articles Ratings /ratings/en/research/articles/240903-bottleneck-in-exits-will-increase-some-alternative-investment-funds-leverage-13224499.xml content esgSubNav
In This List
COMMENTS

Bottleneck In Exits Will Increase Some Alternative Investment Funds' Leverage

COMMENTS

EMEA Financial Institutions Monitor 1Q2025: Managing Falling Interest Rates Will Be Key To Solid Profitability

Global Banks Outlook 2025 Interactive Dashboard Tutorial

COMMENTS

Banking Brief: Complicated Shareholder Structures Will Weigh On Italian Bank Consolidation

COMMENTS

Credit FAQ: Global Banking Outlook 2025: The Case For Cautious Confidence


Bottleneck In Exits Will Increase Some Alternative Investment Funds' Leverage

Private equity and venture capital funds struggled to find an exit for their investments in first-half 2024, even as investment and fundraising rebounded.  S&P Global Ratings anticipates that tight exit markets will push funds toward debt to preserve investors' capital or provide returns on aging investments. Yet we don't expect that all our ratings on alternative investment funds (AIFs) will be impaired by rising leverage. Even though a higher debt burden at the fund level will weaken our view of financial risk, most rated AIFs have the headroom to absorb this debt increase at existing rating levels. That said, not all investors support new leverage to materialize cash flows. Some limited partners (LPs) and general partners (GPs) will therefore seek liquidity in the secondary market, even if this entails a haircut.

What's Happening In Private Capital Markets?

The amount of private capital is higher than ever, with investment and fundraising resuming growth in first-half 2024.  After a sluggish 2023, first-half 2024 has been much more buoyant for the private capital industry. For example, total private equity acquisitions through the first half of 2024 stood at $310 billion, up 24% from $250 billion for the same period last year. Fundraising also recovered slightly, with private equity dry powder at a record high of $2.6 trillion in June 2024.

While funds have never been larger, exits are at a multi-year low.  Even though exits picked up from an extremely slow start at the beginning of 2024, they were still down 24% in second-quarter 2024--compared with second-quarter 2023--and 60% below the extraordinary high in 2021 (see chart 1). This presents a challenge for an industry where the average holding period is now about 5.7 years and exit strategies are becoming increasingly important.

Chart 1

image

Why Does It Matter?

Tight fund liquidity can push private capital toward debt.  If the fund's termination date is not imminent, a quiet exit market does not necessarily pose a risk to funds and the ratings on these funds. Our quantitative liquidity analysis considers a fund's ability to meet its obligations by relying on repeatable cash flows, uncalled capital commitments, and other contingent liquidity sources, instead of selling assets. Based on this specific aspect of our liquidity analysis, restricted exit opportunities do not necessarily put ratings at risk, as long as liquid resources are sufficient. However, private capital providers rely on asset sales over the medium term to repay their LPs and debt.

A weak exit environment will increase investors' pressure on funds to protect or return their capital.  Investors demand realized returns on their assets, often with the intention to reinvest in future vintages. We therefore expect funds will turn to net asset value (NAV) funding to either preserve LPs' uncalled capital or satiate LPs' demand for returns. In a NAV deal, a fund draws on a facility that is secured by its asset base. Consequently, funds can avoid calls on LP commitments when investing and can even return this capital to LPs directly (dividend recapitalization transaction). While these transactions can calm LPs' concerns and even lock in net internal rates of return, they may create additional financial risk.

Chart 2

image

Some investors will seek liquidity in the secondary market rather than accepting more leverage.  Not all LPs will be willing to accept additional debt at the fund level to generate returns on their investment. We understand that a minority of net asset value debt raised over 2022-2023 was used to pay returns to investors. Instead of holding out for a fund-level liquidity event, LPs--and even GPs--can sell their stake to other investors in the secondary market. Even though this often comes with a haircut, it enables fund partners to generate liquidity without increasing financial risk in the underlying fund.

How Will This Affect AIF Ratings?

We expect rated AIFs will be able to handle rising leverage, without incurring downgrades.  Fresh debt will enable funds to navigate a tricky dealmaking environment and support their investments. That said, a higher debt burden at the fund level will weaken our view of financial risk. Even so, approximately one-quarter of the private equity and venture capital funds we rate operate with a debt level that impairs ratings. As such, the least leveraged funds in our rated universe can turn to debt to meet rising liquidity demands from investors, while maintaining relatively solid ratings. We note, however, that some leveraged funds lack this flexibility. Furthermore, secured net asset value financing is still at an early stage, with a market size of about $80 billion-$100 billion or about 1% of the total industry's net asset value. Overall, the private capital industry can accommodate rising indebtedness in the face of a tight exit market over the short term, without ratings being compromised.

Fund-level debt can create medium-term challenges.  The successful repayment of creditors over the medium term relies on funds exiting their investments in a timely way. This means the urgency for a functioning exit market intensifies as debt maturity approaches. Even if funds are left with several assets as they approach maturity, there are vehicles available to dispose of these assets while still repaying their creditors. These vehicles, called continuation funds, can help address debt maturities in time by enabling an asset sale, the proceeds of which can then extinguish existing liabilities of a fund. That said, any debt used by the continuation fund to purchase the asset from the prior fund will then carry its own financial risk--creating a fresh financial risk for the GPs' creditors, rather than removing it entirely.

Unclear market pricing will muddy the waters additionally.  Difficult exit markets have kept buyers out of the market, stymied exit opportunities, and left dry powder at all-time highs. Furthermore, asset owners, who have yet to raise money from private capital markets, are sat on the sidelines, waiting for better valuations and funding rounds before tapping in. As a result, the accuracy and timeliness of the private capital industry's existing asset valuations are somewhat uncertain. This pricing uncertainty accentuates the tight market dynamics for private capital as market participants seek an updated market value for their assets.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:William Edwards, London + 44 20 7176 3359;
william.edwards@spglobal.com
Secondary Contacts:Andrey Nikolaev, CFA, Paris + 33 14 420 7329;
andrey.nikolaev@spglobal.com
Thierry Grunspan, Columbia + 1 (212) 438 1441;
thierry.grunspan@spglobal.com
Philippe Raposo, Paris + 33 14 420 7377;
philippe.raposo@spglobal.com

No content (including ratings, credit-related analyses and data, valuations, model, software, or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced, or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor’s Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees, or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness, or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an “as is” basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages.

Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P’s opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment, and experience of the user, its management, employees, advisors, and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. Rating-related publications may be published for a variety of reasons that are not necessarily dependent on action by rating committees, including, but not limited to, the publication of a periodic update on a credit rating and related analyses.

To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof.

S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process.

S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.spglobal.com/ratings (free of charge), and www.ratingsdirect.com (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.spglobal.com/usratingsfees.

 

Create a free account to unlock the article.

Gain access to exclusive research, events and more.

Already have an account?    Sign in