Since 2020, GP-led deals have become the norm rather than the exception, accounting for more than half of total annual transaction values.
Not so long ago, the private equity secondaries market represented a relatively small sliver of the private equity pie, but today, that slice is getting larger. Appetite for such deals has been growing extremely strongly: so much so that 2021 saw deal volume worth a total of $132billion – more than double the volume transacted five years earlier1. But within this trend, another notable feature is emerging: the rise of the General Partner (GP) led secondary, where GPs are driving deals, rather than Limited Partners (LPs), as has traditionally been the case. Since 2020, GP-led deals have become the norm rather than the exception, accounting for more than half of total annual transaction values2.
As with any growth market, private investors will be keen to know what’s driving demand, and whether this is an area they should consider including within their portfolios. In this post, we explore those questions, looking at what secondary investing is, what a GP-led deal entails, why activity is increasing and what this means for investors (and the portfolio businesses involved).
The unprecedented volume of activity in the secondary market is being fuelled by record levels of fundraising by dedicated secondaries funds and an increasing desire by GPs and LPs to explore innovative secondary transaction structures, designed to deliver value and liquidity solutions.
Traditionally, a secondary transaction was a way for a LP in a private equity fund to achieve early liquidity by selling its interest to a third party at or below net asset value (NAV), with the agreement of the GP managing the fund, before the end of the fund life. In a GP-led transaction, as the name suggests, it is the GP who initiates the deal, restructuring the fund and bringing new investors on board to return cash to existing LP investors, and retaining control over the management of the assets in the fund for longer.
Why is activity increasing?
There are several very good reasons why this upswing in GP-led secondary deals is happening now. A series of major economic shocks, from Brexit to Covid-19 to the global energy crisis and the conflict in Ukraine, has unsurprisingly knocked many private equity portfolios’ business plans off course. Portfolio businesses may have lost one or two years’ worth of growth because of the disruption, so achieving target returns will take longer than originally envisaged.
At the same time, some portfolio businesses may have taken on more debt to provide cashflow and working capital through tough trading conditions triggered by lockdowns, meaning that investors will need to hold their investments for longer while that debt unwinds and recovery gathers pace. Therefore, exit timeframes may have to be adjusted if the full projected value is to be realised.
That may not suit all LPs. If they are happy with the level of returns as they are now, they may not be prepared to wait any longer for better ones beyond the fund’s pre-determined lifespan: they will want to take their NAV at the appointed time and go. GPs can resolve this issue by replacing those LPs with new LP investors and rolling assets into a continuation fund in which the hold period is pushed out by another couple of years.
Another factor at play is that exit markets for private equity investments were effectively closed during most of 2020. This lost period of exit activity is creating an even more crowded market now, where only the very best assets are being pursued. Waiting until conditions are calmer may be a smart strategy for sellers.
It used to be the case that GPs would only contemplate such a move to buy themselves more time if their fund was in some kind of difficulty, but now the rationale, though still pragmatic, is founded on much more positive arguments. There are clear benefits in adopting this approach – for everyone involved.
Extended hold periods mean that the GP has scope to maximise value creation opportunities, deliver follow-on capital to execute growth initiatives, if required, and capture additional economic upside. There may also be a reset of the carried interest applicable.
For existing LPs, GP-led secondary transactions provide the opportunity to obtain liquidity or in some cases, to choose to retain exposure to assets that remain strong candidates for upside potential.
New investors replacing existing LPs get access to more mature assets that are already part-way through their value-creation journey, meaning that there is already embedded value in the fund, lower risk, and a shorter time to exit. Distributions can, therefore, be expected earlier: in one-to-three years, compared to the three-to-five years typical with primary private equity funds. This investment horizon differential can enhance portfolio diversification: which is more critical than ever in the current volatile economic climate (as discussed in a previous post).
Portfolio businesses may welcome it too. Having more time to execute their strategic plan eases the pressure on management to deliver for investors, and to get themselves sufficiently ‘in the money’ before they have to sell as well. Most managers only have one crack at a capital event from the sale of their business, so it’s important that they are not rushed. Continuing with the same fund manager with whom they have built up a rapport and who knows the business well, rather than switching to a new GP to deliver the next round of funding, may also be seen as a positive.
How can I invest in secondaries?
Investing directly in private equity secondaries has traditionally been an institutional-grade opportunity, with a typical minimum investment requirement of £10million, putting it beyond the reach of most private investors. Our model provides access, by enabling clients to invest in £25k units and working with specialist market-leading funds in this space.
To date, GP-led secondaries deals have been most prevalent in the major buyout market, where large funds have become more and more innovative about providing liquidity solutions. Now, however, we’re also seeing the concept gain traction in other parts of the private market too, such as venture funds, and even in the private debt market, increasing the breadth of options available.
Momentum – both in terms of volumes of transactions, and in the types of innovative structures that are being explored – looks set to continue accelerating. There’s plenty of opportunity for new investors to provide liquidity to those existing investors who want it, and to increase the diversification of their portfolios in the process. Appropriately channelled, capital from private investors could be an important source of investment for this burgeoning market. Why should institutional investors have all the action?
1Source: Jeffries, the investment bank
2Source: Jeffries, the investment bank