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Private capital liquidity in a challenging exit market: Key tax considerations
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  • Insight
  • 10 minute read
  • June 23, 2026

At the start of 2026, we identified several themes likely to shape private capital this year: a pickup in M&A transaction activity, continued pressure from retailization on fund structures and operating models, longer private holding periods affecting liquidity and exit planning, and growing attention to “tax alpha” in how LPs evaluate GP performance. In the months since, market developments have begun to validate those expectations.

Consider a familiar scenario: A sponsor holds a high-performing enterprise software company acquired five years ago. Revenue has tripled, EBITDA margins have expanded, and the asset still has runway. But the exit market hasn’t cooperated. Strategic buyers are bidding well below where the sponsor sees value, and the IPO window remains uncertain. Meanwhile, LPs are pressing for distributions.

The sponsor is weighing their options to get liquidity to their investors. A continuation vehicle (CV), net asset value (NAV) facilities, dividend recapitalization, and preferred equity may all be viable, and can each address the liquidity need, but they produce materially different tax outcomes depending on structure, timing, and investor mix. Here’s how their analysis plays out.

Private equity’s exit backlog has grown to nearly 33,000 unsold companies globally, representing more than $3 trillion in value. In the U.S., the backlog stood at 13,325 portfolio companies as of March 31, according to PitchBook data cited by WSJ Pro Private Equity.

WSJ Pro Private Equity, “The PE Paradox: Volatility Fuels New Deals as Old Assets Sit Frozen in Portfolios,” May 13, 2026, citing PitchBook data as of March 31.

Moving the asset to a new vehicle

With a CV, the sponsor moves the portfolio company into a new vehicle. Existing LPs can choose to cash out, roll over, or do a partial mix of both. For rolling LPs, the transaction offers continued exposure under new economics. For sellers, it creates a liquidity option at a valuation that a third-party sale may not currently support. The process resets the ownership timeline, which requires careful attention to valuation, governance, conflicts, term length, management fee, carry, and other economics.

The tax consequences hinge on the transaction’s form. If the legacy fund sells the asset to the new vehicle, gain is recognized and allocated among legacy partners, generally including rolling investors who reinvest their proceeds. A mixed redemption-and-contribution structure, by contrast, may produce different results on gain recognition, basis, and holding period.

One threshold question is whether the legacy fund crystallizes any carried interest. If it does, the Internal Revenue Code Section 1061’s three-year holding period rule governs character: gains on assets held three years or less are recharacterized as short-term capital gain. The interaction between a CV transaction and these holding period mechanics raises important questions, including whether a rollover resets the clock and how look-through rules apply to the assets held through the new vehicle.

Also, the GP rollover requires careful analysis. Whether gain is recognized or deferral is preserved can depend on the transaction form, including liability shifts, deemed distributions, and whether the rollover is respected as tax-free or instead treated as a taxable sale and reinvestment.

The structure’s sequencing also matters, including whether the transaction is implemented through a redemption-and-contribution model (where LPs redeem their interests and contribute proceeds to the new vehicle) or a direct asset transfer (where the fund transfers the portfolio company directly to the new vehicle). Different paths to the same commercial outcome can produce different answers on gain or loss recognition, basis, holding period, and income allocations among redeeming and rolling investors.

The new vehicle’s carry arrangements bring separate questions. A CV often resets economics, which can start a new holding period for purposes of the long-term capital gains determination. Management rollover and incentive equity should also be reviewed carefully.

For LPs, the tax consequences depend on the election they make and the overall transaction structure. Where cash-out LPs receive cash or proceeds that exceed their basis, they generally will recognize gain or loss on the sale, which usually is capital in nature except to the extent it is attributable to assets that can produce ordinary income on a look-through basis. Timing, withholding, and reporting should be addressed early, particularly where there are non-US investors, effectively connected income concerns, or portfolio assets that may give rise to ordinary-income treatment.

Rolling LPs require a different analysis. A rollover may be intended to qualify for tax deferral, but that result depends on the form of the transaction and whether the LP receives cash or other consideration that could trigger current tax or support a recharacterization. Rolling LPs also need to track basis, holding period, and the character of future allocations in the CV, including any built-in gain or loss that may carry over into the new structure. Where an LP partially cashes out and partially rolls, basis allocation and holding-period tracking become especially important.

Tax allocations are a key component of the analysis. If the existing fund recognizes gain at the partnership level, the allocation of that gain among the partners is governed by the partnership agreement and applicable tax rules. A central structuring question is whether taxable gain can be specially allocated to the redeeming LPs who receive liquidity, rather than being allocated more broadly under regular allocation mechanics.

Note: There are different views on how far allocation approaches can be taken, and comfort varies depending on the governing agreement, capital-account revaluation mechanics, and built-in gain or loss allocation principles. These allocation issues should be worked through early because they can materially affect each LP’s tax liability regardless of whether that LP cashes out, rolls, or does both.

Tax-exempt investors should evaluate UBTI exposure if the new vehicle uses leverage or holds debt-financed assets. Non-US investors face ECI risk, particularly where the portfolio includes US real property interests.

State tax issues can also be material, including withholding, apportionment, and nexus created by the new structure.

Borrowing against portfolio value

Now suppose the sponsor isn’t ready to move the software company into a new vehicle but still needs to deliver liquidity. A NAV facility lets the fund borrow against portfolio value and distribute proceeds to LPs, buying time without forcing a sale. Depending on the facts, the facility may be used to fund distributions, support portfolio companies, refinance obligations, or bridge timing gaps. If this is the route the sponsor selects, they should communicate clearly and early about why any borrowing is being incurred, how it supports the fund’s strategy, and how it is expected to be repaid.

Additionally, the substance of the NAV-based credit facility must match the form. If the facility functions more like a disguised sale or lacks arm’s-length debt economics, the tax treatment could be challenged, with consequences for interest deductions, withholding, and investor reporting.

A key tax consideration surrounds the interest expense related to the borrowed funds. Section 163(j) generally limits the tax deduction for business interest expense to the sum of business interest income and a percentage of the taxpayer’s adjusted taxable income, subject to elections and exceptions that may be available depending on the fund’s activities and asset composition. If the borrowing occurs at the fund level, the fund and its investors will need to determine how those costs are allocated and whether any deductions are limited.

Debt-funded distributions also require careful review where proceeds flow through the fund waterfall. If the GP receives carry-related cash before the fund has sold an asset, a timing mismatch emerges between cash economics and taxable realization. The borrowing itself does not change the character of carried interest, but it can raise basis, distribution, and tracking issues that affect how the GP’s carry is taxed when the underlying asset is ultimately sold.

The structure of the facility can also create issues for the GP entity, management company, and related parties if guarantees, fee arrangements, or cross-collateralization features are not reviewed in advance. Sponsors should also consider how leveraged distributions will be reported to LPs, including whether they are treated as return of capital, current income, or another category.

For LPs, the key question is the basis impact. A debt-funded distribution generally reduces an LP’s outside basis and may trigger gain if the amount distributed exceeds that basis. However, LPs also receive an increase in outside basis for their allocable share of the fund-level liability (i.e., the debt or NAV facility), which may partially or fully offset the basis reduction from the distribution. LPs should also consider how interest expense and financing costs associated with fund-level borrowing are allocated among investors, because the allocation methodology can affect each LP’s share of deductible interest and the application of the Section 163(j) limitation at the partner level, as discussed above. The consequences may vary by investor depending on the character of the distribution, the LP’s available basis, and the LP’s broader tax profile, including the timing of basis recovery, gain recognition, and future taxable allocations.

Tax-exempt investors should also evaluate whether fund-level leverage creates debt-financed income that generates UBTI. Clear reporting on deductibility of financing costs is essential.

"[T] the longer hold times are giving firms the opportunity to build up their portcos’ fundamentals that will make their portcos more attractive to buyers upon exit. Based on our experience, we see five data-driven opportunities firms can use to reshape portco operations, improve their value creation potential, and unlock AI’s potential."

5 data-driven trends to unlock PE portcos’ AI-enabled potential, www.pwc.com.

Pushing leverage down to the portfolio company

Alternatively, the sponsor could leave the fund structure untouched and instead have the software company itself take on new debt, distributing the proceeds upstream. This dividend recapitalization accelerates cash to LPs and potentially to the GP through carried interest, while the sponsor retains ownership.

At the portfolio company level, the central question is whether the interest on the new borrowing is deductible. As with NAV facilities, Section 163(j) applies, and the portfolio company’s ability to use the deduction will depend on its adjusted taxable income, the nature of its business activities, and whether any applicable elections are available. If the company operates through a pass-through structure, those limitations flow to the fund and its investors.

For LPs, the tax treatment of the distribution depends on the character of the payment at the portfolio company level, including whether the portfolio company is a C corporation or a pass-through entity, which determines whether the proceeds carry dividend income or are treated as a partnership distribution that reduces outside basis, with excess over basis generally treated as gain. Investors should also consider allocable interest expense and investor-level deduction limitations. Because a recap increases portfolio company leverage, the tax benefits depend on the company’s ongoing ability to service and deduct the interest.

Bringing in new capital without a full exit

Finally, the sponsor could bring in a preferred equity investor at the fund or asset level, raising capital without a full exit or traditional debt. Because preferred equity sits between debt and equity in the capital stack, its tax treatment turns on the instrument's terms. The threshold question is whether the IRS respects the instrument as equity or recharacterizes it as debt, and there is no bright-line test.

Beyond classification, sponsors and investors must evaluate how the preferred return is characterized for tax purposes, whether phantom income may be created, how the instrument interacts with the distribution waterfall and substantial economic effect rules, and what consequences arise on exit or conversion. State tax outcomes, UBTI, and ECI exposure should also be considered, particularly where the investor base includes tax-exempt or non-US investors. For a detailed treatment of these issues, see our prior post, Private market access is getting more complex, not just more available.

The bottom line

Each of these solutions has its own complexity, challenges, and upside. Each solves for liquidity in a different way and generates a different tax profile. The common consideration is that tax consequences are hardest to fix after commercial terms are set. Sponsors that model the tax early, pressure-test investor-level outcomes across entity types, and coordinate with advisors before elections are due can decrease the likelihood of the costliest surprises.

Explore the full 2026 Private Capital Outlook

Four predictions on shaping the future of fundraising, liquidity, and tax strategy

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Brian Rebhun

Brian Rebhun

Financial Services Tax Lead, PwC US

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Ryan Schneider

Ryan Schneider

Asset and Wealth Management Tax Leader, PwC US

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Amy McAneny

Amy McAneny

Private Equity Tax Leader, PwC US

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