Introduction

As we head into the second half of the year, geopolitical and economic uncertainties persist, and markets around the globe have slowed accordingly.  While private equity (PE) fundraising and M&A activity levels remained generally strong in the first half of the year (although comparatively weaker than 2021), the macroeconomic environment, market volatility and heightened regulatory oversight present challenges to which the PE industry will need to adapt.

We may see increasing competition in fundraising in the second half of the year, as the demand by sponsors for capital continues to be strong, as well as an increasing use of bespoke structures that are tailored to investors’ needs and warehousing vehicles as alternative sources of capital. 

Meanwhile, as overall M&A activity slows, we anticipate that continuation funds and fund-to-fund transactions will remain popular. More generally, we expect parties to deploy more creativity in structuring and bridging valuation gaps to get deals over the finish line, including in the secondaries market as well as M&A and leveraged finance transactions.

Fundraising

Although the first two months of 2022 were relatively slower in pace, the fundraising market has since continued to be as strong as the previous year.  Many large sponsors deployed the capital of their predecessor funds more quickly than anticipated and are quickly returning to the market with new offerings. With investor allocations to PE continuing to increase, available capital has so far kept pace with demand.

However, whether that continues to be the case as sponsors continue to call for dry powder remains to be seen. Indeed, fundraising in the second half of the year is expected to become quite competitive, especially for smaller and middle-market firms squaring off against larger, more established managers for capital. Due to the number of sponsors raising new funds, many investors, especially larger institutional investors, may already be fully allocated, or nearing full allocation, for the year. These investors appear to be prioritising their relationships with larger, more established managers, who often require sizeable commitments and may be fundraising for a variety of products simultaneously. PE firms may therefore elect to postpone closings until next year, in order to have access to investor pipelines that are already full for 2022 but may have capital available to invest in 2023. 

It is expected that high levels of participation in PE by retail, insurance and non-US investors will continue, as these investors seek to expand their exposure to private markets. Given the heightened competition for capital by sponsors, sponsors may be more open to considering offering bespoke structures tailored to these investors’ needs in exchange for larger commitments to one or more of their funds. One such increasingly prevalent offering is a collateralised fund obligation structure, which provides insurance companies with access to multiple funds of a particular sponsor. Sponsors are also increasingly targeting capital from high net worth retail investors in both US and non-US markets, particularly from banking institutions.

In terms of exits, the significant uptick in the use of continuation funds is expected to continue. These opportunities are suitable for sponsors looking to provide their investors with liquidity while still retaining control of portfolio companies that such sponsors believe have further value-creation potential beyond their typical hold period. By offering investors the choice of receiving cash, sponsors also hope that this cash will be reinvested into the sponsor’s new funds.

The longer-term effects of inflation and global events such as Russia’s invasion of Ukraine remain to be seen. While these developments have not significantly affected the fundraising market thus far, sustained macroeconomic uncertainty could dampen investors’ future allocations to PE. 

Fund Finance

Although the pace of fundraising for smaller and middle-market firms has moderated in 2022, the fund finance market has been buoyant as more sponsors turn to fund-level financing solutions. Recent trends behind more sophisticated products, such as NAV facilities – preferred equity and hybrid facilities – have accelerated and then been further boosted by turbulence in the leveraged loan market.

In the subscription facility space, pricing has widened modestly, but capital call facilities are still being raised and extended at a good pace (even for separately managed accounts or SMAs). The increase in the use of rated feeder notes as a fundraising tool has led to more discussion regarding the mechanics needed in fund documentation to obtain borrowing base credit for debt commitments. Funds and banks are also dealing with investors tied to sanctioned persons. There have been several amendments this year to resolve these issues.

Furthermore, as insurance companies look for opportunities to invest in a diversified portfolio of funds, and funds look for ways to access additional capital, there is a rising demand for innovative rated note structures. The past year has seen an increase in the use of such note structures, and their popularity is expected to continue to grow as long as market performance is strong and insurance regulators do not change the investment classification of the notes issued under these structures.

Expanded use of NAV facilities and preferred equity solutions, as well as of hybrid facilities, is also expected. While the increased use of NAV facilities for buyout funds has been more pronounced in Europe, it is anticipated that the trend will begin to gain more traction in the United States. The fund finance market is poised for more growth with the increase of alternative fund finance credit providers, and with sponsors turning to fund-level credit to fill liquidity needs, both as a defensive measure and for opportunistic investments such as purchases of portfolio-level debt.

Funds Regulatory

The year so far has seen unprecedented rule-making activity by the SEC directed at investment advisers, including PE fund managers.  The rules proposed during the first quarter of the year included those relating to Form PF, cybersecurity, special purpose acquisition companies, climate change disclosure for public companies, and ground-breaking amendments to the Investment Advisers Act of 1940 that would impose new disclosure and reporting requirements and significant new restrictions on private fund advisers. Then, on 25 May, the SEC proposed two new rules relating to ESG practices applicable to investment advisers and to funds registered under the Investment Company Act of 1940. 

The first rule relates to ESG-related investment adviser and registered fund disclosure, and includes the following requirements and guidance applicable to private fund advisers.

• Amendments to Form ADV Parts 1A and 2A: these would require disclosure of advisers’ consideration of and use of ESG factors and would require an adviser to private funds to classify its strategies as “ESG integration”, “ESG-focused” or “ESG-impact” depending on the significance of ESG factors in the adviser’s investment strategies.
• Guidance related to compliance procedures and marketing: The proposed rule includes guidance reminding advisers that they are prohibited from distributing advertisements that include any untrue statement of a material fact or material omission with respect to ESG representations. The release offers the example of an adviser overstating in an advertisement the extent to which ESG factors into managing its client portfolios.

The second proposed ESG rule would extend the investment company “names rule” under the Investment Company Act of 1940 to ESG funds registered under that act, so that a registered fund using ESG terminology in its name would be required to invest 80% of its assets consistent with that focus.

Given the SEC’s breakneck pace since the beginning of this year, it seems that the second half of 2022 will continue to be a period of intense US regulatory activity for PE advisers.

Private Funds Transactions

Activity in the secondaries market during the first half of 2022 was coloured by market volatility. While there appears to be no shortage of quality assets fit for a secondaries transaction, sponsors and sellers who have the luxury of time appear to be holding off in anticipation of market corrections, while secondary buyers are tightening their deal selection criteria and, where possible, deferring deployment. Many deals that came to market in the first half of 2022 based on Q4 2021 or Q1 2022 sponsor valuations have faced real – and often fatal – repricing risk. At the same time, sponsors have found it increasingly difficult and time-consuming to fill out the secondary investor syndicate necessary to cover the required equity check, particularly in large single-asset transactions.

Facing these challenges, sponsors and sellers are being creative to get deals over the line. For some time, sponsors have turned to earn-outs and similar provisions to bridge pricing gaps; those strategies have been joined by mechanics for multiple closings, deferred consideration or more flexible use of debt financing and cross-fund equity financing to accommodate potential secondary equity syndication shortfalls. Some sponsor strategies have been more optical in nature, such as bringing valuation dates up a quarter (when supportable by the underlying facts) or communicating deal pricing to their investors using traditional M&A vocabulary (such as multiples of EBITDA) rather than the customary secondaries formulation of discounts to trailing valuations.

The combination of buy-side constraints and growing transaction sizes, particularly at the top end of the GP-led market, have caused sponsors to use several vehicles simultaneously to pursue a single transaction. Those vehicles might include a continuation fund, sponsor-managed co-investment vehicles, and one or more of the sponsor’s blind pool funds. However, this structure requires the sponsor to manage different entry valuations, return profiles, time horizons and other considerations – all for the same asset(s).  Doing so successfully requires sponsors to wear multiple hats at the same time, communicate well with all constituencies and have a well-considered conflict-mitigation plan from the outset.

The rise of continuation funds and strip sales to sponsor-affiliated “annex” funds has also impacted the long-standing principle that co-investors will invest and divest at the same time and on the same terms as the sponsor’s fund with which they originally invest. Any transfer of assets from an original fund to a continuation or annex fund, either of which would likely acquire securities at a different valuation to the co-investor’s entry valuation, may disrupt this alignment if co-investors do not also exit in that transaction. The question as to whether such a transaction represents an “exit” in which co-investors should be able, or be required, to participate is a thorny one for both sponsors and co-investors, whose views may be dependent on unforeseeable facts and circumstances. As more sponsors engage in larger and more complex GP-led transactions, both sponsors and investors will have to grapple with how to manage ongoing conflicts of interest – including regarding exit – that arise in these transactions.

M&A

While 2022 began with a continuation of the wave of M&A activity seen in 2021, the mid-year mark has seen a slowdown in PE deal-making. Lingering pandemic disruptions, Russia’s war in Ukraine and the economic uncertainty brought on by rising inflation and interest rates have all had a chilling effect, leading to valuation gaps between prospective buyers and sellers. In particular, PE M&A activity has been hampered by the limited appetite of traditional lenders to provide debt financing, as banks seek to offload commitments from deals signed before the onset of the Ukraine war and face significant losses on those loans. To fill this financing gap, the deals that are being signed are relying heavily on direct lenders and bigger equity cheques. For these reasons, sponsors are being more selective about the deals they pursue and bring to their lending relationships.

It is anticipated that there will be a continued transition period as buyer and seller expectations reset, particularly in light of the combination of lower asset prices and increased financing costs. It appears that the relative certainty provided by continuation fund and fund-to-fund transactions will continue to be popular in this environment. Given the depressed public markets, sponsors may find take-private transactions attractive, but public boards may not be receptive in light of what they may perceive to be undervalued stock prices. However, if economic challenges persist, public companies may look to PE sponsors to fund private investment in public equity (PIPE) transactions, as seen in the early days of the COVID-19 pandemic.

In addition, PE M&A activity is increasingly in the sights of US antitrust authorities. Senior officials at both the Federal Trade Commission and the Antitrust Division of the Department of Justice have made public statements signalling enhanced scrutiny of PE transactions. Particular focus has been brought to bear on PE roll-ups in sectors such as healthcare, with regulators demonstrating a willingness to use the tools available to them, such as prior approval provisions, including to police deals that may otherwise not have been subject to their review.

Leveraged Finance

Over much of the last decade, PE sponsors and their portfolio companies have benefited from the bull market, with low interest rates and robust debt capital markets allowing issuers to add leverage at attractive rates and with borrower-friendly terms. However, since the second half of the first quarter, the market has begun to show signs of weakness. That softening has continued, with July expected to have the lowest level of primary issuances in the last 15 years and year-to-date volume showing a dramatic 77% decline compared to 2021.

The few new syndicated financings that have made it to market during the past two months have been met with challenges. For many of these offerings, both the underwriting banks and the sponsors have sought modifications to the underwritten terms in order to increase investor demand – modifications that have often gone beyond the “market flex” provided for at signing. The types of modifications have varied depending on the nature of the transaction, but have included shortening of maturities, increasing of rates and original issue discount, increasing of amortisation, replacing a portion of the indebtedness with a subordinated or term loan A tranche and a general tightening of covenants. With several large underwritten transactions yet to come to market, participants will be watching to see if any trends emerge regarding which modifications are successful in driving investor demand.

Traditional investment banks have been very cautious about underwriting new transactions. For those transactions that are underwritten, banks are reducing overall leverage, increasing the cost of capital and seeking greater flexibility in terms of market flex. As an alternative to the uncertainty associated with the syndicated markets, many sponsors have turned to private debt funds to provide financing solutions. While private debt funds have increasingly shown an ability to fund transactions of any size, including multibillion-dollar take-privates, they too have sought to limit new deal exposure in light of current market conditions, general economic uncertainty and the perceived likelihood of a recession.

It is expected that these tumultuous conditions will continue for the remainder of the year. As such, both traditional investment banks and private debt providers will probably take a more cautious approach to underwriting new investments and seek tighter covenant packages on the deals that they do underwrite. It is likely that more sponsors will simultaneously consider both syndicated and private debt options for their transactions in order to ensure that they are obtaining the most attractive financing available.

International Economic Sanctions

In response to the invasion of Ukraine, the United States has imposed an unprecedented array of sanctions, raising significant challenges for continued business dealings in or involving Russia. 

Prohibition on new investments by US persons

All “new investments” in Russia by US persons are prohibited. “New investment” is defined as the commitment of capital or other assets for the purpose of generating returns or appreciation, made on or after 6 April 2022. 

Prohibition on certain services by US persons to persons located in Russia

US persons cannot provide accounting, trust and corporate formation, and management consulting services to any person located in Russia, with some exceptions. 

Blocking sanctions

Many wealthy Russian individuals and financial institutions are now targets of blocking sanctions. US persons are prohibited from any dealings involving – and are required to freeze the assets of – designated persons and any entities that are 50% or more owned by such designated persons. Although only US persons are required to comply with blocking sanctions, the US has authority to apply “secondary sanctions” on non-US persons that have materially assisted, sponsored, or provided financial support for, or goods or services to or in support of, blocked persons. 

Evasion of sanctions

Any transaction that evades or avoids (or has this purpose), causes a violation of or attempts to violate US sanctions is also prohibited.

Effect of new sanctions

These new sanctions have affected PE funds in two principal ways.

Designated LPs

Once an LP in a US fund or US-managed fund becomes the target of blocking sanctions, nearly all dealings with that LP will become restricted. In the absence of a licence or exemption, no distributions, redemptions or payments involving the LP can be processed, and no subscriptions or contributions from the LP can be accepted. The LP’s interest in the fund must be blocked and segregated from other investors’ interests in the fund, and the fund or its manager may be required to notify the Office of Foreign Assets Control (OFAC).

The implications of having an LP designated for sanctions will vary, and the limited partnership agreement of each fund may provide for or require certain actions regarding sanctioned LPs. For example, some agreements may allow for a capital call from the other LPs or for a new LP to replace the sanctioned one. There may also be implications for the fund’s credit-related obligations (eg, repeating representations in a credit agreement) or representations made by the fund regarding its portfolio companies or other investments. 

Restricted portfolio companies

Restrictions on new investment and certain services, considered together with the increased difficulty of conducting business in Russia without the involvement of sanctioned persons, have significantly altered risk assessments, leading many Western investment managers and investors to divest local assets or seek to exit the market. 

Screening for sanctions-related risks

In the face of the array of US sanctions, coupled with significant EU and UK sanctions, it is recommended that funds ensure they have sufficient insight into their LPs to be able to screen quickly for sanctions-related risks. Proactive steps can also be taken to identify relevant sanctions-related representations and commitments for funds and their sponsors. Finally, many funds are now conducting sanctions-related risk assessments of their portfolio companies, probing their activities and investments regarding Russia and considering whether mitigating steps are warranted. 

Data Strategy and Security/Employment Litigation

Employers are increasingly turning to AI tools to assist in hiring and other employment decisions, including employee promotions, evaluations and terminations. Simultaneously, regulators and legislators are subjecting these tools to greater scrutiny out of concern that they may be inadvertently discriminatory. Sponsors and their portfolio companies should therefore pay close attention to the AI tools they use to manage human capital to ensure that they are compliant with these emerging regulations.

At the federal level, the US Equal Employment Opportunity Commission (EEOC) has made it a priority to ensure that AI does not “become a hi-tech pathway to discrimination”. The Department of Justice has also joined the EEOC in warning of potential discrimination risks due to the increased use of AI by employers. In May 2022, the EEOC issued its first non-binding technical guidance regarding how employers’ use of AI may violate existing requirements under the Americans with Disabilities Act. Among other things, the EEOC recommends that employers give applicants or employees written notice that they are undergoing an assessment by an AI tool and that they may request reasonable accommodation or exemption from the tool.

At the local level, New York City recently became one of the first jurisdictions to pass a law aimed at reducing bias in automated employment decisions. As of the date of this publication, similar bills are pending in California and Washington, DC. The New York City law takes effect on 1 January 2023 and places several requirements on employers using “automated employment decision tools”. The new law defines such tools as any “computational process, derived from machine learning, statistical modeling, data analytics, or artificial intelligence, that issues a simplified output” and replaces or substantially assists decision-making. Notably, the breadth of this definition extends the law to cover a wide variety of tools that do not rely on AI, including game-based tests, resume/CV review tools, and personality assessments. Employer obligations under the New York City law include:

• an independent bias audit of the tool;
• publishing the results of the bias audit on the employer’s website;
• notifying any candidate or employee who is a New York City resident that a tool will be used and the characteristics it will consider;
• provide candidates or employees residing in New York City with the ability to request an alternative selection process or accommodation; and
• disclosing information about the type of data collected for the tool, the source of the data and the employer’s retention policy.

Employers using AI tools to hire or promote talent in New York City should assess whether they must take any additional steps to ensure compliance with this new law. Furthermore, most employers that are not subject to the New York City law have obligations under general anti-discrimination laws.  As a result, employers should understand the emerging compliance obligations associated with these tools and the steps that can be taken to reduce risk, including assessing the results of any bias testing conducted by the tool provider.

Insurance

Last autumn, the Financial Stability (E) Task Force of the National Association of Insurance Commissioners (NAIC) (the "Task Force") charged the NAIC’s Macroprudential Working Group (the "Working Group") with co-ordinating with state regulators and other interested parties to provide further clarity to regulators’ questions and considerations concerning the growing number of complex transactions involving insurers and PE firms. In response, the Working Group prepared a draft list of “Regulatory Considerations Applicable (But Not Exclusive) to Private Equity (PE) Owned Insurers” (the “Regulatory Considerations”), which have subsequently undergone multiple rounds of revision and exposure for comment. 

On 27 June 2022, the Task Force and Working Group adopted the revised list of Regulatory Considerations. On 21 July 2022, the NAIC Financial Condition (E) Committee adopted and voted to send the Regulatory Considerations to the NAIC Executive (EX) Committee.

The Regulatory Considerations include the following regulator discussion result, which was described as essentially a 14th consideration: 

"[R]egulators discussed a desire to meet with various industry representatives to discuss the incentives behind private equity ownership of insurers and conversely the concerns other industry members may have with such ownership. Regulators believe the insights from these conversations will benefit their ability to monitor and, when necessary, contribute to the work occurring in the various NAIC committee groups regarding these considerations."

The Regulatory Considerations highlight insurance regulators’ view that they need additional information regarding certain transactions involving insurers, including those between minority investors and insurers. States’ insurance holding company acts and regulations (which are substantially similar to the NAIC models) have always provided approval, non-disapproval and notification rights regarding controlling and affiliated parties based on “control”, which is generally presumed at direct or indirect ownership of 10% or more of the voting securities of an insurer, although control can also be found in other ways and based on a combination of factors (indicia of control), including by contract or otherwise. 

The Regulatory Considerations do not present substantive rules or regulations but rather present principles and discussion of them for further work to be done by other NAIC working groups and task forces. The NAIC or state insurance regulators will not necessarily take action on any items included in the Regulatory Considerations, and it is too early to determine whether the Regulatory Considerations will result in significant regulatory changes. Rather, the Regulatory Considerations reflect regulators’ focus on the increasing complexity of transactions in recent years (including transactions not involving PE) and an inquiry into whether current documentation and disclosure requirements adequately enable regulators to identify and assess the risks of insurers.