Rethinking Liquidity Management in Today’s Elevated Rate Environment

Higher interest rates, uncertainty about the global economy and volatility in financial markets that felled two prominent lenders and stoked concerns about bank balance sheets have forced private equity funds to recalibrate their expectations about harvesting portfolio company investments. Here’s what PE firms can do:

Increased borrowing costs have made exits through mergers and acquisitions less likely, and equity markets are not readily enabling the monetization of investments through initial public offerings (IPOs) or special purpose acquisition companies (SPACs). Last year, M&A deal volumes fell 17 percent from the previous year, and the value of these transactions plummeted 37 percent. At the same time, IPO issuance fell 45 percent from 2021, and SPAC activity plummeted 86 percent from the previous year.

The diminished opportunities for private equity firms to cash out of investments has resulted in a denominator effect that has made the fundraising environment more challenging for GPs. In the first nine months of 2022, global private equity fundraising fell 41.8 percent from the previous year. At the same time, LPs are less sanguine on the market. Investors expect inflation and challenging economic conditions to dampen returns.

This mix of challenges has forced private equity firms to adapt by changing how they raise capital and by optimizing their liquidity management programs while closely monitoring the health of their banks and lenders.

Strategy Defines Performance

Until recently, private equity firms have been able to rely on cheap credit to generate returns and encourage investor participation. With inexpensive debt readily accessible, private equity funds gave less consideration to manage how they deploy capital pledged from LPs in dealmaking and the internal processes needed to ensure an efficient capital call process.

The higher borrowing costs and diminished liquidity in debt and equity markets have already started to erode returns of funds that relied on low interest rates to generate healthy rates of return. One segment of the private equity industry that has been hampered by high rates are funds that specialize in real estate, where high borrowing costs weigh heavily on asset prices, damping sales activity.

Regardless of a fund’s strategy or expected outcome, practices that improve transparency and give a real-time view of cash, credit rates and availability, and investor capital, are being sought by private fund managers. It is amid this difficult climate that the notion of “just-in-time” liquidity is more relevant for private equity funds. 

Keeping a Real-Time View on Liquidity

Traditionally, private equity firms have not relied on treasury and operations technology as much as other market participants. Instead, they have made do with cumbersome spreadsheets, basic accounting platforms, or corporate treasury solutions that are not suitable for the alternative asset space. Today’s volatile markets have shown that that these antiquated, less efficient methods of liquidity management do not scale effectively and may be a drag on performance.

Amid concerns about the stability of financial institutions on the back of recent closures of Silicon Valley Bank and Signature Bank by regulators, private equity fund managers now realize the importance of more closely reviewing counterparty health by monitoring credit rating actions and credit spreads in debt markets.

Also, during this period of growing uncertainty about financial markets, private equity funds recognize how important it is to diversify their liquidity across multiple banking and lending partners. As part of this effort, they are looking to better manage cash flows to avoid unnecessary idle cash balances. In some cases, fund managers have swept excess cash directly into a money market fund or account.

At the same time, LPs likely are responding to the heightened financial market volatility with demands for greater transparency and much of this will show up in more extensive due diligence by investors. Meanwhile, some private equity market participants may already be aware of shortcomings in their operations. A survey of chief financial officers last year by S&P Global Market Intelligence revealed that private equity firms plan to spend more effort and time on digitalization.

Avoiding “Lazy” Capital

With private equity firms now facing a higher cost of capital, ways to minimize “lazy” capital, cash lying around waiting for deals to happen, is top of mind for fund managers looking to generate returns for their LPs and remain efficient.

For example, cash from a credit facility will accrue interest, and money sourced from investors could be more effectively deployed elsewhere rather than sitting unused on a balance sheet. These inefficiencies, over time, may chip away at a fund’s IRR. Not only do firms need to contend with problems of capital leakage, but they are dealing with a complex set of matters not immediately connected with the change in market conditions as well.

In addition to compliance and IT issues, private equity firms have to address the needs of a wide range of geographic locations, each with its own tax and regulatory considerations. This can quickly become complex for firms with bank accounts in jurisdictions across the globe.

Juggling these competing demands is proving impossible with spreadsheets and manpower alone, especially as firms attempt to scale. To alleviate some of these concerns, private equity managers may want to consider automating the collection of a wide pool of data to track available credit facilities, cash on balance sheets and capital waiting to be put to work.  

Here are three strategies for private equity managers to consider as they take on challenging market conditions associated with higher interest rates:

1. Have extra capacity on their credit lines and diverse sources of funding while using technology to streamline document submissions and other paperwork to turn around financing quickly.
2. Create a more efficient process for capital calls and modernize the reconciliation process via machine learning and other algorithmic tools.
3. Improve communication between the front and back office, and ensure both have an accurate, real-time view of the deal pipeline and the current state of liquidity, thus informing managers of the best route to fund their deal.

Overall, today’s challenging conditions in financial markets and the global economy are spurring private equity fund managers to consider new tactics to avoid issues with liquidity. After an extended period of easy credit, today’s investors need to be sure that every bit of capital is used efficiently.