What does the future hold for secondary private equity investments?

A difficult start to 2022 has introduced several new challenges to investors and entrenched others. Investors are understandably taking stock, and determining their next steps in the search for secure return with acceptable levels of risk.

We think the private equity market generally should be primed for a number of opportunities to arise, and that deal volume in general partner (GP)-led secondaries will accelerate.

The broader market and private equity implications

As broader markets correct, private equity will too. As is typical when markets correct there is a delayed response in the way GPs and sponsors revalue their portfolios. We’re in the middle of that now. But that’s in terms of valuations. In the private equity investment environment nothing really changes. It remains somewhat insulated from the broader market.

If you look back, history has shown - in the form of vintage year performance - that this type of environment often represents a better time to deploy capital. Deploying capital in market downturns, where companies might be available at more attractive valuations, should generate better returns, all else being equal.

Yes, using leverage will undoubtedly become more expensive after a run of 10 years or more when it has been cheap. That will challenge returns. The really good outsized returns we have seen over the past two years are unlikely to be repeated. But underwriting will not really change. Some sectors will do better. We’ve clearly seen healthcare assets and consumer staples do well in this particular vintage, and will probably see more activity in those areas.

Ultimately, a good company that can grow in a difficult environment, bought at a reasonable valuation can still generate returns that we think will outstrip public markets.

Historical context of the secondary industry

The secondary market started in the early 2000s, with $1-2 billion in annual volume, mostly to generate liquidity over the shorter-term. This limited partner (LP)-secondary market has developed to over $60 billion in size over the years, and it ebbs and flows with the liquidity needs of large institutions. In addition, LPs have utilised LP secondaries as a strategic tool to actively manage their portfolios.

Fund commitments would be sold through an advisor or with their GP, to an existing LP. That’s an interesting market in itself and has grown in popularity, especially since the Global Financial Crisis. To return to the vintage year point, that was a great time for LP-secondary transactions because you could get attractive valuations on these portfolios. It’s compelling for a number of reasons. The seller gets the liquidity they need. The buyer gets a portfolio that typically will have good internal rates of return (IRRs), and will have stable cash flows, with a shorter duration private equity investment.

The rise of GP-led secondaries

GP-led secondary transactions are a fairly new type of transaction in the broader private equity sense. They are all driven by the need for sponsors to sell companies and generate liquidity in their older funds.

As a sponsor let’s say you’ve built the portfolio, raised the fund, and invested in 10 companies over a three to five year period. Within that you have usually got some early winners that you would normally sell either to strategic buyers, via IPO or to another private equity sponsor. Now a fourth option has emerged, to sell to yourself.

It sounds simple, yet these are quite complicated transactions, and the opportunity is to really “double-down” on winners. It’s an M&A transaction, a true sale of the company, but one that allows liquidity to be returned to LPs, selling an asset to themselves into a continuation vehicle that they will own and manage. For sponsors, it allows the value creation journey to continue for a number of years.

Managing conflict of interest concerns

In GP-leds, you have to run a rigorous sales process, managed from beginning to end. Advisors are hired as a third party to ensure the GP is not setting the price themselves. That would make no sense. There are very clear rules and the SEC is looking to govern it further, which is a good thing. There are clear guidelines on how to manage these conflicts.

What sponsors are trying to achieve is to let existing LPs sell, or to continue to invest in terms that are similar to their old holding. By doing that, they take many conflicts off the table. It is important existing investors are not forced to sell. They can continue the journey if they think the price is too low or if they think there is more upside in the asset. It’s more an option rather than a forced sale of the asset from the perspective of the existing investor.

New investors are the secondary investors. They could very well be LPs, also invested in the old fund that owns the asset, because typically secondary investors will have a primary business. What’s attractive for new investors is that you can invest alongside your core managers in star assets they already own.

That familiarity with the asset is very different about these deals. Normally in LBOs a sponsor will take a view on a new asset and will take certain risks in terms of working with a new management team and financial due diligence. Those aspects you take off the table here, because you’ve already worked with the company for a number of years, know the management and know the end market. If you can manage the conflicts, set the price fairly and make sure the GP is aligned properly you typically will see a positive selection bias, because in our view, GPs will only look to invest in their best assets.

Where do investors look for an advantage in GP-led secondaries?

What’s important is the ability to source the most attractive GP-leds. We believe we can source the best transactions in the lower middle market our core managers. It’s a competitive market and will only grow more so.

The market was ~$2-3 billion in 2013 and was closer to $70 billion last year. Covid-19 had a lot to do with that. It forced a lot of GPs to look at portfolio companies, and rather than forcing these companies through an exit process, why not own it in a continuation vehicle and look for further upside for investors? That has obviously generated a lot of interest from secondary investors, as it should.

Thinking about what the future holds for GP-leds

Where we are in the cycle will impact all markets including private equity and including secondaries. What’s important when you look at transactions today is finding companies that can endure a down market and a weaker broader economy.

We expect sponsors to continue pursuing GP-leds transactions. Our view is that every private equity manager will try to do one to two GP-leds in their older funds. That dynamic is not likely to change. The need for liquidity for investors will become a bigger challenge if you have a recession, because all other exits become more challenging.