The growth and development of the asset class has inevitably led to greater regulation. While this does increase compliance costs, it also creates opportunity for firms that are in a position to take advantage. We think there are three themes that will dominate in 2023.
There is now a broad acceptance in the market that GP-led restructurings are often a sign of strength rather than weakness – and can be a win-win solution – giving a fund sponsor more options when exit markets are difficult (and particularly where the underlying asset's growth trajectory requires more equity investment than the selling LPs are committed to fund); it also helps to increase distributions to limited partners who need liquidity, making it easier for them to commit to new funds.
As we discuss in our annual update, GP-led transactions are becoming more complicated in some respects, and more straightforward in others. More straightforward because GPs and LPs are now familiar with navigating the potential conflicts that can arise and have a good handle on the tricky US tax issues: accepted market positions have emerged as the starting point in the term sheet. Also more straightforward in that the continuation fund is now often a way to exit a single investment (although it is still frequently used for asset-bundles and whole portfolios too).
More complicated, though, as the market becomes more sophisticated. Traditionally, these transactions have been DD-lite and that has allowed them to be done relatively quickly. But, if a continuation fund is a means of selling a single asset, then why not do the same due diligence as on a share sale, with the same warranties, indemnities and insurance? And, if that’s the case, when is the transaction an exit for the management team and when is it not? Well-advised management teams are focused on this point, and its interaction with the trigger point for carried interest, such that a GP-led secondary will often now trigger an exit for the management team.
Impending regulation in the US could also add some further complexity to deals, although the market's acute focus on conflicts of interest means that the SEC rules are unlikely to add much of substance to widely-adopted best practices – especially as refreshed ILPA guidelines, expected this year, should give the LP community further confidence.
Constraints on the availability of capital have accelerated the quest by the largest global alternatives managers to tap into new sources. Traditionally, alternative asset strategies have mostly been aimed at institutional investors, and this will continue – but wider access is an important development. There is increasing interest from alternative asset managers in evergreen, semi-liquid funds that are attractive to wealthy and advised individuals – and increased interest from those investors.
The regulatory hurdles are significant – perhaps underscored by the FCA's flagship 2023 policy: the "consumer duty". Demanding new rules will, from July 2023, require elaborate organisational structures to ensure good outcomes for clients and investors, and UK-regulated firms that are turning their attention to "semi-professional" investors (mostly high net worth individuals) will be firmly in scope. Although the FCA's new rules will apply to many funds whose investor base is predominantly institutional, the compliance burden will be particularly high for firms deliberately seeking capital from individual investors – made more acute because the FCA is planning to ditch a £50,000 minimum ticket safe harbour.
But other news is more positive: the decision by the UK's Department for Work and Pensions in January to make changes to the charge cap will help defined contribution (DC) pension schemes to include alternatives in their default funds. Moreover, in December, the UK Treasury announced a plan to scrap the controversial PRIIPs key investor document (KID), which was particularly problematic for private fund strategies. And we now have political agreement on ELTIF II, an EU long term investment fund vehicle offering a retail passport, uptake of which will surely further increase. Meanwhile, the UK's version of the ELTIF – the LTAF, an authorised fund vehicle for firms investing in illiquid assets – still struggles for attention. However, since its primary audience is DC pension schemes, it may come into its own now that the charge cap reforms have been confirmed.
Our key advice on this is: be loud and proud about what you do, but be very, very careful.
Regulators are constantly repeating their determination to take action against those who overstate their sustainability credentials, or fail to follow through on promises made to investors – and we can expect much more regulation of that in the coming year: from the UK, in the form of a specific anti-greenwashing rule, the EU, whose proposed regulation of fund names could have far-reaching impacts, and the US. Having made new rules, we should also expect strenuous enforcement.
But sustainability also poses a once-in-a-generation opportunity for fund managers – which is being accelerated by these emerging regulations. Private markets firms are very well-placed to take advantage of increasing investor appetite for ESG-friendly funds and impact strategies, and many are already doing so. Those that see sustainability as a strategic opportunity (and not only a compliance cost) will see the benefits in the months and years ahead – especially if it can be used as a differentiator in the crowded market for capital.