With a slowdown in exits restricting their deployment plans, LPs want to exert more control over when and how GPs generate distributions. Investor relations capabilities are key to managing this process

Institutional investors are no longer interested in marked-up yet unrealised Asian portfolios: distributions to paid (DPI) is the new IRR. While not all-encompassing, the idiom reflects a prevailing attitude that is regularly flagged by managers contemplating a return to market.

“All LPs are super-focused on DPI. It’s completely different from our last fundraise in 2019. Then it was about performance, money-on-money multiple, and where you thought you would end up. Now they just ask about DPI,” said Jason Shin, a managing partner at VIG Partners, a Korean mid-market private equity firm that is preparing to pitch its fifth fund to international investors.

This emphasis on distributions is part of a broader push for liquidity. The slowdown in exits has thrown budgeting into disarray, leaving many LPs with fewer resources and reduced flexibility to pursue planned investment objectives. On one hand, they are calling on GPs to invest with caution, limiting drawdowns. On the other, they are looking to maximise cash outflows from fund investments.

It has contributed to greater scrutiny of how certain activities – which might be deprioritised during times of plenty – are captured in limited partnership agreements (LPAs). When making commitments to new funds and in reviewing existing agreements, the language around recycling of investment proceeds, secondaries, borrowing against portfolios, and extension of investment periods is carefully parsed.

“There is more focus on cash flow and on trying to create more certainty around deployment and divestment. Investors don’t want to force sales at the wrong time, so they are also exploring other paths to liquidity, such as continuation funds, NAV [net asset value] financing, and rolling assets into other funds,” said Kai-Niklas Schneider, a partner and funds specialist at Clifford Chance.

“The amount of work we are doing for clients in this ‘in-between space,’ which ultimately involves creating liquidity opportunities, is greater than ever before.”

The nature of these assignments – from addressing queries from managers about what is permitted under LPAs to helping investors establish how they can force certain courses of action regarding underperforming portfolios – indicate how GP-LP relations might be strained. Equally, they underscore the value of effective communication in pre-empting potential points of tension.

For some small to mid-size managers that have smaller and perhaps less sophisticated IR functions than their global peers, it represents a step change. Rather than serving as an appendage to sales, often led by the firm’s partners with an element of junior-level support, IR must focus more heavily on relationships.

“A lot of investor relations in Asia is very simplistic. Firms stick to the everything-is-great level, without stopping to explain why part of the portfolio might be struggling and what is being done about it,” said Wen Tan, founder and CEO of Azimuth Asset Consulting, an advisor to asset owners and asset managers. “But if you are transparent, and address issues openly, that can improve the LP impression of you.”

Recycling reconsidered

The liquidity dilemma is easily recognisable in headline Asian data. Exits fell 37% year-on-year to USD 50.7bn in 2023, the second-lowest total in a decade after the pandemic-blighted 2020, according to AVCJ Research. Fundraising, meanwhile, was the weakest in 10 years. The USD 56.7bn committed to managers focused on the region – excluding renminbi-denominated vehicles – represented a 48% decline from 2022.

Sam Robinson, a managing partner at family office North East Private Equity Asia, observed that managers are endeavouring to generate distributions in the hope that it makes LPs look more favourably on new fundraises. Secondaries are top-of-mind for many, but valuation mismatches mean relatively few transactions get traction. Amid all that, he recently received a notification about recycling.

“There wasn’t anything wrong, it was a clarification point. Normally, these get waved through, but right now, some LPs might want to get money back in any way possible, so they seek clarification on recycling,” Robinson said. “We might see more of this. If you aren’t selling, maybe an asset is struggling and needs support. Even if it’s not, a GP might want to do some follow-ons. This may involve recycling.”

Before the market turned, managers were not necessarily incentivised to recycle capital: rather, they would ride on the momentum created by exits to raise even larger funds. Indeed, there is no clear consensus among fund formation lawyers that it has become a meaningful point of contention.

According to Jordan Silber, a partner at Cooley, which has a lot of Asian VC clients, recycling facilitates more efficient use of capital because managers don’t need to hold as much in reserve for follow-on investments and late-in-life fees; these can be satisfied using exit proceeds.

Arrangements vary, but recycling tends to be capped as a percentage of total fund commitments. If a USD 100m fund with a 120% cap commits USD 20m to management fees and expenses and deploys USD 80m, then up to USD 40m can be channelled into new deals rather than immediate distributions provided it meets certain criteria. Depending on how agreements are worded, recycling might be limited to situations where there is an 18-24-month turnaround.

“Sometimes, because of poor planning or because the economy has shifted or because the IPO window has closed and a company that was just going to do a Series E now needs a Series F and G as well, there is a need for more money and recycling could address that,” said Silber.

“If the GP is out of money, it might to the LPs and ask for the 120% limit to be increased to 140%. However, if IPO markets are seized up, there are usually few exits. Going to 140% doesn’t help if there’s no cash. That’s where continuation vehicles come in.”

Other industry participants note the dynamics in Asia have changed because an adverse fundraising environment means that a manager could be 100% drawn on an existing fund and lack visibility on new sources of capital. When funds reach 90%, Robinson advises GPs to think carefully about deployment, telling them, “Whatever you think your fundraising timetable is, it’s longer.”

Prevailing market conditions may therefore encourage recycling – managers unable to make investments are more likely to see team instability – at a time when some LPs are paying more attention to it.

“When the market was hot, LPs didn’t think twice about recycling. And GPs didn’t think twice about it in terms of accounting and how you treat it. Now, we are seeing communications between GPs and LPs about how the cash can be treated, and LPs are asking their lawyers and accountants to investigate it,” said Lorna Chen, a partner at Shearman & Sterling.

“Assumptions that it is market practice cannot be taken for granted. You must go back and check the language in LPAs, which can be different, depending on negotiations when they were drafted.”

Mind the flow

A primary point of concern is not the limits on recycling set out in the LPA, but the extent to which GPs can engage in recycling below the fund level without risk of breaching these provisions. In one scenario, an investment is exited, the proceeds flow up to the fund, and a portion might be recycled. In another, proceeds remain in the special purpose vehicle (SPV) and are used for follow-ons or other investments.

“Institutional investors have told me that even though the fund may have exited an investment, the LPs might not see any money. The GP then says the LPA allows them to recycle at the SPV level. The argument comes back to whether such SPV-level recycling is used within the spirit of the clause,” said Geoff Chan, a partner at Skadden.

“There are situations where, on exiting an investment, you may need to restructure, roll over to a connected transaction or repay loans, so there may be no money flowing back up. It’s fair for the SPV to pay off what it needs to pay off. On the other hand, taking the money and deploying it in another deal is a bit different.”

Similar considerations apply to NAV facilities, whereby GPs obtain capital for bolt-on and follow-on investments – and for distributions as well – by borrowing against existing portfolios. LPAs impose limits on indebtedness at the fund level and it is debatable whether provisions are broad enough to capture facilities collateralised by fund assets below the fund level.

According to Clifford Chance’s Schneider, distributions and re-investments at a portfolio company level are not necessarily restricted by the fund level terms and LPs may be none the wiser about recycling. He is more circumspect regarding NAV financing, noting that lenders would likely want to see proceeds flowing up to the fund level because they have a cash sweep provision.

Tan of Azimuth added that much depends on whether LPs know what to look for. “The way a lot of organisations are set up, the legal aspects fall under a different ambit to investment professionals,” he said. “Investment decisions are made and passed on to the legal team for execution. Often, the legal team has scope to negotiate terms of an investment, but it cannot kill an investment.”

Some investors, however, are looking to stamp out any ambiguity. Schneider is seeing LPAs that are increasingly sophisticated in terms of imposing restrictions all the way through the investment structure so that proceeds are pushed back to the fund level. This is echoed by Chan of Skadden, who noted that most GPs would not risk aggravating a significant LP during a fundraise by pushing to retain flexibility.

“I have seen situations where multiple cross-deal, cross-fund, and SPV-level flexibility was removed. It’s not about saying no, just making the GP discuss the matter with the LPAC [LP advisory committee],” he explained. “This procedure alone often will already eliminate bad behaviour because it imposes a delay, and so the GP will only go to the LPAC if it is certain it wants to do something.”

Relationship management

The fact that North East’s Robinson received an unsolicited notification on recycling indicates proactive behaviour on the part of GPs as well. This is driven by an appreciation of the hot-button issues within the LP community and a desire to prevent the spread of discord by making the case for why such actions are in the best interests of the fund.

“There will be some back and forth when you are doing this, but ultimately LPs get comfortable with it and agree to it,” said Shawn Yang, a partner at Debevoise & Plimpton. “If you have a decision to make and need to consult LPs, our advice is that you should send the notice to everyone.”

NAV financing has yet to achieve critical mass in Asia, but it is attracting more scrutiny in North America and Europe as LPs consider how factors such as duration, structure, and use of proceeds will impact alignment of interest. NAV financing is now explicitly referenced in some LPAs, but irrespective of that, two LPs based outside of Asia said they expect notifications from managers when facilities are used.

This notion of communication in the interests of relationship management rather than as a matter of obligation is taking hold in Asia regarding the implementation of liquidity solutions. Fund formation lawyers observe that, with better relationship management, a fair number of the enquiries they receive from LPs about potentially suspect behaviour by GPs would never be placed, but it is a learning process.

“Most GPs value their relationships with LPs more highly than the black and white of the LPA,” said James Ford, a partner at Allen & Overy. “Investor relations and the franchise value of your name as a business are your currency in private equity – you don’t want to destroy that.”

Affirma Capital is familiar with the sharp end of IR, having endured a protracted separation from its former parent, Standard Chartered Bank, during which the somewhat conflicting agendas of the bank and various external LPs became all too clear. Nainesh Jaisingh, Affirma’s CEO, believes that communication of intent and transparency of intent is vital in maintaining strong relations with LPs.

“If there is alignment with LPs in achieving the best outcome, they are accommodating and flexible. They want to check that what you’re doing – in spirit and in letter – is what you’re supposed to be doing as a fiduciary,” he said.

“Tools such as extensions and continuation funds can play a role in creating liquidity, but there will always be questions about proper alignment. We’ve seen some indiscipline in the market – assets were bought at silly prices in 2021 and they aren’t coming back soon, which makes providing DPI difficult – so there is a risk that these tools will be used to kick the can down the road.”

A tough sell

In certain cases, LPs are unwilling to be patient. Engagement might be light touch at the beginning – a key LP expresses disappointment at fund performance and asks for a constructive conversation about the next steps – and then escalate to a larger group of investors using threats such as termination of the investment period to push for investment team changes, specific asset disposals, and fee discounts.

“There might be reductions in fees, but they would also look at other ways to address concerns, such as the GP stepping in,” said Clifford Chance’s Schneider. “I’ve seen managers assist investors’ exits from funds because the investors are important to them globally [across multiple funds].”

For all the benefits of strong IR in addressing concerns and identifying solutions, there is still a sub-set of LPs that has switched off, regardless of efforts to generate liquidity. This is usually driven by fundamental misgivings about the manager or the market. Geopolitics is often a direct or indirect factor.

While Shearman’s Chen sees some budget-conscious LPs calling on GPs to slow deployment, which may lead to investment period extensions, others want to get out. “They might decide that market conditions are so bad that they will naturally terminate deployment when the investment period ends,” she said. “If the manager has USD 100m unused, they prefer to allocate that to other strategies or geographies.”

This disengagement is most frequently observed in a China context, with one Asian institutional investor highlighting the absence of North American LPs from virtual and in-person meetings – the implication being that they have already ruled out the re-up and will not do much beyond rudimentary tracking.

Other markets in Asia are not so stigmatised and investors continue to engage with local managers, but the broader fundraising picture illustrates that the region is not an easy sell. According to Jaisingh of Affirma, LPs have little time for managers who achieve scale and prominence by catching a rising tide.

“They look at the team and the platform, including the governance and communication and whether information is consistent and of high quality,” he said. “It comes down to relationships and people doing what they said they would do. But ultimately, there’s no better IR than sending cash back.”