment. Alliance is well equipped to provide guidance on which recapitalization alternatives are a fit and define a process that will provide the optimal outcome for both the GP and its Investors.
ABOUT ALLIANCE GLOBAL ADVISORS:
Alliance Global Advisors is a women-owned consulting firm focused on empowering the institutional investment community to elevate best practices. Advising clients with over $380 billion in assets under management, Alliance partners with organizations to provide an independent perspective and innovative approach to critical strategic initiatives. Our partnerships allow senior management teams to focus on what matters most: diligently managing client capital, creating value and delivering exceptional returns in a performance-driven market.
Disclaimer: This blog was originally published in March 2022 and will be updated periodically to reflect changes in the industry. The content may contain or cite personal and/or professional opinions that differ from the views of Alliance Global Advisors.
https://corporatefinanceinstitute.com/resources/knowledge/strategy/dividend-recapitalization/
https://www.fe.training/free-resources/accounting/dividend-recapitalization/