Navigating successful exits in investments is a strategic endeavour that requires planning, and adaptability to market conditions. This is the case across industries, including the aviation space. As market conditions and investment landscapes evolve, firms and asset owners in this space are increasingly exploring alternative exit strategies to maximise returns and mitigate risks.

Traditional Exit Strategies and Challenges

Traditional exit routes include strategic sales or trade sales, initial public offerings (IPOs), and secondary market transactions, such routes having long been the cornerstone of private equity and strategic investor exit strategies. These methods offer liquidity and unlock value for investors by capitalising on market opportunities and investor demand.

However, recent challenges in the economy generally, and specifically in the aviation space, underscore the complexity of traditional exit strategies. Fluctuating interest rates and economic uncertainties impact buyer financing and valuation expectations, and factors such as evolving regulatory environments and geopolitical risks also influence the feasibility and timing of exits. In the first quarter of 2024, the value of global private equity-backed exits dropped to its lowest quarterly total since 2021 as higher interest rates continued to have an impact on private equity deal activity. Higher interest rates and an uncertain macroeconomic outlook also made it difficult for parties to agree on company valuations. For private equity and venture capital general partners (GPs), this has created significant pressures – the lack of exits leads to a decrease in distributions to limited partners (LPs) which impacts fundraising as LPs subsequently reduce allocations to GPs.

Continuation Funds: Extending Investment Horizons

Continuation funds have emerged as a compelling strategy in the private equity industry, offering flexibility beyond the typical fund life of 7 to 10 years. These funds allow firms to retain ownership of mature assets, postponing exits to capitalise on favorable market conditions and enhance asset value over an extended period. In recent years, because they provide this access to long-term value realization, continuation funds have gained traction and have become one of the most popular type of secondary transactions led by GPs.

Structure of a Continuation Fund

Continuation funds are structured to facilitate the extended holding of mature assets beyond the traditional fund life. Typically, GPs establish continuation funds as an extension of an existing fund nearing the end of its investment horizon. These funds will acquire one or more portfolio companies from the legacy fund, and investors in the legacy fund usually have the option to: (i) sell their interest in the existing fund and receive a pro-rata share of the purchase price; (ii) roll over their interest into the continuation fund; or (iii) in some cases, both. Rolling investors may be offered the option to roll over their interest either on a reset or a status quo basis.

By extending the investment horizon, private equity firms can then enjoy additional time to manage and potentially enhance the value of these assets. This flexibility is crucial for waiting out market downturns or executing value-enhancing strategies.

Key Features of Continuation Funds

• Flexibility: By extending the investment horizon, continuation funds provide more time for assets to realise their full potential, for example in the case of assets that are underperforming in the short term but can create significant returns in the long term, or when well-performing assets can generate significant additional return beyond the fund’s term.
• New capital: Continuation funds offer the opportunity to raise additional capital to support the funding requirements of the portfolio companies. Incoming investors also gain exposure to more mature, high-performing assets, and also enjoy more visibility to the portfolio companies.
• Risk mitigation: Continuation funds mitigate the risk of forced sales during market downturns, allowing firms to wait for more favorable economic conditions.

Exploring alternative exits: Asset-backed securitisations (ABS)

Apart from the traditional exit routes and continuation funds, subject to the relevant portfolio assets, ABS have been an alternative option. ABS issuances comprise debt securities collateralised by a pool of assets typically representing contractual obligations to pay, such as loans, leases, or receivables. These assets generate cash flows that are then used to pay interest and principal to the ABS holders. Examples of assets involved in ABS can include residential mortgages, commercial mortgages, auto loans, and credit card receivables. Aviation assets such as aircraft leases can also be securitised into ABS structures, enabling a lessor to manage its portfolio of assets more efficiently and providing investors with exposure to stable cash flows from aviation industry operations. Although the aviation ABS sector had slowed down, amid strong growth in air traffic demand and the recovery of the leasing industry, there has been a recent uptick with several ABS potentially in the pipeline. Please refer to our other article “Aviation ABS Market Positioning for Takeoff?” for further details.

Issues with ABS

• Asset suitability: Not all assets are suitable for ABS structures due to varying cash flow reliability.
• Credit quality: ABS issuance and performance are influenced by factors like credit quality of the underlying assets, investor demand for structured products, and the regulatory environment. In particular, ABS transactions typically involve rigorous credit rating processes to evaluate the quality of the underlying assets and reliability of cash flows. Overcollateralisation could be an important factor in getting better credit rating. While this can lower investor return expectations, it can also increase the base of potential institutional investors who require certain credit ratings on their debt investments for regulatory capital purposes.
• Interest rate / pricing challenges: Rising interest rates and inflation in recent times whilst have contributed to a slowdown in the ABS market, this looks poised for recovery with several central banks slowly starting to ease into interest rate cuts. Investors who have been more cautious in the volatile market, are starting to look at ABS transactions more favorably as it becomes ‘relatively’ easier to price.

Exiting through fund structures

Aside from continuation funds or ABS, asset owners and GPs can also opt for non-traditional fund structures that would allow them to access liquidity and potentially attract a wider base of investors. Such fund structures typically have the following features:

• REIT-like structures: Similar to Real Estate Investment Trusts (REITs), the asset owner establishes a fund structure to pool the portfolio assets, and investors are invited to invest into the fund. The fund is managed by a fund manager set up by the asset owner, and a service company, typically the asset owner, would service the portfolio assets.
• Liquidity considerations: The fund can be open-ended or close-ended, depending on the liquidity of the underlying assets and availability of financing. Balancing liquidity preferences with asset liquidity would be an important consideration, as evidenced by challenges faced by some funds in times of high demand for redemption.
• Control over assets: In such structures, the asset owner would retain control over the portfolio assets and enhanced liquidity as new investors contribute capital to the fund, and the asset owner would also enjoy a continuing income stream from the fund manager (management fee) and service company (service fee).
• Investor scrutiny: To achieve a successful exit via this structure, the past track record and experience of the asset owner in managing the portfolio assets would be crucial factors for attracting investors and new capital.

Conclusion

Managing investment exits requires a blend of foresight, strategic planning, and adaptability. While traditional exit routes remain important, the evolving landscape necessitates exploration of innovative strategies like continuation funds, ABS transactions, and fund structures. As market dynamics continue to evolve, adapting to new challenges and opportunities would be key to achieving successful returns and investor satisfaction.