Private equity and venture capital funds struggled to find an exit for their investments in first-half 2024, even as investment and fundraising rebounded.  S&P Global Ratings anticipates that tight exit markets will push funds toward debt to preserve investors' capital or provide returns on aging investments. Yet we don't expect that all our ratings on alternative investment funds (AIFs) will be impaired by rising leverage. Even though a higher debt burden at the fund level will weaken our view of financial risk, most rated AIFs have the headroom to absorb this debt increase at existing rating levels. That said, not all investors support new leverage to materialize cash flows. Some limited partners (LPs) and general partners (GPs) will therefore seek liquidity in the secondary market, even if this entails a haircut.

What's Happening In Private Capital Markets?

The amount of private capital is higher than ever, with investment and fundraising resuming growth in first-half 2024.  After a sluggish 2023, first-half 2024 has been much more buoyant for the private capital industry. For example, total private equity acquisitions through the first half of 2024 stood at $310 billion, up 24% from $250 billion for the same period last year. Fundraising also recovered slightly, with private equity dry powder at a record high of $2.6 trillion in June 2024.

While funds have never been larger, exits are at a multi-year low.  Even though exits picked up from an extremely slow start at the beginning of 2024, they were still down 24% in second-quarter 2024--compared with second-quarter 2023--and 60% below the extraordinary high in 2021 (see chart 1). This presents a challenge for an industry where the average holding period is now about 5.7 years and exit strategies are becoming increasingly important.

Chart 1

Why Does It Matter?

Tight fund liquidity can push private capital toward debt.  If the fund's termination date is not imminent, a quiet exit market does not necessarily pose a risk to funds and the ratings on these funds. Our quantitative liquidity analysis considers a fund's ability to meet its obligations by relying on repeatable cash flows, uncalled capital commitments, and other contingent liquidity sources, instead of selling assets. Based on this specific aspect of our liquidity analysis, restricted exit opportunities do not necessarily put ratings at risk, as long as liquid resources are sufficient. However, private capital providers rely on asset sales over the medium term to repay their LPs and debt.

A weak exit environment will increase investors' pressure on funds to protect or return their capital.  Investors demand realized returns on their assets, often with the intention to reinvest in future vintages. We therefore expect funds will turn to net asset value (NAV) funding to either preserve LPs' uncalled capital or satiate LPs' demand for returns. In a NAV deal, a fund draws on a facility that is secured by its asset base. Consequently, funds can avoid calls on LP commitments when investing and can even return this capital to LPs directly (dividend recapitalization transaction). While these transactions can calm LPs' concerns and even lock in net internal rates of return, they may create additional financial risk.

Chart 2

Some investors will seek liquidity in the secondary market rather than accepting more leverage.  Not all LPs will be willing to accept additional debt at the fund level to generate returns on their investment. We understand that a minority of net asset value debt raised over 2022-2023 was used to pay returns to investors. Instead of holding out for a fund-level liquidity event, LPs--and even GPs--can sell their stake to other investors in the secondary market. Even though this often comes with a haircut, it enables fund partners to generate liquidity without increasing financial risk in the underlying fund.

How Will This Affect AIF Ratings?

We expect rated AIFs will be able to handle rising leverage, without incurring downgrades.  Fresh debt will enable funds to navigate a tricky dealmaking environment and support their investments. That said, a higher debt burden at the fund level will weaken our view of financial risk. Even so, approximately one-quarter of the private equity and venture capital funds we rate operate with a debt level that impairs ratings. As such, the least leveraged funds in our rated universe can turn to debt to meet rising liquidity demands from investors, while maintaining relatively solid ratings. We note, however, that some leveraged funds lack this flexibility. Furthermore, secured net asset value financing is still at an early stage, with a market size of about $80 billion-$100 billion or about 1% of the total industry's net asset value. Overall, the private capital industry can accommodate rising indebtedness in the face of a tight exit market over the short term, without ratings being compromised.

Fund-level debt can create medium-term challenges.  The successful repayment of creditors over the medium term relies on funds exiting their investments in a timely way. This means the urgency for a functioning exit market intensifies as debt maturity approaches. Even if funds are left with several assets as they approach maturity, there are vehicles available to dispose of these assets while still repaying their creditors. These vehicles, called continuation funds, can help address debt maturities in time by enabling an asset sale, the proceeds of which can then extinguish existing liabilities of a fund. That said, any debt used by the continuation fund to purchase the asset from the prior fund will then carry its own financial risk--creating a fresh financial risk for the GPs' creditors, rather than removing it entirely.

Unclear market pricing will muddy the waters additionally.  Difficult exit markets have kept buyers out of the market, stymied exit opportunities, and left dry powder at all-time highs. Furthermore, asset owners, who have yet to raise money from private capital markets, are sat on the sidelines, waiting for better valuations and funding rounds before tapping in. As a result, the accuracy and timeliness of the private capital industry's existing asset valuations are somewhat uncertain. This pricing uncertainty accentuates the tight market dynamics for private capital as market participants seek an updated market value for their assets.

Related Research

• An Overview Of Our Proposed Criteria For Rating Subscription Lines Secured By Alternative Investment Funds' Capital Commitments, May 20, 2024
• Rising Global Defaults Will Test Private Credit Funds In 2024, May 1, 2024
• How We Rate Alternative Investment Funds, Feb. 23, 2024
• ABS Frontiers: The Blurring Of Private Credit Funds And CLOs, Jan. 30, 2024
• Uneven Liquidity And Strained Valuations Are Pushing Some Funds Toward Debt, Sept. 28, 2023
• Credit FAQ: Defining And Rating An Alternative Investment Fund, March 31, 2023
• Difficult Markets Will Test Europe's Rated Alternative Investment Funds, Dec. 5, 2022