Five Trends in Private Capital Fund Formation and Investment | Blake, Cassels & Graydon LLP

In 2023, private capital pooled funds continued to be an excellent vehicle for investors to invest in different asset classes while allowing for diversity of investments.  Last year, fund sponsors continued to raise large amounts of cash to deploy. The industry is expecting growth over the coming years in each of the major asset classes, with Preqin estimating that US$24.5-trillion will be invested in the alternative industry by 2028. Below, we’ve highlighted some of the most significant developments in private capital funds in 2023: 

1. Fundraising Challenges. While large, established sponsors are still able to raise substantial funds, there is a general trend that it is an increasingly difficult fundraising environment, especially compared to 2020 and 2021. In fact, it has been dubbed by one Bain & Company private equity consultant as “the most difficult fundraising environment ever.” That statement needs to be put into perspective given the growth of funds over the last couple of decades, but it is still relevant to the fact that the pendulum has swung to a more investor-friendly environment. As a result, investors have increasing leverage to influence fee discounts, reporting and other material terms in fund documents. For new entrants to the market, as well as emerging sponsors, there is an increasing number of funds with just one investment, as sponsors strive to prove that they are savvy investors and worthy of trust in a larger fund setting. Even for the larger, more established sponsors, we are seeing more focus on ensuring that there is transparency both in the fund’s operations and reporting, and the timing of realizations is coming increasingly into focus. As well, some investors are seeking, or sponsors are proactively offering, the ability to co-invest in assets before the investor has committed to the fund itself. This method is a sweetener to a fund commitment and a way to better get to know the sponsor.
2. Growth in Secondaries Market / Desire for Liquidity. Along with fundraising challenges, we are seeing a growth in the secondaries markets. This is driven by requests from investors for liquidity. Also, because private equity has outperformed public markets in recent years, investors are looking to re-balance their portfolios through the secondaries market.  There is also a broader awareness that secondaries are a core part of the overall market. Among investors, there is no longer a stigma with using secondaries as a portfolio management tool. While the core component of the secondaries market is still tail-end funds with assets that could benefit from more time to maximize exit opportunities, we have also seen a trend to younger assets (between three to five years) for general partner-led secondaries. These tend to sell at a smaller discount and can be attractive to investors. There were US$100-billion in secondaries sales in 2022, where over 50% were first-time sellers. The majority of this volume came from investors looking for portfolio management.
3. Rising Importance of ESG. Despite some political headwinds in the United States, environmental, social and corporate governance (ESG) considerations remain important to investors. As McKinsey states in their joint study with Nielsen IQ, consumers are stating their desire for products with ESG-related claims and backing up those statements with spending. While investment in sustainable or green funds slightly dampened in 2022 and 2023, many investors, including the large institutional investors, remain focused on ESG metrics and ensure that sponsors are considering and using ESG guidelines in their investments, especially through enhanced ESG reporting.  

   Demand from investors is translating into action from sponsors. An increasing number of general partners are signing up for industry alliances focused on ESG and adopting ESG key performance indicators to report on year over year. The most significant evolution for ESG in private equity has been a conceptual shift. Investors no longer consider ESG as solely a risk management factor, but as a genuinely value-additive factor, which drives valuation premiums.

   Many jurisdictions, including Canada, have issued regulatory guidance on disclosure practices for investment funds, particularly for funds whose investment objectives reference ESG factors.   

4. Continuation Funds. Recent events, including the pandemic, volatile markets and geopolitical tensions, have heightened secondary market activity. This challenging environment for fund exits has prompted managers to actively seek alternative strategies. Continuation funds, historically perceived as last resorts to manage underperforming assets in an otherwise successful fund, have become an increasingly popular portfolio management tool. This method allows managers to retain their high-performing assets for a more optimal exit time, alleviates the pressure to sell a stable asset that at least some partners would prefer to hold for a longer term and provides an exit route to investors seeking liquidity. Continuation funds accounted for 50% of the US$132-billion secondary market volumes in 2021, and approximately 10% of liquidity in 2022 was through continuation vehicles. Use of continuation vehicles is expected to grow. The Institutional Limited Partner Association (ILPA) has updated its guidance on sponsor-led fund restructurings in response to several key concerns of investors that arose from the increased use of continuation funds. This update included recommendations for more detailed disclosure by sponsors, minimum time periods for existing investors to decide whether to opt in or opt out of the new fund, and changes to transaction structures to address sponsors’ inherent conflicts of interest where sponsors have an interest both on the buy side and on the sell side. Investors are especially focused on how a sponsor’s carry will crystalize.
5. Use of Canadian Limited Partnerships. In Canada, a number of sponsors from different jurisdictions have expressed interest in using a limited partnership governed by the laws of Ontario or another Canadian province as the fund vehicle. Except in limited circumstances, a limited partnership is a flow-through vehicle for Canadian income tax purposes, and Canada is a stable jurisdiction typically viewed as neutral. There is a caveat, however, that if the fund intends to invest in property with a Canadian nexus, Canadian limited partnerships may not be the ideal choice for the fund vehicle. In such circumstances, we suggest that tax advice be sought.