This article is sponsored by Evercore and appears in affiliate title Private Equity International’s GP-led Secondaries Special.
2020 year in review
It is clear from the stream of headlines that the secondary market, once a ‘cottage industry’, is now a featured performer on the main stage of the alternatives world. While overall secondary market volumes declined by 25 percent in 2020, primarily due to disruptions caused by the covid-19 pandemic, the acceleration of GP-led secondary transactions continued to reshape the market landscape. GP-led secondary volume grew 23 percent year-on-year, equating to an impressive 41 percent CAGR since 2012. What is less obvious in the statistics is the innovation underlying such growth, with market participants expanding the application of capital to provide bespoke solutions to financial sponsors, and their investors and portfolio companies.
Although the secondary investment thesis has broadly remained consistent over the years – defined by a focus on sponsor/asset quality and alignment of interests – the current trend relates to the evolution of the secondary attachment point. The historical buy-side entry points were predominantly the acquisition of limited partnership interests in funds and, to a lesser extent, bank spinouts and end-of-life fund restructurings. Today, a flexible application of secondary capital has improved the attractiveness of GP-led opportunities for a broadening universe of potential investors, and 2020 was the first year on record where overall volume was majority GP-led transactions.
There was also a surge of GP-led transactions involving a single portfolio company in 2020. These transactions provided secondary investors the ability to isolate covid-19 resilient portfolio companies in an uncertain environment, and capture organic and inorganic growth opportunities presented by market dislocations over an extended hold period. There is an expectation that these transactions have staying power in a post-covid world for companies with differentiated growth prospects and as GPs increasingly realise the benefit of retaining star assets.
Are GP-leds a market disruptor?
The GP-led market has the potential to disrupt the market for traditional private transactions. Marquee sponsors have flocked to the secondary market in recent years to facilitate various objectives, while mitigating the pain points of traditional private market transactions, including but not limited to:
- Refreshed alignment: bespoke transaction structures can re-align duration, investor bases (LPs and selectively direct shareholders), capital requirements, incentive plans and capital structures (if necessary);
- Investor optionality: unique transactions that create optionality for LPs that may have divergent views on realisation alternatives, investment horizon and the ability to support outsized capital requirements of certain portfolio companies;
- Portfolio management efficiency: ability to address fund/portfolio-wide objectives in a single process (eg, portfolio-level equity recapitalisation) as compared with multiple company-specific processes (eg, simultaneous company-level equity recapitaliations), which increase execution risk and resource strain;
- Management/board disruption: due diligence processes that typically rely heavily on the sponsor rather than management teams, thus allowing management teams to focus on day-to-day operations and value creation initiatives. In addition, secondary investors seek strong alignment with the sponsor as compared with a direct investor that is likely to reset governance terms and require board representation.
The runway for future market growth remains tremendous when considering the competitive advantages of GP-led deals versus traditional private market transactions, specifically:
- Sponsor-to-sponsor sales: sales of portfolio companies from one financial sponsor to another have increased significantly, and are estimated to have consistently exceeded $100 billion in annual value since 2014. This trend is a natural product of the maturation of the alternatives sector and the expansion in available private equity dry powder. Select investors are critical of these transactions, citing the high friction costs for LPs that are investors in both the selling and buying funds;
- Minority equity sales: monetisation events whereby sponsors sell minority equity interests in portfolio companies to family offices, public pensions and sovereign wealth funds, among others, have become increasingly popular as a means to crystallise unrealised value. Sponsors often agonise over management team distraction in sell-side processes (resulting in potential lost growth), changes to board/governance dynamics, and in some instances minimum return and holding period protections provided to new investors;
- Fund-to-fund sales: there have long been opposing views when a sponsor sells a portfolio company from an older vintage fund to a newer vintage. Various conflicts of interests arise in these transactions; in many cases, however, sponsors and their new fund investors have been rewarded handsomely for doubling-down on their ‘winners’, while old fund investors do not typically have an option to participate and are subjected to capped upside (and downside);
- Long-dated funds: proponents of long-dated ‘core’ funds tout the concept as being the best solution to the duration mismatch and high friction costs associated with traditional 10-year fund structures. While the concept in theory addresses these issues, such fund structures have generally been slow to gain traction, absent select examples. Many sponsors have astutely highlighted the key issue – accurately selecting a subset of new investment opportunities as outsized ‘winners’ without a multiple-year history of ownership and collaboration with management teams is a challenging task.
Record volume and quality of GP-led opportunities in 2020 exemplify the ‘all-weather’ adaptability of these flexible solutions. Continued innovation further enhanced the application of one of the newest alternatives in sponsors’ toolkits. 2021 and beyond are ripe for GP-led transactions to evolve and gain market share from the traditional private market transaction types.
Nigel Dawn is a senior managing director and head of Evercore’s Private Capital Advisory group; Ryan Rohloff is a managing director in Evercore’s Private Capital Advisory group.