Portfolio Advisors: The case for GP-led secondaries

This article is sponsored by Portfolio Advisors. 

How has the GP-led secondaries market grown in recent years?

Stephen Sloan: The GP-led market has transitioned from a few innovative transactions in the wake of the financial crisis to the highly institutionalised market, with volume rivalling that of LP secondaries, that we see today. The GP-led market has grown by almost 40 percent [annually] for the past five years, with these transactions proliferating far more quickly than anyone predicted.

Brian Mooney: The most interesting dynamic is that the bulk of the volume today is driven by brand name, blue chip sponsors. These GPs are looking to create opportunities to continue owning and managing their most attractive assets beyond the original life of their closed-end fund. That is very different from the majority of deals done five to 10 years ago.

What has driven that change?

BM: A big driver has been the changing exit environment for private equity-backed companies. That exit landscape varies year-to-year but, overall, there has been a drop in the number of PE-backed IPOs and a corresponding increase in sponsor-to-sponsor exits. Faced with the choice between selling an attractive asset to a competitor and having a tool to continue to own that asset, a GP-led continuation fund transaction is increasingly becoming the more desirable option.

Further, the direct deal environment has become more competitive for sponsors and buying a new asset involves key risks that are already mitigated when a GP can re-buy a known asset. We view these situations as very attractive from a risk perspective.

How have LP attitudes towards these deals evolved?

BM: Ask the existing LP base in any current fund what their preference is when faced with the choice of a near-term liquidity event or the option to continue backing a GP with an attractive set of assets, and you will typically get a bifurcated response. GP-led transactions can satisfy both options. As volume has grown and more brand name GPs have utilised these transactions, LP comfort levels have increased markedly. In the early years of the market, conversations often revolved around sponsors looking to raise additional capital, or generate carry, where it might not otherwise have been possible. Those deals are still out there but it is not where the bulk of the market is focused today.

SS: LPs have the choice of exiting at a fair market price or continuing to hold. I think that genuine optionality is the big change that we have seen over the past decade, which has helped drive broader LP support.

What makes these deals an attractive investment proposition?

BM: For the part of the market where we focus, we believe there is a positive selection bias. GPs are now looking at options for their best assets rather than what is simply left in a fund. You are able to garner substantially more insight into the asset and business plan than with traditional LP secondaries, so the underwriting is more detailed and focused. There is also stronger alignment with the GP which, in most cases, will be committing a substantial amount of its own capital and re-setting a portion of its carry to the new investors’ basis.

Given the different risk and return profiles, how do investors view GP-led deals versus traditional LP secondaries?

BM: We are very bullish on the growth of both GP-led transactions and traditional LP secondaries and we believe they both offer attractive risk/return profiles; however, these two types of deals sit at meaningfully different points on the spectrum. Specifically, GP-led secondaries allow investors to make more focused bets on specific assets and specific GPs with greater transparency and stronger alignment.

What parts of the GP-led market do you find most attractive and are you seeing deals specifically emerging from the covid situation?

SS: We have seen the largest ever volume of GP-led secondaries during the covid period. However, I do not think the pandemic is driving that dealflow – the momentum was already there. In terms of where we see the most attractive opportunities, I would certainly say the US mid-market. The large universe of high-quality sponsors with high-quality assets is still relatively underserved when compared to the large-cap deals that have dominated market volume to date.

Who are your competitors and is that changing?

SS: Historically, these deals have mostly been capitalised by the typical secondaries players using an allocation from their main secondaries vehicle. While the number of active players in the space and the amount of allocated capital are both growing, they are not keeping pace with the growth in transaction volume and pipeline. Our focus is to invest a dedicated pool of capital in the best opportunities in the mid-market GP-led space; we believe this specialisation, combined with our dedicated team and platform, sets us apart.

Have you seen much innovation in terms of the way these deals are executed?

BM: Every deal is highly bespoke, so it’s difficult to generalise about macro trends in deal terms and structures. There is always a unique set of objectives and constituents at the table. As these deals have become more mainstream, we are seeing increased commonality in processes, timelines, transparency and communication with LPACs and existing LPs.

Looking forward, what’s in store for GP-led secondaries?

SS: I think we are at an inflexion point. The secondaries market could potentially double in size over the next seven to 10 years and GP-led transactions have the potential to drive the majority of that growth. If you look back to the early days of the LP secondaries market, there was initially scepticism about why investors would sell in a buy-and-hold asset class; sophisticated institutions then realised secondaries are an effective way to manage your portfolio.

You can draw a parallel with the GP-led market. What was initially an innovative solution for potentially difficult situations has now been adopted by many of the most successful private equity sponsors in the industry, as a means of generating additional value in their best assets while providing optionality to their LPs. We have seen the highest volume of GP-led secondaries ever take place over the past year. Looking at the pipeline for 2021, there seems no doubt that dealflow will continue to grow rapidly, putting it on a par in terms of scale with the LP secondaries market.