GP-Led Secondaries: A Deep Dive

LPs are dealing with a prolonged period of negative cashflows. In 2022 and 2023, private equity distributions hit decade lows, dropping to 15% and 11% of NAV, respectively, rivaling the cash crunch of the Global Financial Crisis when distributions as a percentage of NAV hit 9% in 2009. With M&A and IPO markets continuing to stall, firms are struggling to generate distributions to keep the fundraising flywheel moving.

As a result, the GP-led secondaries market has emerged as an attractive avenue for GPs to address their liquidity needs without relinquishing the potential gains from premium assets in a more favorable economic climate. In 2023, continuation funds comprised 12% of all sponsor-backed exit volume, doubling YoY and highlighting the extensive uptake of these mechanisms in addressing a parched liquidity landscape.

GP-Led Secondaries Market Trends

Over the past few years, the GP-led secondary market has solidified its position as a key source of liquidity for sponsors, standing out as a beacon of activity amid the broader downturn in private equity exit volume throughout 2023. Using a secondary transaction, GPs can generate liquidity and provide LPs with the option to maintain or exit and exposure. Simultaneously, they can retain their top-performing assets, steering clear of lackluster exit scenarios while securing additional capital to fuel growth endeavors.

These vehicles have also allowed GPs to circumvent a cold dealmaking environment in which high interest rates, inflation, and macroeconomic volatility have made acquiring new assets difficult and, ultimately, riskier. Instead of buying new assets, firms can use continuation vehicles to drive further value and attract capital for companies they know well to accelerate buy and build strategies, drive geographic expansion, and achieve other growth initiatives.

Key Benefits to GPs

Among various tools available in the GP-led market, continuation funds have emerged as the go-to choice in GP-led secondary transactions due to several key benefits.

Maintaining the Existing Debt Structure

Continuation vehicles frequently enable GPs to maintain the current debt structure for portfolio companies, avoiding the need for refinancing at elevated interest rates. This feature contributes to their increasing favorability over alternative secondary options like preferred equity and structured solutions, which experienced a 5% decline in deal volume last year. Moreover, they often present a more advantageous choice compared to NAV loans, which are also vulnerable to rising rates.

Deferrals Move the Needle on Bid-Ask Spreads

In an environment characterized by persistent bid-ask spreads, deferral options have been instrumental — 51% of continuation vehicle transactions in 2023 utilized delayed payment methods, a significant increase from 6% in 2022. Similar to other aspects of continuation vehicles, deferrals offer mutual benefits. GPs can secure higher pricing, while buyers gain the opportunity to enhance IRR by spreading payments over an extended period, typically 6-12 months.

Characteristics, Terms, and Trends of Continuation Vehicle Deals

In today’s market, an overflow of GP-led opportunities compared to the available capital allocated for secondaries strategies has led to a notable supply-demand disparity. Consequently, buyers can afford to be highly selective in the deals they pursue, leading to a pronounced bifurcation in the market. High-quality assets and deals garner significant attention, while transactions plagued with challenges related to the underlying asset or GP have struggled to close.

Realistic valuation expectations, top-notch assets and management, robust alignment, and sound transaction rationale are imperative for a deal to thrive. Moreover, the underlying assets must promise enticing upside potential while also ensuring favorable returns for existing LPs looking to exit the fund — a challenging balance to strike.

Asset Class and Industry Matter

Asset class and industry are often the primary filters buyers apply to deals they consider. Mature business models, seemingly more stable valuations, and therefore narrower bid-ask spreads (than, say, growth and venture) have contributed to buyouts composing 86% of GP-led market share. With the large majority of secondaries dry powder currently allocated to buyouts, the asset class will likely maintain its dominance in the short term.

Within buyout deals, buyers show a preference for industries with limited cyclical exposure. Areas like healthcare, business services, industrials, and tech have generally dominated interest. Capital-intensive industries have largely struggled to gain traction.

Behind buyout, infrastructure holds 14% of secondaries dry powder. Credit secondaries have also sparked considerable interest, fueled by the significant capital raised for direct lending funds. Meanwhile, growth and venture have struggled to penetrate the secondaries market due to valuation concerns.

Flight to Quality

In today’s buyer-centric market, capturing buyer attention requires assets with compelling narratives. Similar to the state of the M&A, IPO, and sponsor-sponsor exits, GPs need to craft a compelling ‘exit’ story for assets rolling over into continuation vehicles. The path to future upside needs to be clear and credible. Whether it’s a single or multi-asset deal, promising top-line growth, high free cashflow conversion, and strong EBITDA margins coupled with an achievable outlook for long-term operational value creation are often required for a deal to close.

Like other private equity sectors, buyers are also gravitating towards familiar assets and managers. The GP’s performance and track record with the asset are significant factors. Has the asset consistently performed well within the sponsor’s portfolio? Does the GP have a history of effectively enhancing value in the company? Does the proposed value creation plan align with the GP’s track record ? Buyers have the ‘ultimate exit’ top of mind and need assurance regarding an asset’s quality and future demand, especially amid a sluggish exit environment plagued by uncertainty.

Strong Transaction Rationale

Successful deals in today’s market are anchored by a compelling transaction thesis, often showcasing a clear sense of urgency that illustrates why the asset necessitates this deal and capital today rather than two years down the line. Ultimately, astute buyers can discern between genuine and manufactured opportunities. Deals aimed to support a struggling fundraise or offload assets a GP is struggling to sell elsewhere to provide liquidity from its flagship fund won’t cross the finish line.

To successfully close a deal, the GP needs a strong transaction rationale. If a firm plans to use the continuation fund for further value creation in the assets, it needs to demonstrate how the asset(s) will benefit from additional time and capital. If the asset needs more time to pull on organic growth levers, can the tailwinds that made it a top performer in the legacy fund be replicated in the continuation fund?

Additionally, continuation funds are commonly used by GPs to support buy-and-build strategies for particular assets when the capital needed to fuel acquisitions outstrips what the flagship fund can accommodate. In these scenarios, a GP must craft a strong thesis of the buy-and-build plan and the corresponding quantum and timing of follow-on investments.

The imperative to lead with a compelling transaction thesis has become increasingly important amid the current macroeconomic backdrop. In the pandemic era, sponsors pursuing continuation vehicles could have easily sold their assets in a favorable valuation climate, creating more inherent trust in the underlying rationale. Today, with pressure to generate distributions at an all-time high, buyers are really digging deep into the motivations underlying the transaction, contextualizing them within the broader fund. If sponsors haven’t exited any fund assets for an extended period, it’s crucial to demonstrate the value of the CV to dispel concerns that it’s solely aimed at securing a fundraise.

Alignment

Setting prices in GP-led secondaries is inherently more intricate than in straightforward ownership transfers. Sponsors face inherent conflicts of interest, straddling both the buy-side and sell-side. Hence, conducting a fair process that fosters alignment among all parties is imperative. While establishing an objective valuation and offering transparency into the underlying methodology are crucial, LPs and secondary buyers want to see that GPs have skin in the game.

Typically, this entails GPs becoming net buyers of the asset(s), rolling over 100% of crystallized carry, and injecting a substantial amount of their own capital. Buyers tend to have greater confidence when fund managers invest more capital alongside the continuation fund LPs, indicating a heightened level of the sponsor’s own conviction of the deal. Moreover, LPs prefer deals offering a status quo option, enabling them to retain their legacy distribution waterfall without committing to new arrangements — with approximately 40% of continuation fund transactions offering this option in 2023.

Deal Size

Size is another critical factor to consider. In large deals requiring substantial capital, assembling a syndicate with numerous participants can pose challenges and surface potential misalignment among different groups within the buying pool. For example, if the lead investor receives economic incentives, like management fee discounts or different carry terms, compared to the other secondary investors, it can create significant alignment issues. Lead investors are tasked with negotiating for the continuation vehicle. Therefore, if they aren’t participating on equal economic terms with other participants, it can substantially impact deal timing, particularly if non-lead secondary buyers seek to negotiate.

Introducing flexibility and optionality for GPs and LPs while also expanding the high-quality opportunity set available for secondary investors, the GP-led deal market is poised for continued rapid growth. With secondary dry powder poised to be spread more evenly between LP and GP-led deals, the space will continue to be an outlet for all parties to manage a host of use cases. Ultimately, a continued uptick in GP-led deal flow will have implications for GPs, existing LPs, and secondary investors alike. For GPs looking to sell, substantiating the forward-looking value creation plan with data and showcasing past successes are essential for attracting buyers. For LPs and secondaries investors, having the tools to efficiently underwrite and assess these opportunities will become paramount.

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