Exit strategies for limited partners

In a typical LP-GP relationship, LPs provide capital, while GPs take on a more active role in fund management. This is generally beneficial for both parties, but can be frustrating for LPs that need liquidity and do not have full control over the timing of capital calls and distributions—or potential exit opportunities.

In this blog post, we’ll explore several types of exit strategies for limited partners. Learn why allocators might seek liquidity solutions outside of waiting for a traditional exit managed by their GPs—as well as what some roadblocks could be, and how to best prepare for a successful exit.

Understanding traditional exit routes

Some of the most common exit strategies that GPs utilize include:

• Initial public offerings (IPOs): An IPO is the process by which a private company “goes public” and sells new shares to public market investors, who in turn can trade the shares on the stock market. Companies within a GP’s portfolio can go through this public listing process, in which case the GP distributes shares to the LPs or liquidates the shares and sends cash.
• Mergers and acquisitions (M&A): M&A deals are transactions in which company ownership is consolidated. In a merger, two or more companies will combine into one legal entity, whereas in an acquisition, one company will purchase another. GPs that are interested in an M&A exit will often consider a sale to a strategic buyer where a portfolio company is sold to a larger corporate buyer.
• Sponsor-to-sponsor buyouts: Also known as a secondary buyout, this is when one GP sells a portfolio company to another GP.

All three options can be beneficial, although GPs may decide not to exit for a variety of reasons—including high transaction costs, unrealistic expectations, unfavorable deal terms, and poor timing. That said, these are not the only paths to liquidity, and GPs have gotten more creative as they have had to adjust to a tough exit environment these past few years.

Common challenges faced by limited partners in exiting investments

Illiquidity of investments

In our recent Allocators’ Atlas webinar, 21% of poll respondents said that they were currently over-allocated to the private markets. While this is not a huge percentage of total attendees, it does highlight a common challenge that many LPs face.

Stocks, bonds, and other public market equities tend to be liquid investments, meaning LPs have the option to cash out at their convenience. In the private markets, however, there is usually much less flexibility.

Poor market conditions and timing

Dealmakers have had to adjust to a new market environment post-2021. This led to a huge gap in expectations between potential buyers and sellers, and a subsequent slowdown in exit volume.

Many GPs reacted by holding onto their investments for longer than LPs had initially expected. This is just one example of how quickly the tide can turn—and how these shifts in market sentiment can have an outsized impact on LPs’ portfolios.

Misalignment with fund manager’s strategy

Fund manager evaluation is a critical step in the investment process. If you do your due diligence and select the right partners, you can hopefully avoid major headaches. That said, LPs do not always agree with GPs—particularly when it comes to using some of the newer portfolio management strategies we’ll explore below.

Key strategies to unlock liquidity for LPs

Secondary market sales

Broadly speaking, this is when investors buy and sell securities, either in the private or public markets. For allocators, it’s specifically a transaction in which an LP sells their fund interests to another LP, such as such as an institutional investor, family office, or often a secondaries fund. This is commonly referred to as LP-led secondaries.

GP-led secondaries are another type of sale, which the GP initiates on behalf of the fund. GP-led secondaries often take the form of a continuation fund, where external investors provide capital to finance the deal and an option is posed to existing LPs to either roll to the new fund or sell out to the new investors.

NAV loans and preferred equity

Also known as NAV facilities, NAV loans are credit facilities secured against a fund or a portfolio of funds. The NAV loan for an LP allows the allocator to collateralize the value of their portfolio holdings and essentially sell or partially sell the future distributions expected from the fund(s).

Preferred equity is a similar strategy, which involves the sale or partial sale of the fund interest at an agreed valuation in exchange for priority payment schedule, while providing exposure to future potential upside in the investment.

Both of these vehicles can also be employed by GPs, as we’ll touch on briefly.

What are the benefits and risks of these strategies for LPs?

Considerations for secondary market sales

In 2017, private fund secondary transaction volume stood at $58 billion, and in 2022, it reached $111 billion—the second-highest level the space has seen. While this was a drop from 2021’s record high, the secondary market has still remained strong, as it is one of the only viable routes to liquidity for LPs in a stalled exit environment.

Secondaries are no longer just for troubled assets. They can be a great portfolio management tool—even for LPs that have not felt the full force of the denominator effect—as buyers can potentially capitalize on strong pricing opportunities across a broad variety of deal types.

That said, some LPs have been hesitant to use this strategy, opting to wait out recent market volatility, rather than sell at a discount.

As our webinar panelists noted, timing and rationale are crucial when considering secondary market transactions. Allocators need enough time to discuss this option, as well as any potential alternatives, with their GPs and their advisory committee. For both LP and GP-led secondaries, it’s worth asking:

• What is the structure of the transaction?
• What is this transaction trying to solve for?
• Are there any conflicts of interest between buyers and sellers?

Considerations for NAV loans and preferred equity

In 2022, the Fund Finance Association estimated the size of the NAV facilities market was approximately $100 billion, and some fund finance experts expect the market to grow to $600 billion by 2030. While this growth is largely driven by GPs, some limited partners are also utilizing NAV loans.

Given the lack of distributions in the current market, some LPs may want to consider NAV loans and preferred equity as liquidity solutions. Rather than selling their portfolio stakes and forgoing any potential upside, LPs can use these strategies to:

• Invest in newer vintage funds
• Honor upcoming capital calls
• Finance commitments to a fund
• Rebalance portfolios in times of stress

Note that there is a huge variety in the structure and pricing of NAV facilities, and some terms may be better than others for your particular use case. For GP-led NAV loans specifically, some LPs have also voiced concerns around a lack of transparency.

Conclusion

A growing number of LPs have started exploring secondary market sales, NAV loans, and preferred equity in lieu of traditional exits, which have yet to rebound. If you are researching these strategies for your own portfolio, remember that they are not one-size-fits-all. Every deal will have a unique structure, with its own balance of risk and return that you will need to weigh.

Consider your current portfolio construction—and whether you need cash now, or if you have enough liquidity to see how the market evolves. Also think about what you will do with the proceeds. Just getting cash for the sake of getting cash may not be optimal. If there is a strategy to deploying that liquidity into a better risk/return opportunity, then that can be a key reason to explore these options.

Most importantly, don’t be afraid to ask questions. Your advisory committee, general partners, and professional advisors should be open to discussing the pros and cons of each strategy. As you evaluate your options, PitchBook’s allocator solutions can also be a helpful resource.

Strengthen your portfolio with PitchBook for limited partners

PitchBook is designed to help LPs optimize every stage of the investment process—from fund manager due diligence to market research and portfolio analysis.

Request a free trial to learn more about our best-in-class analyst research and proprietary suite of asset allocation tools—including Manager Scoring, Portfolio Forecasting, and benchmarking.

Already a PitchBook customer? Log in.