This article is sponsored by Neuberger Berman.
Once a transaction of last resort for zombie funds, the GP-led secondaries deal has become part and parcel of the private equity toolkit, offering LPs flexibility towards the end of a fund’s life.
Indeed, these deals accounted for around a third of all secondaries transaction volume globally in H1 2019, according to Greenhill & Co, with values estimated at around $14 billion, double the $7 billion seen in the first six months of 2018.
This growth has been driven by an increasing number of well-known private equity names completing GP-led secondaries over the past few years as well as a proliferation in deal types – from those involving single assets and strip sales through to whole fund and preferred equity structures. We spoke to Tristram Perkins and Ben Perl, both managing directors at Neuberger Berman, to explore some of these trends and what they potentially mean for GPs and LPs.
What have been the most significant developments in this corner of the market in recent years?
Tristram Perkins: Early on, these transactions were not as well understood and there was a question or concern as to whether there might be a stigma associated with them – the perception was that perhaps only challenged funds or GPs would dare engage in a GP-led secondary. Today, these transactions are better understood and many investors and sponsors appreciate how they can create value for all stakeholders, not just fix or restructure challenged funds.
This shift in perception has led some of the best-known GPs to adopt the technology and has led to significant growth and continued innovation and evolution. There is now a broad recognition that, when structured appropriately, GP-led secondaries offer LPs in older funds options for liquidity or the opportunity to continue to participate in the portfolio’s potential upside over a longer period of time.
To what extent would you say the growth in these deals is cyclical versus secular?
Ben Perl: We see it as a secular trend – GP-led secondaries are a pragmatic response to some of the structural challenges posed by closed-ended private equity funds. While these fund structures have many positive attributes, the typical 10-year timeframe is not always perfect. Sponsors often find their portfolio companies would benefit from additional time or access to capital and therein lies a natural and healthy tension. Does the sponsor try to manage the portfolio within the pre-defined parameters promised to investors or change duration expectations to maximise value?
As Tristram alluded to, before GP-led secondary solutions evolved as a viable alternative to the status quo, sponsors were often forced to make more binary decisions that were not necessarily ideal for all of their limited partners. When a GP-led solution is properly executed, it provides investors with enhanced options and the freedom to choose what they prefer as a limited partner – continued investment or accelerated liquidity.
TP: As it relates to cyclicality, we are also sometimes asked how GP-led secondary volumes may be influenced by where we are in the economic cycle. Our view is that we may well see demand for GP-led secondaries increase if the cycle turns. Private equity has been exceptionally liquid over the past few years and yet there has still been a build-up in unrealised value across portfolios and the average duration of funds has been extending. If that’s occurring in a hyper-liquid market, it’s highly likely that GP-led secondaries will be even more in demand when exits become harder to achieve as a result of an economic downturn.
With more GPs raising longer duration funds, will demand for GP-led secondaries reduce?
BP: We do see a lot of demand for longer duration funds. But we believe these funds will likely not dampen the opportunity set for GP-led secondaries. As mentioned earlier, many sponsors believe that it’s difficult to know when you first invest which assets you want to hold for a longer period of time. For these groups, GP-led secondaries will continue to be a more elegant solution than forming separate pools of capital and changing their investment philosophy.
TP: The past decade has seen a shift in mindset among some LPs – they appear far less concerned about duration and more concerned about reinvestment risk than previously, and are seeking longer hold periods. GP-led secondaries can help them achieve this with arguably lower risk than in a longer duration fund as the profile of a new buyout transaction is inherently very different from that of owning an existing asset for longer.
There are now multiple ways of structuring these deals. What is driving innovation in the market?
TP: The different structures reflect the fact that each fund is unique and GP-led solutions are not a one-size-fits all solution. Each GP is trying to select the technology that will best meet the needs of its LP base and its specific objectives. In a “tender offer”, for example, the objective is usually to offer liquidity earlier in a fund life to limited partners who may not want to stay invested for the full term of the fund or continue to invest with that GP. As part of these transactions, the GP is also often looking to replace these exiting limited partners with new investors and will seek a primary commitment from the secondary acquirer.
This motivation, and even the structure of this transaction, is quite different than that of a “continuation fund”. In a continuation fund, the GP is typically responding to more of the structural challenge that we spoke about earlier. The GP is telling its investors that it wants to maximise long-term value for its portfolio or a subset of the portfolio, but it also understands that its investors have divergent needs and expectations for liquidity and duration as the fund reaches its contractual term. The continuation fund is thus formed to acquire the assets needing additional time and/or capital and limited partners in the legacy fund are provided liquidity or the option to remain invested by rolling over or reinvesting into the continuation fund where they can participate in the expected upside over a longer duration.
What about some of the other structures?
TP: Single-asset sales are also an interesting development and not always pursued at the very end of a fund’s lifecycle – they typically offer the opportunity for limited partners and the GP to hold onto high-quality assets where a GP feels the value creation process is not yet complete and where it’s clear that it would like to own the asset for at least another three to five years.
We believe that they work well in situations where the asset would create value via a leg-up on growth, such as through M&A or capital expenditure. After all, the GP will have hand-selected the management team, identified risks and laid the groundwork – why would they sell and not enable their LPs to benefit from the longer-term upside? While some GPs might have historically considered a cross fund sale in this context, this usually doesn’t offer LPs a choice and puts GPs in the uncomfortable situation of having to determine the value of the asset – in a GP-led transaction, the secondaries market undertakes price discovery.
How do you see the market developing in the future?
BP: What has driven innovation has been increasing understanding among GPs about what’s at the core of the technology – that there is a secondaries industry that knows how to price risk and that isn’t looking for control, but rather partnership and alignment. There is a deep pool of capital in the market that can help GPs solve issues across a variety of structures, and we believe that will continue to be the case.
TP: The market understands the need for these complex, bespoke transactions to be conducted with the utmost integrity, transparency and fairness. This is driven by the quality of GPs seeking out these solutions, who have strong, viable franchises that will only engage in transactions that are good for their stakeholders as well as groups like ILPA, which have published helpful guidelines.
While it is hard to say there is a standardised solution, we believe that each year the market gets better at the process and understanding what options limited partners in the asset class need. So long as GPs, and we as secondary investors, stay focused on providing the right options with the right process and making sure stakeholders are left better off than the status quo, then we think GP-led volumes will continue to grow and the myriad of solutions with continue to evolve.