Ares on the quest for liquidity

More opportunities are opening up for buyers as GPs turn to the secondaries market for capital, but they must be selective if they are to achieve strong risk-adjusted returns, says Nate Walton at Ares.

This article is sponsored by Ares Management.

Nate Walton, Ares Management
Nate Walton

Where are you seeing attractive opportunities in the secondaries market today?

The LP stakes market is at an interesting inflection point as some investors are now finding themselves overallocated to private equity and they need liquidity to rebalance their portfolios. As a result, there are attractive opportunities to provide liquidity solutions to LPs at wider discounts. At the same time, the GP-led market is also offering solutions for liquidity needs at the fund level.

Ares acquired Landmark Partners in 2021 to grow its presence in the secondaries market. How are you using that platform to make investments?

We have now fully integrated Landmark Partners into the Ares business and formed the Ares Secondaries Group. Through the integration, we combined resources from across the Ares platform to help support the growth of our team and strategies. This means that when we are looking at secondaries market transactions, for example, we can generally leverage the broader Ares investment platform to gain greater insight into industry trends and support decision-making.

How are GPs now using the secondaries market?

One of the biggest focuses for GPs in the current market is providing liquidity to their investors at a time when M&A activity has slowed and valuations have contracted. Many are facing lower potential valuations for their portfolio companies, so rather than sell to a competitor or strategic buyer, they can offer an attractive alternative to existing LPs. Those LPs can then choose whether to roll into the continuation fund or receive liquidity. GP-led transactions were already growing, but I see this current market dynamic as a driver for more of these transactions.

This is also a strategy that works through cycles. Managers know how hard it is to find great companies, and the GP-led market can solve for the dilemma of whether to hold or sell their best companies. Secondaries managers like Ares have capital solutions that can allow them to hold for longer and possibly generate further value for investors.

GPs are also looking at ways to grow their businesses. They have been raising funds faster than ever before, so they have to invest more in GP commitments and other growth initiatives, such as launching new strategies. Rather than sell a stake in their management companies to raise this capital, GPs can use structured capital solutions, which can be less dilutive and typically have a built-in redemption mechanism. In fact, we are seeing some GPs that previously sold management stakes buy these stakes back using structured capital.

Given the market’s growth, how can buyers ensure they are targeting good quality deals?

The secondaries market is under-capitalised and allows buyers like Ares to be highly selective. As a result, we have invested in just a small portion of the transactions that we evaluate. We invest where we see the potential for alpha generation, selecting among the best assets managed by leading GPs. That said, we believe we will start to see some dispersion of returns in this space because it is unclear whether all investors in continuation funds have the knowledge, relationships and information to consistently make high quality investment decisions.

“The secondaries market is under-capitalised and allows buyers like Ares to be highly selective”

Why aren’t we seeing larger pools of capital dedicated to this space?

Part of the issue is that, to date, LPs have been figuring out from where they should be allocating to the strategy. This will be resolved over time because of the potential for strong risk-adjusted returns from the GP-led strategy, which can offer comparable rates of return to direct private equity. We believe the loss ratios and volatility will be lower than in direct private equity investments and co-investments because of the alignment of interest and prior knowledge of the assets.

Ares Secondaries has been investing in the GP-led space for more than 10 years. However, the market is still relatively nascent in its maturation, and we believe that sometime between 2025 to 2030, we will see substantially greater capital flowing into this space. We have already seen some sophisticated LPs set up their own allocations and teams for GP-led transactions.

You mentioned alignment of interest – what are the most important steps to achieving this?

Transparency through the process is paramount, and GPs should share their plans with their investors at an early stage.

One fundamental question buyers need to ask is whether they are paying a reasonable price. If you are investing in great companies, you should not be relying on a huge discount for your return because the existing LPs will find that hard to accept. They also need to ask why the transaction is happening and diligence the quality of the manager – this is almost as important as the quality of the asset.

“We believe the loss ratios and volatility will be lower than in direct private equity investments”

Then there are terms such as new capital invested by the GP and carry roll-over, which is often about 90 percent of carry. Fee structures and tiered hurdles can also be used to improve alignment.

Overall, ensuring proper alignment of interest is critical and helps remove one of the biggest risks in investing: the unknowns. If you are investing in a continuation fund with GPs that are aligned with you, you are greatly reducing the number of unknowns because the GP has owned the assets for years and has deep familiarity.

How do you see the secondaries market evolving over the next five years?

We will continue to see LPs and GPs use the secondaries market as a liquidity tool. LP stakes will continue to grow at a healthy pace, particularly given the growth in the primary market over recent years. We believe the GP-led market is, and will be, a mega-trend because it provides a solution for GPs’ best assets that has long been sought.

However, secondaries players will need to guard against the possibility that GPs bring too many assets to the market. Sifting through to find the best opportunities with the strongest return potential will take resources, qualitative and quantitative due diligence and experience, all of which we bring to bear within the Ares Secondaries Group.

Nate Walton is head of private equity secondaries in the Ares Secondaries Group