This article is sponsored by Jefferies.
GP-led volume in 2022 was the second-highest on record at $52 billion, per Jefferies data. What types of deals are you seeing today?
Continuation fund transactions accounted for 85 percent of total GP-led volume in 2022, and around half of all GP-led transactions were single-asset continuation funds, as outlined in Jefferies Private Capital Advisory’s January 2023 Global Secondary Market Review. There was a lot of anecdotal talk from advisers, buyers and GPs saying that the single-asset market was troubled over the last year. Yet, while there were challenges at the very high ends of deal size, for transactions that were in the $250 million to $750 million of equity range, the market remained strong and healthy.
Why were large transactions challenged?
Bigger transactions largely rely upon the syndication side of the market, which oftentimes draws upon smaller secondaries funds and more traditional LPs, such as pension funds, sovereign wealth funds, fund of funds and endowments. Some of these groups don’t have dedicated dry powder to invest in the secondaries market, they are just investing out of their overall private equity programme.
Many of those entities have suffered from the denominator effect, are overallocated to alternatives more generally and therefore have had a more difficult time being able to commit to continuation funds on a syndicate capacity. Transactions that can largely be capitalised exclusively through secondaries buyers have had a lot more success.
Are single-asset continuation funds usually for the jewel in the portfolio, or do they tend to be decent quality assets that need more time?
I think it is more the latter. The threshold of quality is still very high. The business needs to demonstrate clear future value creation and resilience to market downturns. Additionally, it’s more applicable to a company that already has a healthy capital structure – an attractive debt package with a fairly long maturity. That itself adds value to doing a continuation fund versus a direct sale as these deals do not typically trigger a change of control for the existing debt, thus eliminating the need to obtain new financing. A business with a clean capital structure immediately becomes an interesting candidate for a continuation fund.
What are some of the macro factors making GP-led continuation funds particularly attractive?
It’s incredibly difficult for GPs to generate exits right now, and therefore distributions to LPs, through regular paths. The IPO market is at a standstill and the direct M&A market is down dramatically, as is leveraged loan issuance. The continuation fund exit path is becoming increasingly attractive for sponsors and their LPs because it is producing a full cash exit option. In addition, that transaction is not dependent upon the health of the debt capital markets. So, as sponsors look forward to 2023 and think about where they will exit businesses and generate return for their funds, particularly if they had a slow 2022, they are increasingly pivoting towards the continuation fund market.
What are secondaries buyers interested in taking on right now?
I would estimate that more deals have been brought to market in the last six months than in any six-month period prior, so the need for buyers to triage where to spend time has become increasingly important. You see buyers trying to apply filters and find ways to think through which deals they should spend the most time on. These considerations span three main areas.
First, do they have a pre-existing relationship with the sponsor? Second, is the sponsor showing that they have clear conviction and alignment going forward? For example, are they rolling 100 percent of their carry into the transaction or are they considering putting a cross-fund transaction alongside the continuation fund?
Third, at the asset level, is there a clear future path for growth? That means considering historical success maintaining margins, growing EBITDA, new avenues to grow into, or an inorganic growth opportunity, and then also understanding how rising interest rates and increased commodity costs would impact the business. How critical is this good or service to the end market it serves? Any deal involving a business with a real or perceived cyclicality or capital intensity is much harder to get done.
How is the cross-fund element helping deals get done?
If a buyer is having trouble getting conviction on pricing, the fact the sponsor is willing to put its newest fund’s track record at risk is a real show of confidence that they believe in the business going forward. I think that structural component or dynamic is allowing transactions to get done that otherwise would not. If you own a business in Fund III and you’ve done a three times cash-on-cash return and a secondaries buyer is about to buy that from you at three times, the buyer may say, ‘well, I’m really just de-risking it for you as a sponsor’. But when you go and put Fund IV into the deal at the same 3x, you’re telling the buyer you think the new fund is going to double or triple the value of its money too.
Approximately 25 percent of single-company deals had that structure across full-year 2022, and if you isolate that for the second half of the year, my guess would be that figure is closer to between 40-50 percent. In comparison, it was closer to 10 percent of the market in 2021. Of the deals Jefferies advised on in 2021, none had that structure in place; of the single-company deals we closed in 2022, about 25-30 percent had it; and in the single-asset deals we have in market today, about 75 percent have it.
Are you seeing more deals being tested in the market that are not getting done?
Anecdotally, I would say there are more failed deals today than there were two or three years ago. The reason transactions fail is largely a function of lack of alignment with buyers, transactions that are simply too big and, similar to the M&A context, because there’s a bid-ask spread between buyer and seller.
That is why it is crucial for sponsors to have good advice going in, so they know what is achievable. Having an adviser that knows the secondaries buyers and can get them to spend time and attention on their transactions is vital. It is a busy market, so you need to package these opportunities in a digestible way for buyers.
How is the broader market environment affecting pricing?
GP and LP prices are tied together because it relates to opportunity cost. In 2021, LP pricing for a healthy buyout fund was in the mid-90s as a percentage of net asset value, and in 2022 it dropped to the mid-80s. For secondaries buyers that need to decide where to deploy the finite amount of capital in their funds, that means the buying opportunity on the LP side has improved dramatically, and the ability to underwrite higher returns has increased significantly in the last year.
“It is a busy market, so you need to package these opportunities in a digestible way for buyers”
If you think of that on a risk-adjusted return basis as the least amount of risk and now with higher returns, it causes you to put a higher premium on a more concentrated transaction like a single-asset continuation deal because it is an inherently riskier transaction.
Coupled with the fact that sponsors’ quarterly marks lag relative to public trading peers, that has certainly put downward pressure on pricing. In 2021, 70 percent of GP-led continuation deals traded within a 5 percent band of par of the value, and 30 percent traded at a larger discount. In 2022, 40 percent of transactions traded at a larger discount.
Some 95 percent of LPs take liquidity on those transactions today, when a year or two ago, you would see probably 80 percent taking liquidity on a transaction pricing at par. If you were to sell your overall LP interest on the market today, you would only get maybe 87 cents on the dollar versus 99 cents a year ago. This means you’re arbitraging your value a little bit to sell via a continuation fund at a 5 percent discount versus to sell your LP interest at a 15 percent discount. That is why we’re seeing such high selling volume on these transactions.
Do you have any predictions for the continuation fund space?
Often sponsors do these deals only if they can sell 100 percent of the company to the continuation fund and get a full exit. However, when sponsor A sells a company to sponsor B, it is very common for sponsor A to rollover 20 percent of its equity.
With capital likely to be constrained during the next couple of years, sponsors will likely start to entertain transactions where they sell less than 100 percent of one company to a continuation fund and retain a portion of the equity inside the existing fund. It’s a way to address the capital constraint issue, and for the existing fund to retain some residual upside. That would be a big change for our market in terms of how we judge success, because historically, success has been very binary: you sell 100 percent of the company or the deal has failed.
Matt Wesley is global head of private capital advisory at Jefferies