The average PE hold period is getting longer. According to data provider Preqin, PE firms held on to European assets for an average of 5.65 years in 2017, up from 4.41 years in 2007. Extended hold periods have been driven by a number of factors, including the raising of longer-term PE funds by some of the larger general partners and the increase in direct investment by limited partners with long-term investment horizons (such as pension or sovereign wealth funds). As hold periods increase, some management teams have begun to ask PE firms for the right to exit their investment before the PE fund exits. In our view, this could mark the beginning of a trend, and one which should be monitored closely as early liquidity rights can create misalignment between sponsors and executives.
In the past, portfolio company executives very occasionally requested “put” options to sell shares in exceptional circumstances (for example death or permanent disability) and early liquidity rights have been a feature of infrastructure fund deals for a while. However, the concept of early liquidity has expanded into PE deals over the past 12 months as executives look to avoid being locked in for long periods with PE sponsors. We are increasingly seeing examples of early liquidity rights being asked for by management teams and, in a number of cases, conceded to by PE sponsors.
Early liquidity rights can be granted to management in various ways. Executives can be granted a “put” option to sell their stake after a certain hold period, or given enhanced tag rights — the right to sell a proportionately greater number of shares than the sponsor on any tag sale. We are also seeing so-called “share shop” structures, which allow executives to buy and sell shares from one another.
In our view, early liquidity rights could easily become a more common feature of PE deals. As strong management teams assess bidders in a sellers’ market, they may push for these more favourable terms. There could be many reasons for this, not just longer PE hold periods; management at founder-owned businesses or other executives close to retirement may want a clear exit route and so ask for liquidity rights before they commit to a PE deal. That said, requesting such rights is still “off market” and is likely only to be agreed to in exceptional circumstances.
As hold periods become longer and management teams feel more able to dictate terms, sponsors will need to consider creative ways to allow early liquidity while maintaining alignment. There are a number of creative solutions to explore such as limiting how many members can sell shares within a set time period, limiting liquidity rights to one or two key executives, or linking the timing and/or pricing of such rights to certain agreed objectives. All of these solutions come with risks, and balancing the conflicting interests of management and the funds in these circumstances is not straightforward. Deal teams should consult their advisers before conceding too quickly to early liquidity rights.