EisnerAmper: The need for transparency in GP-led secondaries

Many LPs are being called on to make significant decisions about whether to hold or sell positions in older funds. EisnerAmper’s Robert Mirsky discusses the potential for conflict

This article is sponsored by EisnerAmper and first appeared in the December LP Perspectives 2019 special of sister publication Private Equity International.

Sponsor-led (or GP-led) secondary deals – which see GPs roll over assets with potential future upside into new funds, offering LPs either liquidity or a position in the new vehicle – are clearly here to stay. Last year saw a record $22 billion of completed GP-led secondary transactions globally, according to research by Lazard Freres, comfortably beating the previous high of $16 billion seen in 2017. And in 2019, we’ve already seen large numbers of GP-led transactions, including those led by blue-chip names, such as Ares Management, Oaktree Capital, PAI Partners, Warburg Pincus, Bridgepoint and Blackstone.

This is something of a turnaround: in the not-too-distant past, they were largely transactions of last resort, struck when there was misalignment or when other types of issues between LPs and GPs arose. Yet GP-led secondaries are now well-established tools for fund managers and their investors to find a way around some of the structural characteristics of the private equity closed-end fund. Today, they can help meet liquidity needs for investors at the end of a vehicle’s life, while offering those with longer horizons the opportunity to benefit from future value creation in a company or handful of companies that remain in the portfolio beyond the 10-year fund duration.

Yet, given their complexity, these deals can throw up an array of conflicts of interest and tax issues for all concerned. We spoke to Robert Mirsky, principal and head of the asset management group at EisnerAmper, to discuss the issues that can emerge and how LPs can gain comfort they are striking a good deal.

Why do you think we’ve seen such an increase in GP-led secondaries?

Robert Mirsky

They have increased exponentially and I think this is because, when managed and structured well, they can be a win-win-win for the parties involved – the GPs, the existing investors and the new investors. Historically, GP-led secondaries tended to be used in situations where there was a misalignment of interests between the LPs and the GP, but we’ve now seen many of these deals executed successfully and so there are now significantly more investors actively seeking out opportunities in this space.

However, I would caution that this is not a solution that suits all scenarios that can arise. Sometimes, it may be better to seek a fund extension or directly sell a stake, particularly if you only have a small minority of investors seeking liquidity.

Yet these deals can throw up issues around how assets are valued, can’t they?

Yes, which is why there has to be transparency around these types of deal to ensure all parties are satisfied that an appropriate valuation has been arrived at. There are four constituent parties to this – the existing LPs that want liquidity, existing LPs that want to roll over, the new investors and the financial sponsors. Each of these has a different interest and incentive on valuations – leaving LPs will want maximum value, new investors want an attractive price and so on. Valuations are at the heart of these deals because if they are not arrived at reasonably and fairly, either the deal doesn’t get done or there is a risk of being sued further down the line. So, not only should there be a valuation carried out by the GP, one by the secondary buyer and one by existing LPs, there also needs to be one done by an independent party to give comfort that a fair price is being paid.

To what extent are independent valuations now a standard part of the process?

There is now an acceptance that independent valuations are necessary. After all, these are free market transactions and the independent work can act as a bridge between the various LP valuations and that of the GP. It gives comfort that someone outside of all the parties, with no interest in the deal, has come to a reasonable view based on the available information. It’s not quite standard practice, but it is good practice.

ILPA issued guidance on these deals earlier this year – how is that affecting processes?

The Institutional Limited Partners Association has taken the stance of providing best practice guidelines for GP-led fund restructurings and, while some of it may seem like common sense, it is really helpful to have the process set out clearly. ILPA took the starting point of looking at how these transactions were running and asked the question of what the appropriate standard should be as far as how valuations should be reached, how to ensure full transparency and how to avoid conflicts of interest. It recommends, for example, that LP advisory committees should be involved, third-party valuations be used and sets out the information that needs to be shared and a timeline. It also offers guidance on how fees should be apportioned so that whoever benefits from the transaction should pay part of the fees.

These guidelines are increasingly being used and they are helping to standardise transactions around good practice. Previously, there was a dichotomy between deals being done in the US and those in Europe. It was already fairly standard in the US; in Europe, however, there was much more variation in terms of information provided, timelines, etc. There had been instances, for example, where LPs were given just a week to decide whether they wanted to sell or roll over – that’s not a reasonable amount of time. The guidance means that transactions in Europe are now more consistent with what we were seeing in the US.

So, under which circumstances would you say GP-led deals are most appropriate?

These deals are best suited to situations where a fund is reaching, or has reached, the end of its life, yet there is an asset or a few assets that still have growth to go and have the potential to generate significantly more value over the coming years. You need investors that want to benefit from the upside and roll over their stake and you need new investors that are interested in buying out the positions of existing LPs that need liquidity. And, of course, you need a GP with a clear plan for how to maximise the value creation potential in the business.

These can be extremely effective transactions and are proving to be very attractive for LPs with longer time horizons that prefer to be able to benefit from upside than seeing the GP forced to sell assets – that can end in fire sales of businesses. Some sovereign wealth funds, for example, have a time horizon of 100 or more years and so they don’t need their money back after 10 years; if they keep their holding for a further five years, it’s beneficial because it’s keeping their capital at work and enabling them to take advantage of further value addition.

Why do you think US transactions were previously more standard than those in Europe?

Many US GPs were already inadvertently following what has now been recommended by ILPA in large part because the Securities and Exchange Commission had been watching these deals for several years. There have been instances where the SEC has issued fines and investigated instances alleged violation of reasonable standards or where full disclosure had not been made to LPs – I think the threat of SEC enforcement helped raise the standards in the US before ILPA issued its guidance.

ILPA has some recommendations around advisory appointments – how do these help?

Let’s take the valuation issue as an example. GPs obviously owe a fiduciary duty to the LPs in their original fund and need to maximise the value from the remaining assets, yet they are also incentivised to keep the valuation low so they can gain more upside from the new fund, where incentive structures will be reset – there’s a clear conflict between these two. Yet the biggest conflict here is that the only recourse an LP has if it is not satisfied with the price offered is not to sell.

ILPA recommends that an advisor to the fund (separate to that for the GP) be appointed to protect the interest of fund investors and that this should be in addition to the LP advisory committee’s advisors and those of the LPs. Clearly, this can be expensive, but the issue is that, unless reasonable steps are taken to protect all interests, it’s easy to see how you can arrive at an adversarial position.

There are other conflicts that can crop up, aren’t there?

Yes – tax is a big issue here because not all investors are created equal. The tax implications of selling or rolling over into the new fund will be different for a US investor, from those for a UK investor. US investors are subject to tax on worldwide income and may be subject to withholding tax, for example, and you have to ensure that you are not prejudicing one investor over another. Existing LPs in particular will need to consider whether there is a recognition event if they sell or roll over and they need to be aware that these deals can have significant tax consequences for original investors if they are not structured well. These are complex transactions and you have to understand the whole picture to structure them appropriately.

How do you see this part of the market developing over the future?

We will see a continuation of the trend towards a greater standardisation of the way in which GP-led fund restructurings are undertaken – the ILPA guidance is a great start in this regard. In the US, regulators will continue to watch closely, but the question is whether the European regulators may also become more involved. If we see one or more transactions go wrong, that may happen.

Overall, I see tremendous opportunity in the future and I expect the growth in volume and value to persist, especially given that the expected IRR in these deals is around the 15 percent mark.

If we see a recession over the coming years, these deals will come even more into their own because they will be a more attractive proposition than a fire sale. There’s so much liquidity around this part of the market, selling LPs may well generate higher returns through GP-led secondaries’ even at a discount. If a quarter to a third of secondaries are currently GP-led, I’d expect that to move to closer to 50 percent over the next five years. That’s significant growth when you take into account the amount of capital that has been raised over recent years – we’re in the baby-boomer phase of private equity.