This article is sponsored by Travers Smith.
With such a large pool of capital now available in the secondaries market, GPs are getting more creative to meet investor demands for liquidity, differentiated performance and sophisticated portfolio management. Here, Travers Smith partner Sam Kay, and senior associate Edward Ford, highlight developments in the market.
What are the current trends in the secondaries market and what sort of activity is that driving on the part of LPs and GPs?
Edward Ford: There is already a large pool of capital in the market and this is set to get even larger, with the top 10 secondaries funds alone reportedly seeking to raise more than $70 billion in 2020. On the GP side, that presents opportunities and our clients are increasingly looking at how they can tap into that capital and use it to differentiate themselves from their competitors and to address some of the inherent problems in the way that closed ended funds are structured.
For example, GPs have traditionally been expected to exit investments in line with their fund’s 10-year life. This can lead to arbitrary results – in many cases, the optimum exit time for a particular asset may not align with the expiry of the fund’s life and the GP may believe that it is ultimately preferable to maintain exposure to that asset, rather than effectively become a forced seller. Likewise, there is unlikely to be substantial dry powder left in a fund by years 8-10, which can mean that assets that would benefit from follow-on capital can be underfunded. GPs are able to solve these problems, and others, by accessing secondary capital, preferred equity and NAV based debt products.
Sam Kay: LPs are having to adjust to this marketplace as well. There is a group of LPs that is quite keen on this because it gives them an option for liquidity in their own portfolio. Some LPs (funds of funds would be an example) are targeting IRR performance so early liquidity is attractive, which is in contrast to traditional investors such as pension funds wanting returns to match the liability profile on their portfolio.
Another feature of the market is that if LPs are receiving liquidity earlier than they might have expected to (for example when GPs utilise preferred equity or NAV based debt solutions and distribute the proceeds to LPs), they need to make sure that their deployment programmes match these liquidity events. Likewise, LPs with LPAC seats are generally quite heavily involved in GP-led secondary processes as their consent is generally required to clear the various conflicts that exist within the structures.
What are the pros and cons of GP-led secondaries, and how do they work in practice?
EF: A typical GP-led secondary transaction involves a GP running a (typically intermediated) auction process and, ultimately, arranging for one or more secondary buyers to capitalise a continuation vehicle which acquires the selling fund’s portfolio at a price set with reference to the most recently available quarterly NAV. The target portfolios range from single assets to entire portfolios. The GP will generally offer the existing LP base the opportunity to ‘roll’ (to maintain their existing exposure to the portfolio on the same terms) or to exit. It’s likely that the GP will also be required to ‘roll’ some or all of the cash that it receives as carried interest or co-investment return into the new structure. The GP will charge a management fee and a carried interest for its continued management of the portfolio.
The drivers vary from deal to deal, but key benefits include the possibility to offer the LP base a liquidity option (but not a liquidity requirement), an ability to maintain exposure to high growth assets and an ability to raise further follow-on capital (as the ‘rolling’ LPs and secondary buyer will typically make further funds available).
SK: In different formats, these transactions have really been around for years. Immediately post the financial crisis, people were talking about fund restructurings in the context of zombie funds. They have been viewed quite negatively, but they are now recognised for their potential upsides for both LPs and GPs.
One of the key issues is they are complex transactions because of the multiple parties involved – the GP, the underlying assets, one or more new investors who are underwriting the transaction and injecting new capital, and then all the investors in the current fund some of whom may want to roll into the new structure and some will want an exit. Then you have an issue of conflicts and the alignment of interests between those parties. Now the Institutional Limited Partners Association has published its own guidelines on how GPs should be running these deals, it has validated the idea that these transactions can be pursued.
The deals are getting no less complex: we are seeing a variation on the theme, whether that’s strip sales, end-of-life portfolios or single asset deals, and we are also seeing these deals moving into other asset classes like infrastructure, real estate and credit, which all bring their own issues.
How do preferred equity structures work?
EF: In a typical preferred equity structure, a preferred equity provider provides capital to the fund structure, which can be used either to provide liquidity to LPs or to finance follow-on investments. The preferred equity provider receives a percentage of future portfolio distributions until it has received a specified return on its investment, typically set at an IRR hurdle with a minimum multiple on invested capital requirement. The preferred equity provider does not take security over the fund’s assets and there are not generally set repayment dates. It is an inherently flexible product and the providers market themselves as being sufficiently creative so as to be able to tailor a solution to individual GPs.
For a GP, the key upsides versus a GP-led secondary are that LPAC consent is not typically required and that the existing LP base do not lose exposure to the full portfolio at a set discount to NAV. It is also possible to structure preferred equity transactions to mirror some of the optionality that defines a GP-led secondary, so LPs are given the option to receive liquidity or to be carved out of the transaction entirely.
SK: The challenge is these deals are just a liquidity or follow-on play; they are not about resetting any fund terms or revisiting carry fee arrangements, duration of the fund, or the exit from certain assets. The other issue is if you have a third-party finance provider involved, they will have to make their own assessment of the portfolio and the certainty of returns. If you think about a venture portfolio or a private equity fund focused on the emerging markets, for example, that can be more challenging for a finance provider to get comfortable with.
What about NAV-based lending?
EF: These are structurally similar to preferred equity deals but the lender provides debt rather than preferred equity. Of course, debt is cheaper because the lender will take security over the portfolio and require greater downside protections. In effect, from a GP’s perspective, the trade off between preferred equity and debt is a tradeoff between the relative cost of the product and the relative loss of control over the portfolio. The other key difference is the ongoing requirement to service interest payments that will typically exist in a debt product, but will not in a preferred equity product – in a concentrated or illiquid portfolio, servicing interest payments can be a challenge.
How do you expect secondaries market activity to develop over the next year?
SK: The GP-led restructuring concept is definitely growing the fastest, partly because it is within the control of GPs and LPs. It is entering into the mainstream as a tool to address liquidity options and for funds to manage their portfolios. Going forward, I think GP-led restructuring will also be seen as an exit opportunity for one or more assets in a portfolio. So, where PE firms have traditionally thought of exit options as trade sales, secondary sales to another PE house or IPO, they will now have a fourth option, which is the sale of the asset to another vehicle that the GP still controls. We are seeing GPs looking at high-performing assets as suitable for GP-led restructurings in order to generate an exit but maintain the relationship as manager of the assets.
EF: Despite the prevalence of these deals and the fact that they are often talked about, most GPs have still not done them. For those that haven’t, they are going to have to start thinking about them in order to respond to the early movers, some of whom can already demonstrate that they are able to do so. The reality is that, when executed successfully, using these products and techniques will allow GPs to present enhanced performance data and provide LPs with liquidity ahead of a GP’s next fundraise. That’s a powerful marketing message.