Secondary investments refer to the buying and selling of an investors interest and unfunded commitments in pre-existing private equity funds. Given the absence of an established trading market, the transfer of interests in private-equity funds can be a complex, time consuming and a labour-intensive process of negotiation. The volume of secondary market transactions has been climbing over the years, largely in-step with the growth of private assets generally. That said, the market can be cyclical, reflecting not only exit conditions but also the need for liquidity from investors which in turn dictates the price or discount paid for such interests.

A ‘traditional’ secondary transaction includes the transfer of investments and unfunded commitments from one Limited Partnership (LP) to another. The sale typically requires the consent of the General Partner (GP). There are several other secondary transactions such as ‘tail-end’, ‘structured joint venture’, ‘structured secondary’ to name a few but the common link between them all is they are predominately driven by the LP. As depicted in the graph above, these ‘traditional’ secondary market transactions have made up an overwhelming majority of aggregate secondary market transactions historically. In recent years however, the emergence of GP-led secondary transactions has become increasingly common, so much so that in 2020 they accounted for approximately 50% of all secondary transaction volume with the trajectory expected to continue for 2021.

What is a GP-led secondary transaction?

A GP-led transaction is when the GP initiates the transaction, generally in the desire to restructure the fund with the key objectives being to either extend the fund’s life, raise additional capital and/or return cash to existing investors. These can take numerous forms with the most common being a ‘continuation vehicle’ whereby the GP of an ageing fund believes it needs more time to maximise the value of its assets than the fund’s remaining term allows. The GP therefore establishes a new continuation vehicle to transfer residual assets. Existing LPs are then given the option of rolling their interests into the new fund or liquidating. The liquidation is typically financed by raising additional capital from new investors or ‘rolling’ of existing investors. Other GP-led transactions may involve preferred equity, priority distribution rights and transfer of follow-on capital commitments.

GP-led single asset secondaries have been of particular prevalence of late. These are similar to a ‘continuation’ vehicle albeit the new vehicle will only contain one asset and therefore closely resembles a co-investment. In these cases, GP’s don’t wish to be a forced seller of what is deemed a ‘trophy’ asset due to an ageing fund and/or desire for investor liquidity. The GP is of the view there is considerable value to be gained by holding and in some cases re-investing in the business for a longer duration to see the value creation plan come to greater fruition.

What has led to this sudden growth in GP-led secondaries?

Traditionally a GP’s exit path has been one of either a trade sale to another private equity sponsor, a strategic sale such as a merger or acquisition to another business or a public market IPO. The GP-led transaction has opened up a fourth avenue for an ‘exit’ of sorts.

Several factors are potentially at play but market conditions are likely to be a key driver of this trend. Industry dry powder continues to surge to all-time highs, with an estimated US$1.9 trillion globally yet to be deployed. Dry powder has built over the years from both strong fund-raising activities from growing investor interest and GP’s slowing deal activity due to becoming increasingly selective of the quality of businesses purchased alongside the market multiple being paid. This dynamic was exacerbated by a slowdown of deal activity throughout 2020 as exit conditions were less favourable and therefore GP’s were more inclined to hold onto assets they were familiar with. Other contributing factors that may be driving this trend is the notion of GP-led secondaries can provide the opportunity for a GP to reset fees and crystallise carried interest albeit an additional injection of capital or rolling of carried interest into the new vehicle is common.

Buyer beware

Historically, GP-led secondaries were often referred to as ‘orphaned’ or ‘zombie’ funds as they tended to have a few remaining assets that were either hard to sell at desired valuations or troubled assets that required time, investment and restructuring which were transferred into a new vehicle whereby creating a liquidity event for existing LPs and reset of expectations. While these certainly still exist, especially following a pandemic, the quality of the businesses within the Funds and the rationale for conducting transactions has largely evolved. Nonetheless, it is critical to conduct thorough due diligence of each transaction, specifically the quality and experience of the GP, motivation for the transaction, the potential conflicts that may exist, the alignment of the GP within the new fund, the valuation being paid by new LPs, the terms of the new fund (i.e. fees, preferred equity, unfunded commitments, use of capital etc.). As always, private market transactions are very much a relationship game and those with strong relationships tend to be notified first and given priority access to the higher quality, more attractive deal flow.

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