This article is sponsored by Evercore.
The secondaries market originated to provide liquidity to institutional investors, often distressed or under regulatory pressure, via sales of limited partnership interests. The market has evolved over the years into a well-established marketplace for any type of investor seeking to actively manage their private markets portfolio.
Secondaries market volume reached $72 billion in 2018, up 33 percent from the year prior and up 177 percent from five years ago. While a few years ago $100 billion in annual transaction volume seemed hard to imagine, 2019 volume is expected to fall just short of it. Indeed, the first half of the year already delivered $42 billion – more than the volume reached in the entirety of 2016.
The traditional LP stakes market remains the core of the market, with investors seeking to re-balance their portfolios, focus on core GP relationships and lock in returns by selling older vintage tail-end funds.
However, over the last few years, the GP-led market has grown rapidly and become a significant driver of deal activity. While early GP-led transactions focused on the most challenging situations – the so-called “zombie funds” – recent secondaries market headlines point to well-established, highly regarded managers contemplating or completing strategic secondaries transactions. These transactions have grown in scale and scope, as a broad range of sponsors look for opportunities to generate liquidity in order to achieve a variety of objectives: (i) hold assets for longer; (ii) accelerate the return of capital to investors; or (iii) raise new capital (for the same companies or new investments). This segment of the market has grown from $5.5 billion in 2013 to $18 billion for just the first half of 2019.
The substantial growth in the GP-led market has been accelerated by: (i) stronger acceptance and active engagement by financial sponsors, particularly brand names, to explore GP-led transactions; (ii) investors’ desire to lock-in returns; (iii) the depth of the secondaries market, where secondaries buyers continue to raise substantial amounts of capital and a number of new GP focused specialist buyers are entering the market; and (iv) the creativity of market participants continuously adapting transaction structures to meet the objectives of sponsors, investors, and underlying portfolio companies.
While the secondaries market was originally established to provide “portfolio” solutions, with most buyers requiring a transaction to involve at least three assets, “single-asset” transactions are becoming an established trend.
The rise of single-asset deals
Many sponsors have openly communicated to their investors a desire to hold on to certain assets – beyond the typical term of a fund – where they believe there still exists substantial unrealised value. This trend has led to the emergence of long-duration funds designed to increase flexibility and maximise value. Cross-fund transactions have also been looked to as a solution to retain winners, but do not provide sufficient flexibility for existing investors and raise significant conflicts between funds. The secondaries market has now pioneered innovative transactions to provide a solution to sponsors looking to “re-buy” their top-performing investments and give their investors attractive options – sell the asset from an existing fund to a newly established fund, which will be subject to new terms and is capitalised by new and existing investors.
Single-asset transactions bring unique benefits to all parties: (i) optionality for existing investors to take liquidity or retain exposure via re-investing in the new vehicle; (ii) price and terms established through a competitive process, mitigating conflicts often observed in fund-to-fund transactions; (iii) extended duration to maximise value; and (iv) new capital to invest in the business or to pursue M&A. In 2018, single-asset transactions accounted for just under 10 percent of GP-led deals, and all signs point to that percentage continuing to grow.
Single-asset deals are primarily being employed in scenarios where there is one remaining asset in a fund (or the remaining portfolio is concentrated in one asset) and such asset requires additional time and potentially capital to maximise value.
A secondaries process could yield an attractive and flexible alternative to provide liquidity to investors versus other exit options the sponsor may have. An IPO exit is very much dependent on the nature of the equity markets, is subject to volatility, and requires additional time for a full exit, given lock-ups and the challenges of selling a large number of shares.
In the case of a sale, particularly to a strategic buyer, a company may not yet be at the point where it has fully executed its business plan and offers from buyers may be impacted by that. A secondaries market solution could reflect the value that the incumbent private equity firm can bring to the table and, together with the potentially lower cost of capital of secondaries buyers versus traditional financial sponsors, could result in a higher price.
Successful transactions generally have followed similar blueprints. There needs to be a clear, strong rationale for the transaction that creates a ‘win-win-win’ for the existing investors, the new secondaries buyer, and the GP. Moreover, as these transactions come with inherent conflicts, early and regular communication with existing investors and transparency is critical to ensuring success.
It is also important to provide investors with optionality – (i) the ability to sell at an attractive price; or (ii) the opportunity to “roll-over” and re-invest in the asset. Depending on circumstances, this can be done in a “status-quo” context, ie, with limited changes to existing terms outside of duration. Keeping these in mind are important for a successful outcome for any GP-led transaction.
Single-asset transactions also come with specific challenges. Firstly, often the rationale for a single-asset transaction includes the need for additional capital to reinvest in the business for growth opportunities, to support potential restructuring at the company, or to consolidate ownership in the company. New investors will need to have a clear understanding of how new capital will be used and existing investors will want to have the opportunity to also provide new capital alongside the new secondary investor to avoid potential dilution.
Second, a challenge for some secondaries buyers is the risk profile of single-asset transactions. Unlike a more traditional LP portfolio sale that is highly diversified, the higher concentration increases the risk profile. This can be mitigated by the quality of the asset, particularly when the asset under consideration is performing and perceived as a “trophy” asset. Many buyers have also become more accustomed to underwriting a single asset as a way to increase returns and differentiate their strategy.
Thirdly, single-asset deals are being completed on a larger and larger scale, often above $1 billion. A transaction of such size and concentration can be a challenge for secondary buyers that historically have acquired more diversified portfolios and may have limits to single-company exposure in their funds – typically 1-3 percent of fund size. Syndicated transactions have become common, and we estimate over two-thirds of transactions are being done with three or more investors. Syndicated transactions also allow the opportunity for more traditional, primary-oriented LPs to participate in the secondaries market alongside specialist secondaries buyers.
Where do we go from here?
It is still early days in a GP-led secondaries market that is entering an exciting period of high growth. Transaction volume in the broader secondaries market continues to grow at a rapid pace, and we expect overall secondaries market volume in 2019 will again reach record levels, approaching $90 billion-plus. GP-led solutions should continue to be a key growth driver and may soon reach the size of the LP stakes market. Single-asset transactions are likely to remain one of the key engines of growth in the market. Whereas historically sponsors could only exit assets in one of two ways, an IPO or a sale to a strategic or financial buyer, today there is a real third option for exit: the secondaries market.
Through this market, a sponsor can provide existing investors in an older fund with an attractive liquidity option while maintaining control of a strong performing asset, continue to invest in its growth and value creation, and “re-buy” winners.
Nigel Dawn is a senior managing director and head of Evercore’s private capital advisory group. He is based in New York.
Francesca Paveri is a managing director based in London.
Dave El Helou is a vice-president based in New York.