When Secondaries Investor asked secondaries market participants in December for their predictions for the coming year, no one mentioned a health pandemic shutting down global economies and plunging the stock market into bear territory.
The overwhelming consensus was that very little could threaten the growth of this fast-growing sub-sector.
As of mid-March, the situation of course is very different, with many transatlantic flights suspended and various European countries closing borders and restricting movement to stem the spread of covid-19.
Manager-initiated secondaries processes, commonly referred to as GP-led secondaries, continued to grow last year. Such deals accounted for an estimated $26 billion out of total secondaries deal volume of $80 billion in 2019, according to Evercore. This is equivalent to 32 percent, up from 28 percent the previous year.
Greenhill also put the volume of GP-led deals at $26 billion. Because it put total secondaries deal volume for 2019 at $88 billion, this represents a decline as a proportion of the total to 30 percent from 32 percent in 2018.
The rapid rise of this part of the market has naturally attracted many participants keen to grab a piece of the action. Some secondaries firms have oriented themselves solely towards GP-led processes, such as ICG’s strategic equity team. Lexington Partners, which raised $14 billion for its latest secondaries fund in January, says it expects the vehicle to benefit from the growth in GP-led dealflow. Below, we examine several other factors that threaten its long-term growth.
Travel bans have made company-level due diligence almost impossible, leading to increasing numbers of stalled GP-led processes, Secondaries Investor understands after having spoken to around a dozen market sources last week. GPs are still trying to figure out how a decline in public markets caused by the crisis and last week’s drop in oil prices will impact valuations.
“Any business that has some kind of supply chain or has short-term liquidity requirements is going to suffer,” says one non-traditional buyer based in London.
The threat from covid-19 will be particularly acute for the growth of the single-asset restructuring market, which doubled to a $5 billion market last year, according to Evercore. Such deals tend to be large and represent concentration risk that secondaries buyers previously would not have accepted. With larger funds, secondaries buyers have come to tolerate the concentration of a single asset because it does not pose as great a concentration risk.
In light of the coronavirus pandemic, these processes may have a harder time in the market without steep discounts on pricing.
“If they [buyers and sellers] haven’t signed, I would assume there are some discussions around pricing” on single-asset processes in market, a secondaries buyer told sister publication Buyouts.
Wider range of holding options for GPs
GPs have been increasingly using a range of tools such as long-hold funds and fund to fund transactions – sometimes in the form of rollover co-investments – to hold onto assets. Such options can give liquidity to LPs while allowing GPs to maintain exposure to prized assets. In recent years, EQT, Nordic Capital and BC Partners have all either re-invested in companies they have sold or used partial exits to achieve this. Could the plethora of options available to GPs eat into the GP-led secondaries market’s dealflow? Unlikely, says Jeff Keay, a managing director at HarbourVest Partners. GPs using an existing fund to acquire an asset from an older fund may be appropriate when a single company is involved, but when a GP wants to deliver liquidity to LPs for multiple assets, fund to fund transactions do not make sense.
“That new pool of capital they’re managing was created to do single deals, not portfolio deals, regardless of who the seller is,” says Keay. “As a GP, if you head down that avenue of looking at portfolios of deals, you’ve now opened yourself up to potentially a bit of criticism from LPs [who could say] this is not what I thought you were going to use my money for.”
Others point out that fund to fund transactions and rollover co-investments remain a small part of the private equity market and do not pose a credible threat to GP-led secondaries dealflow.
As for long-hold funds, these vehicles represent a small part of the market and are yet to pose a serious threat to GP-led dealflow, says Tjarko Hektor, founder of secondaries firm New 2ND Capital. Even if long-hold funds one day come to represent two-thirds of all private equity capital raising, there would still be LPs in those funds who would want liquidity via a secondaries process, adds Keay.
One of the biggest threats to the GP-led market comes from the market itself. A marquee deal that ends up underperforming could spook the market.
“Twenty-four to 36 months ago, the default investor position was scepticism if a GP came forward to suggest a GP-led fund transaction,” says Chris Good, a partner at law firm Macfarlanes.
“Now people are much more comfortable about processes and diligence; it is felt that there is a right and a wrong way to do these transactions, and now investors back themselves to spot the difference.”
The speed with which the market has developed means it could take just one blue-chip deal performing poorly for investors to wonder if GP-leds are really such a good idea. “Investors might say, ‘Why did you want extra time to develop this investment when actually we should have just got out of this position a while ago?’ And did the business plan set out at the time of the GP-led transaction actually translate into practice? It’s also been a distraction to this GP who should have been finding another set of assets to invest and build,” Good says.
Equally, a deal involving a well-known blue-chip GP that ends up performing spectacularly for secondaries investors may sow discontent among LPs who had originally chosen to sell their exposure and now wish they hadn’t. In theory, a regulator could come down on a GP-led deal it deems did not treat investors fairly and would focus on whether best practices were undertaken. As such, transparency of information and offering LPs genuine options is crucial, says Keay.
One of the fastest growing sub-sectors of the GP-led market is single-asset restructurings. In such deals, a sole or prized portfolio company is lifted out of an existing fund into a continuation vehicle that is managed by the same GP.
Although there may be plenty of supply, the buyside is capital constrained, resulting in hampered growth, say market sources. At PEI’s CFOs & COOs Forum in January, one secondaries buyer noted that their own fund documents prohibit any one asset from comprising more than 5 percent of the fund. Investors in secondaries funds want “diversification – not concentrated bets”, the buyer added.
According to Nigel Dawn, global head of Evercore’s private capital advisory unit, higher concentrations of assets in secondaries funds could force LPs to re-evaluate the role secondaries funds play in their portfolios. “Traditionally, the secondary market has delivered highly diversified exposure to the private equity market, but recent developments have meant more concentrated exposure to fewer assets,” Dawn says. A $10 billion secondaries fund that allows as much as 3 percent of its capital to be in one company may find it has $300 million of exposure to one asset. “That is actually a lot of exposure to one company,” Dawn notes. Such developments are changing the risk dynamics of the secondaries market in a way that some investors may not welcome, he adds.
LPs in secondaries funds that invest in single-asset deals may also come to take issue with fees charged. A number of LPs co-invest directly in companies with their GPs on a no-fee no-carry basis, and some may be sceptical of the idea of paying a secondaries manager and underlying GP fees and carry for exposure to a single asset via a continuation vehicle structure, says Philip Tsai, global head of secondary market advisory at UBS.
Transaction levels for secondaries overall and GP-led deals in particular will likely be down this year amid the coronavirus outbreak and its effects on global economies, with one London-based buyer at a non-traditional institution telling Secondaries Investor deal volume could drop to $50 billion overall this year.
Still, the GP-led market exists to service a need, says Pal Ristvedt, a partner at Lexington. Amid dips in some transactions, the dynamics in the wider private equity market mean secondaries funds – and their investors – are likely to see dealflow for some years to come.
– Rod James and Chris Witkowsky contributed to this report.