The Rise of GP-Led Transactions
The secondaries market developed organically over the past twenty years as a solution to the illiquid nature of the private equity asset class. Where private equity funds are typically structured as closed-end vehicles with 10-year terms and the option for multi-year extensions, the secondaries market pairs a seller – or a Limited Partner (“LP”) – of a private equity fund interest with a buyer willing to acquire and take on the future commitments (such as funding capital calls, for example) in exchange for all future distributions.
In the early 2000s, secondaries were an emerging market with annual volumes of US$2-10 billion1. In 2008-2009, amid the global financial crisis, the market hit its stride: secondaries became a powerful liquidity tool and annual deal volume surged to US$20 billion2. In more recent years, LPs have been using the secondaries market not only for liquidity solutions but also for portfolio management3. Active portfolio management is now the predominant motivation for a sale of LP interests and was the primary driver for about two-thirds of all sales in 20192.
Secondaries have continued to grow and evolve and reached a record US$88 billion of transaction volume in 20194. One of the most significant recent developments in the secondaries market is the increase in transactions led by the General Partners (“GPs”) of private equity funds. Historically, while GPs were involved in secondary transactions, it was in a passive role through the approval of a fund transfer from the seller to the buyer. Today, GPs are becoming increasingly educated about secondaries and are using them to manage their business and their funds alike.
The Benefits of GP-Led Secondaries
Greater awareness of the secondaries market and its use as a fund management tool has driven significant penetration with GPs over the last five years. Many large buyout firms have considered or closed GP-led secondaries deals, including Ares, Blackstone, Oaktree, TPG and Warburg Pincus. These tools are now being used by a wider range of GPs, including mid-market and small-cap GPs. In fact, GP-led deal flow has been a significant driver of secondary transaction volume and represented 34% of all secondary deals in 20195.
There are several reasons why GPs are increasingly using the secondaries market to manage their private equity funds:
- Near-term liquidity: Offer LPs a liquidity option either through a sale of their interests (or a portion of their interests) or by way of a dividend.
- Extended duration: Continue to own and operate an asset or portfolio of assets beyond the traditional private equity hold period (four to six years) to maximize value.
- Additional capital: Raise new capital to support portfolio companies facing temporary headwinds or to enhance the trajectory of value creation.
- Alignment: Create a new incentive structure with a reset and re-allocation of carried interest.
- Build/enhance relationships: Enables participation from new LPs who may support the GP in future fundraises.
Fund Management Options Available to GPs
There are several types of GP-led transactions and each can be used as a fund management tool depending on the desired result for the GP.
A liquidity offer presented to all LPs to sell their interests in a private equity fund with no substantial changes to the current fund structure.
Benefits for the GP
- Creates a single secondary transaction for all LPs, reducing the number of one-off secondary trades to manage
- Refreshes the LP base with a new LP or group of new LPs who might support the franchise by committing to future funds
- Offers the potential to staple a commitment to a current fund (if in fundraising)
Portfolio of assets - A new vehicle is set up to acquire the remaining assets from an existing fund. Existing investors have the option to sell their interest or roll their interest into the new vehicle. The new vehicle resets economics for buyers (paying management fees and carried interest) and typically offers a status quo6 option for existing investors.
Benefits for the GP
- Provides LPs with optionality. Ability to seek liquidity (typically well-received if the fund is late in the life cycle) or to continue to remain invested
- Extends time period allowing for additional value creation and longer exit horizon
- Raises additional capital to support further growth
- Re-aligns interests with LPs through new carry pool or crystalizes existing carry and re-invests to further benefit from value creation
Single asset - A new vehicle is set up to acquire a single asset from an existing fund. Similar to the continuation fund for a portfolio of assets, existing investors have the option to sell their pro-rata interest in the company or roll their interest into the new vehicle. The new vehicle resets economics for buyers (paying management fees and carried interest) and typically offers a status quo6 option for existing investors.
Benefits for the GP
- Spins-out a strong performing asset that requires additional growth capital, beyond what the current fund can provide due to concentration limits or other portfolio company requirements
- Gives LPs an option to solidify a strong return
- Carves out a company from a fund that is late in its life cycle and requires additional time to execute on its value creation plan. Allows the GP to wind down the fund or focus on harvesting the fund’s remaining assets
- Raises additional capital to execute on M&A or provide growth capital
- In the right situation, can be used to partially crystalize incentives, and provides a means to transition management alignment to newer team members
A portion or ‘strip’ of all or a select group of assets is sold into a new vehicle.
Benefits for the GP
- Offers option for LPs to reduce exposure and achieve liquidity
- Validates the GP’s valuations, providing support to fundraising initiatives
- De-risks a portion of the fund while maintaining upside opportunity
- Provides potential to raise new capital and reset the hold period timeline
A new tier of capital which is raised at the fund level (senior to the common equity) using the net asset value of the portfolio as unsecured collateral. The preferred equity is typically structured by the provider to generate paid-in-kind interest and a minimum return multiple. The preferred equity instrument has a priority on distributions from the underlying portfolio which are used to make payments to the provider. The provider is a passive participant with limited or no financial and operating covenants and there is no change in governance at the portfolio company level.
Benefits for the GP
- Supports portfolio with defensive capital, if unfunded commitments are low, or offensive capital to take advantage of add-on acquisitions or growth capital opportunities; attractive in the current market given the uncertainty in debt capital markets
- Can be used to return capital to LPs (dividend recap), bringing forward distributions if assets need to be held for longer
- Offers lower-than-equity cost of capital while maintaining significant flexibility with no cash payments and limited covenants/governance
- Can be executed relatively quickly and does not present conflicts of interest inherent in continuation fund transactions
Impact of COVID-19 on GP-Led Transactions
As the COVID-19 pandemic started to impact financial markets in early 2020, many GP-led secondaries were put on hold as GPs assessed the financial impact to underlying portfolio companies. The one exception has been preferred equity financings, which increased significantly in Q2 2020 as GPs looked to shore up defensive capital or raise additional capital to be offensive during the market dislocation. Through Q3, preferred equity deal flow continues to be robust and transaction volume for other GP-led deals is starting to normalize. We expect a further acceleration in volume as the impact of COVID-19 on performance through the spring and summer months can now be evaluated to determine the resilience of underlying portfolio companies. While deal flow may slow if there is a pronounced second wave of cases, we predict much less disruption as the performance of underlying portfolio companies through this period will likely be more predictable.
We expect the COVID-19 environment to become a likely catalyst for further growth in GP-led transactions, as the value creation plans in place for many portfolio companies may be on hold or delayed and there will be an increasing need to own assets longer than the traditional private equity fund term will allow. There will also likely be the need for portfolio companies to pivot strategy, or for GPs to invest additional capital to execute on value creation plans. As outlined above, the secondaries market provides GPs with several options to actively manage such crisis situations and achieve a positive outcome for all stakeholders including the GP, existing LPs and the new investor group.
Outlook for GP-Led Transactions
The secondaries market began as a liquidity solution for LPs but quickly developed to become a broader portfolio management tool for both LPs and GPs. While GP-led secondaries are a more recent evolution, they have grown quickly to become a US$28 billion5 market in only a few short years. This rapid adoption and surge in deal volume is evidence of the value these transactions provide to GPs in the active management of harvesting or liquidating private equity funds. With an increasing awareness of the secondaries market and the potential benefits it provides for both firm and fund management, we predict greater utilization of traditional GP-led secondaries and continued growth in this segment of the market.
Matthew is a Managing Director on the private equity team and co-leads secondary activities in North America. Northleaf is an active investor in the secondaries market, including the purchase of LP interests, tender offers, continuation funds, preferred equity and direct secondaries.
1. Greenhill & Co.
2. Evercore Private Capital Advisory.
3. Portfolio management would include a pension fund selling its middle-market fund portfolio following a strategic decision to focus on large-market funds or a fund of funds or secondary fund selling the assets in an older vintage year fund to provide liquidity and close the fund.
4. Greenhill & Co. Global Secondary Market Trends & Outlook – January 2020.
5. Lazard Ltd.
6. Existing investors continue to pay the same management fee and carried interest. No reset of economics.