Secondaries have been a hot topic in private equity in recent years. The first secondaries fund in history raised a mere $6 million in capital back in 1981. Forty years later, the biggest secondaries fund of all, managed by Ardian, has $19 billion in capital. In 2020 alone, secondaries funds raised $100 billion. Four of the ten biggest private equity funds that closed last year were dedicated to secondaries.
The fundraising boom has, since last summer, been accompanied by extraordinary growth in "GP-led" secondaries transactions. Surveys published by Evercore and Greenhill, two specialist investment banks with significant secondaries advisory businesses, suggest that GP-led deals accounted for around half of secondary transaction volume in 2020. While the surging percentage may also be attributable to the volume of LP-led transactions falling in 2020, it is still a strong indication that GP-leds are resilient even in turbulent periods.
GP-leds are different from traditional (LP-led) secondary transactions. In the latter case, an LP decides to sell its interest in a fund (or, potentially, a portfolio of fund interests) and approaches potential buyers, ultimately leading to a transfer of interests with GP consent, with the buyer becoming a limited partner (and taking on the seller's future obligations to the fund) in respect of the transferred interests. Conversely, in a GP-led transaction, it is the GP which initiates the deal, generally in the context of a fund restructuring, the objectives of which may include returning cash to existing investors and extending the firm's control over all or some part of the fund's portfolio.
Types of GP-led secondary transaction
Continuation fund: This is probably the most popular type. If the GP of an ageing fund believes it needs more time to maximise the value of its assets than the fund's remaining term allows, then, rather than keep extending the fund, the GP establishes a new continuation vehicle to take over residual assets. Existing LPs are given the option of rolling their interests into the new fund or cashing out. The cash-out is typically financed by raising additional capital from new investors or 'rolling' investors.
Single-asset recap: Similar in structure to a continuation fund, a single-asset recap is appropriate where there is a duration mismatch between the fund's lifespan and a single "trophy" asset.
Portfolio strip sale: This involves a mature fund selling a specified selection or percentage (the so-called "strip") of the fund's assets. The GP may establish and manage the buyer entity, thus keeping all assets under its effective control post-completion, or it may sell to third party co-investors. The transaction allows the GP to generate liquidity for existing investors or it can be used to reduce the old fund's exposure to (and, thus, risk from) particular assets or sectors.
Tender offer: This is a GP-organised secondary sales process targeted at LPs seeking liquidity.
Preferred equity: A new vehicle is established to provide preferred equity financing in exchange for priority distribution rights from the fund's portfolio companies. These are appropriate where an existing portfolio may require follow-on capital or LPs want liquidity.
Annex funds: A new annex vehicle is created by the GP for an existing fund which is already fully tapped out, allowing the GP to raise follow-on or working capital for the portfolio. Existing investors are given the option to participate, with any remaining capacity offered to third parties.
Stapled transaction: The GP organizes the sale of secondary interests in a fund to a buyer and, simultaneously, the buyer agrees to make a primary commitment to a new (or other existing) fund managed by the same GP.
Why are they growing in popularity?
Historically, GP-led secondaries were used primarily by "zombie funds", with just those last few assets – basically, the hardest to sell at an acceptable valuation – transferred to the new vehicle.
But the surge in GP-led transaction volumes may be down to GPs having a lot of dry powder available, thanks to bumper fundraising, and not enough reasonably priced, high-quality assets to invest it in. The sort of landscape contoured by this disparity encourages GPs to find ways to hold on to star portfolio assets for longer.
In times of crisis, such as the current pandemic, it is perceived as less risky to bet on assets with which the GP is already familiar.
The more cynical might also observe that GP-leds give managers the opportunity to reset fees and crystallise carry, although this is sometimes complemented by an agreement to inject additional GP commitment into the new vehicle.
Top tips in a GP-led transaction
Know Your Buyer: As secondaries grow in popularity, it is prudent to ensure that the GP is engaging buyers who are experienced and motivated participants in the secondaries market, and not just "tourists". Building strong relationships with the correct type of buyer ensures that they will be familiar with the workings of a sale and can foster new, perhaps long-term fundraising relationships, instead of just a one–off transaction.
Manage conflicts: GP-led secondaries are inherently prone to conflicts of interest. The GP has a duty to act in the best interest of the LPs in the current fund while also trying to broker a deal with a buyer which the GP may itself control, giving the GP a financial interest on both sides of the transaction. GPs should carefully disclose all risks and conflicts associated with a transaction and engage independent advisers to ensure that there is a proper conflict management process in place. Fairness opinions from third party providers have become increasingly common as a way of stepping around potential problems. The GP should demonstrate and ensure that LPs have a strong understanding of the logic for any transaction from a financial and commercial standpoint.
Valuations: To address an obvious conflict of interest, GPs should engage independent valuers to verify the numbers and also consider obtaining LPAC or investor approval of the transaction terms, especially the sale price.
GP Commitment: While a secondaries transaction is an opportunity for a GP to reset fees and economics, it is important to consider the impact of the GP commitment being too low. The GP commitment is a strong indication of their belief in a deal or asset and a larger commitment can signify strong alignment and attract better buyers.
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