This article is sponsored by Evercore.
The GP-led secondaries market continues to perform strongly, despite the challenging macro environment. Temporary capacity constraints in the market, along with pricing pinch points, may pose hurdles, but few doubt that GP-led deals are set for further growth.
Alex Longden and Fred Stonell, managing directors in Evercore’s Private Capital Advisory group, say the future is bright for the GP-led market – providing that the needs of all constituents are catered for.
What explains the overall strength of the GP-led secondaries market?
Alex Longden: The GP-led market to date has provided GPs with creative solutions to solve for multiple objectives, while at the same time offering a great outcome for all transaction constituents.
Examples of these objectives might be needing more time to hold an asset, more capital to support future growth, or the desire to return liquidity to investors at strong returns. GP-led secondaries are the tool that allow GPs to simultaneously achieve all these objectives and thereby create win-win situations. An important caveat to note is that a well-run and transparent process is critical to achieving a positive outcome.
Over the past few years, we’ve seen more and more GPs wanting to back their best assets in an ever more challenging primary environment, and benefit from additional time and capital to capitalise on the next leg of the journey.
Liquidity has been, and is expected to remain, a critical priority for LPs in today’s market. As a result, we are seeing LPs welcoming optional distributions at attractive returns provided through GP-led transactions, while at the same time also being granted the opportunity to remain invested in the best assets with their core GP relationships.
To what extent is the market for GP-led deals held back by capacity constraints?
Fred Stonell: We have seen tremendous growth in the GP-led market over the past five years, and we expect that trend to continue. However, last year was probably the first time that we saw capacity constraints for GP-led transactions, notably for single assets. The uncertain macro backdrop, coupled with the volatile valuation environment, meant that most secondaries investors were more cautious around deploying or making sizeable bets on concentrated deals.
Despite GP-led transaction volumes being down – $48 billion in 2022, down from $68 billion in 2021 – the actual opportunity set that buyers evaluated was higher. Buyers saw more deals and higher volumes, but not all these deals closed, reflecting the high bar for GP-led transactions.
In addition, the wider slowdown in M&A activity, coupled with the ‘denominator effect’ that LPs are experiencing, led to an increase in the proportion of LPs that opted to take liquidity on GP-led transactions. This in turn increased the quantum of capital that needed to be raised from secondaries investors and syndicates, putting further pressure on the supply of capital.
How can these capacity constraints be overcome?
FS: While we did see capacity constraints for GP-led deals in 2022, I do think this supply-demand imbalance will equalise over time. Incumbent secondaries players are raising larger funds and have already, or are starting to, raise separate pockets of capital to increase their fire power for GP-led deals. This trend is expected to continue as an increasing number of GPs turn to the secondaries market to explore liquidity solutions. In turn, I expect the quantum of commitments raised in these vehicles will grow with the market.
We are also expecting to see new players enter the market as traditional private equity firms establish GP-led focused strategies. This is in part due to star assets, which GPs may have historically had the opportunity to acquire through traditional M&A channels, no longer coming to market. To gain exposure to these assets, GPs need to raise dedicated pockets of secondaries capital to participate.
Meanwhile, an increasing number of ‘primary’ investors – family offices, pension funds, sovereign wealth funds and the like – are starting to deploy directly in GP-led deals as syndicate investors. The potential pool of syndicate investors is vast and participation rates across LPs are increasing.
Finally, LPs are starting to become more accustomed to evaluating reinvestment decisions on continuation fund transactions. This will further expand the potential pool of capital to fund these deals.
How do opportunities around GP-leds feature during fundraising?
AL: The fundraising market in today’s environment is more challenging than it was 12-24 months ago. As a result, we are seeing an increasing number of GPs exploring GP-led transactions as a means to offer liquidity to LPs, which can be recycled into new commitments.
“From a buyer’s perspective it is critical to ensure alignment with the GP for the next leg of the journey”
In today’s market where some GP-led transactions are syndicated, GPs offer such transactions to strategic LPs, both existing and new. Clearly, it remains critical to have a sizeable and reputable lead investor. However, GPs also often want to make sure that syndicate investors with primary pockets can also participate in the transaction. For some LPs, GP-led transactions are an interesting way to get access to a new strong-performing manager.
Lastly, it’s worth bearing in mind that in selling strong-performing assets at attractive returns into a continuation fund, GPs are enhancing their realised track record and delivering a strong outcome for their LPs. Both of which are generally contributing to a successful fundraising.
How can pricing challenges in the market be addressed?
FS: Pricing was a big topic last year, underpinned by the perception that private valuation marks did not reflect the sell-off witnessed in public markets. This naturally created pressure around pricing, resulting in a widened bid-ask spread.
In 2022, we saw a marginal increase in the number of single-asset transactions that involved GPs selling a minority or co-control stake in the asset to a new sponsor. This served as a tool to anchor the price for the continuation fund, offering an alternative pricing mechanism to a traditional secondaries auction process, which is still the predominant method to establish price in continuation fund transactions.
“LPs are starting to become more accustomed to evaluating reinvestment decisions on continuation fund transactions”
While secondaries investors have become increasingly diligent in their assessment of valuation, they ultimately build their strongest conviction through creating strong alignment of interest with the sponsor. This could be achieved through a substantial re-investment of carry and/or GP commitment proceeds crystallised through the transaction, or through the GP committing fresh new capital to the continuation fund.
In addition, GPs can further enhance alignment by making a new investment through their latest flagship fund. Buyers like this dynamic because the GP is ultimately putting its track record on the line at the same entry valuation, demonstrating strong conviction that the asset(s) will deliver on the business plan and forecast return.
Finally, the secondaries market is capitalised by a very flexible pool of capital. When there are pricing pinch points, there are options and structuring alternatives that can help bridge these valuation gaps. This includes mechanisms such as preferred equity solutions, deferred payment structures and earn-outs.
What else is needed to ensure that alignment exists between all parties during GP-led deals?
AL: This is where it is critical to have the right adviser on board to guide a GP on the optimum process to deliver a successful outcome to all constituents.
First and foremost, GPs have a fiduciary duty to their LPs and, as such, it is critical to ensure a competitive process has been run to deliver a maximised price. There are alternatives to delivering a maximising price, for example through the minority sale in the asset to another sponsor. We have found it extremely important to ensure LPs are kept abreast of developments throughout the transaction process and are also given sufficient time to make informed decisions. This is an area that we spend a lot of time on with our GPs to ensure they receive the support of their LPs.
From a buyer’s perspective it is critical to ensure alignment with the GP for the next leg of the journey. As a result, we see strong GP commitments – in the context of any proceeds that are crystallised through the transaction – as crucial to demonstrating alignment. Buyers also seek to ensure an appropriate incentive structure (ie, carried interest) is put in place to maximise the future performance of the transaction.
Carefully crafting a process that caters to all of the above ensures all constituents view the outcome of a GP-led process as a win-win.
What are the key practices that will evolve as the market grows?
FS: I have no doubt that the profile of the GP-led market will continue to evolve as sponsor participation grows and the investor universe expands. One area that will be particularly interesting to observe is whether there will be a convergence of the GP-led single-asset market and the co-investment market over time. Currently, there is a wide universe of investors actively making co-investments that do not participate in single-asset transactions. As the opportunity set continues to evolve and the GP-led product becomes even more mainstream, this may change, and in turn increase the pool of capital available and the size of assets the secondaries market can absorb.
Secondary to this is the increasing sophistication of investor due diligence. As the market becomes increasingly competitive, investors will need to identify value where others can’t, and ultimately that will materialise through more in-depth due diligence. Third-party commercial and financial due diligence is now considered standard as part of GP-led transactions, and I expect the gap in due diligence requirements between traditional M&A and secondaries processes will continue to narrow.
Finally, a new development that is becoming increasingly common is the presence of warranty and indemnity insurance on GP-led transactions, with an increasing number of insurers and brokers now offering highly bespoke insurance solutions. This is a trend that I expect to continue to gain momentum and become a common feature of transaction processes.