Some investment fund sponsors are now holding damaged assets in many of their late-state funds. Lacking an open market, these sponsors may turn to ‘affiliate transactions’ as their sole alternative to ‘highly dilutive financing transactions or asset sales at depressed valuations,’ says Houlihan Lokey in last week’s client newsletter.

BVWire—UK has spoken to several private equity fund managers with funds that they need to close down who are left holding acquisitions made in 2014 to 2016 in particular that are now potentially worthless. While most sponsors aren’t facing as dire situations, it’s common in the private capital markets that late-stage funds are now deferring portfolio company sales, and the result is liquidity and performance problems.

HL says they’re seeing many funds turn inward to solve these challenges, with so-called affiliate transactions such as:

• Portfolio company support financings. Sponsors may invest new capital into a portfolio company to enhance liquidity and avoid potential defaults. Capital may be invested from a vehicle different than the one holding the portfolio company, and such capital can be in the form of debt, preferred stock, or common equity. Each of these alternatives can impact the economics of co-investors or other shareholders.
• Portfolio company mergers. Sponsors may combine portfolio companies in the same or adjacent businesses—often held in different funds—to rationalize costs and strengthen the enterprise. Also, a vehicle that is currently in the investment phase may fund an acquisition of a (potentially distressed) target by an existing portfolio company.
• Late-stage fund solutions. As exits via M&A or GP-led secondary transactions are postponed, sponsors must still deal with funds that are at or near end of life. To avoid requesting an extension and possibly provide investor liquidity, sponsors may choose to either “cross trade” an asset or portfolio to a later vintage fund or structure continuation vehicles to lengthen hold times and allow for operational and valuation recoveries to occur.

Affiliate transactions, of course, raise the likelihood that valuations and independence will be questioned. HL emphasises this point by concluding:

[A] fairness or valuation opinion assists the GP in satisfying its legal, regulatory, and contractual duties in connection with such transactions and may serve to protect the sponsor from challenge and facilitate discussions about the transaction with the LP advisory committee and co-investors … an independent valuation of the asset(s) subject to a transaction or the evaluation of a security in connection with a related party investment is particularly important to ensure the analysis is up to date and reflects current market conditions.