This article appears as part of affiliate title Private Equity International‘s March GP-led Secondaries Special Report.
As GP-led secondaries continue to gather popularity as a tool in the sponsor’s arsenal, pressure is building on lawyers to ease some of the legal sticking points that make deals so complex to execute.
GP-led continuation funds combine some of the most challenging aspects of mergers and acquisitions with the complexities of fund structuring. They are also typically beset by tricky conflicts of interest as GPs negotiate selling stakes from one of their funds to another, bringing some – but not all – limited partners along, while inviting in new investors.
Still, despite the challenges, more and more sponsors are lining up to do these deals. GP-led secondaries deal volume hit $63 billion globally in 2021, according to Lazard’s Sponsor-led Secondary Market Report, up from $30 billion in 2020. The growth of GP-led deals has significantly outpaced LP-led secondaries over the past five years, with deal volumes roughly equal for both parts of the market in 2021, compared with 2016 when GP-led deals represented less than one-third of the market.
With continuation funds increasingly on the table as an alternative exit route for managers, some LPs are raising concerns with GPs at the point of fundraising and seeking terms in fund agreements that acknowledge that a GP-led secondaries transaction may be on the cards further down the line.
Mary Lavelle, a partner in the investment management practice at law firm Akin Gump Strauss Hauer & Feld, says: “We are definitely seeing more GP-led clauses and I think they will eventually become commonplace. It makes sense, given the increasing number of transactions happening and given they are relatively new.
“If you’re signing up to a fund today that has a 10-year duration or more, it has to be possible there will be an exit solution down the line. It seems sensible to have something governing how that will happen, so the GP has some reassurance on how it will go about doing a GP-led and a prescribed procedure around the levels of consent required. The LPs also get to negotiate how that should work, including things like minimum timeframes of notice for LPs, pricing procedures and information rights, to get a process they are happy with.”
No two deals the same
The problem is that these deals are all different and market practice is changing rapidly, so both sides can be wary of signing up to clauses for transactions that could be a long way off. The types of transactions being executed are also evolving; single-asset processes, for example, have rapidly emerged as the most popular type of GP-led deal in the past 12 months and now represent 52 percent of sponsor-led deals, according to Lazard. In 2020, single-asset deals accounted for 38 percent of total transaction volume, roughly on a par with multi-asset continuation funds, which dropped to 31 percent of the total in 2021.
While everyone would like the process for completing GP-led transactions to be more straightforward and agreed up front, it is the fact that every continuation fund deal is unique that makes standard terms hard to draft in the limited partnership agreement.
John Rife, a partner in the funds practice at law firm Debevoise & Plimpton, says: “These deals continue to be very fact and circumstances specific, and I have yet to work on a continuation vehicle transaction where you could look at some other continuation vehicle and do the same thing.
“The underlying asset or assets are different in every transaction, the tax and structuring considerations are different, and the micro and macroeconomic positions are different every time a sponsor looks to do one of these. That means trying to include a provision in a fund agreement that facilitates one of these deals being done on pre-agreed terms 10 years out creates a lot of challenges for everybody, with no real benefit.
“The likelihood of being able to specify in a fund agreement something that actually works seamlessly 10 years from now is basically impossible.”
Instead, Rife argues that most GPs are currently focused on removing roadblocks to these deals from their fund agreements, rather than setting out how a deal ought to be done. For example, tax structuring can be done upfront to allow for a tax-neutral rollover rather than a taxable event for LPs. Similarly, most fund agreements do not allow transaction-related expenses to be borne by some LPs and not others, so it might be useful to put in place terms saying the fees incurred on a GP-led transaction can only be borne by the LPs that are cashing out.
“Strategically, I think it’s better to keep the conversation around the LPA focused on how you approach conflicts broadly, rather than on getting into the specifics of GP-leds. You want the LPA not to prevent or stand in the way of one of these transactions, but to attempt to prescriptively describe how one would happen is difficult,” says Rife.
Nigel van Zyl, a partner in the private funds group at law firm Proskauer, agrees that most GPs are focusing on smoothing the route for GP-led transactions rather than providing a roadmap: “GPs are really thinking about their general LPA provisions around conflicted transactions and the consents required. There is a focus on how those work so that they can be relied on to help navigate the conflict issues on a continuation fund transaction, should one arise.”
From an LP perspective, he adds: “We are seeing more focus by some investors when they are investing into a new fund on looking at those provisions to understand how they would be impacted by a continuation fund. There are sometimes asks from investors to try to legislate for what the terms of their participation would be in a continuation fund as an existing investor in the selling fund, but that’s actually quite hard to legislate for.”
Nash Waterman, head of the AIP private markets secondaries team at Morgan Stanley Investment Management, says that LPs want reassurance around these processes and are having to increase resources to address opportunities. “We are at a point now where LPs have accepted these as a reality,” he says. “Every LP sees them differently, but the one constant thing that those groups are figuring out is which bucket they want to fall into in the event that there is a continuation fund.
“Many LPs are building out this capability and, while they develop their teams and investment programmes, are looking for experienced partners to evaluate these deals with them. A lot of large investors are very sophisticated and recognise this need, but the need has intensified so quickly that they are sometimes playing catch-up.”
Meanwhile, the number of sponsors bringing these deals to market continues to rise as managers recognise an opportunity to hold on to assets that they like for longer.
“Almost every GP that we speak to will bring up these deals and tell a story of when they were forced to sell an asset to a competitor because they reached the end of their hold period, and that competitor went on to make a lot more money,” says Waterman.
“Continuation funds give the private equity house the ability to produce even better returns by getting the duration it needs.”
That ability to swerve the secondary or tertiary buyout route and hold on to an asset for longer has fuelled the growth in single-asset transactions, building on the success of the sponsor-led portfolio deal. Many LPs will welcome the chance to participate in reinvestment processes, while others will want to crystallise returns and sell out. Offering investors that liquidity option is another big plus for these transactions.
Waterman argues that LPAs will eventually include provisions to make continuation fund transactions easier, and to reassure LPs.
He says: “There’s a handful of groups now that control a large amount of capital in private equity, so they have a strong edge in dictating terms, which keeps them from being forced to make changes that LPs might want to see on continuation funds.”
Emerging market practice
In the meantime, common market practice is developing on how processes should be run and what existing LPs should be offered.
“There is a bit of a difference between the US and Europe on that, probably driven by the level of oversight by the regulators in the US of these transactions,” van Zyl says. “In the US, your starting point is that you have to offer existing investors a status quo option, for example, allowing them to continue to participate in assets on the same basis that they were prior to the transaction happening. There are a number of European transactions where that hasn’t tended to be the case, and there are plenty of justifications for that.
“But the market is evolving and developing, and there is definitely a broad framework emerging of what is market practice.”
The Institutional Limited Partners Association has published its own guidance on GP-led processes, recognising that its principles will not be appropriate for every deal but aiming to provide general parameters for well-run processes.
“There is certainly scope for standardisation, and we have seen more of that in North America than in Europe,” says Rife. “There is scope to standardise things like the disclosure materials being made available to existing LPs and the way the transaction is described in those, so that LPs can compare two deals on an apples-to-apples basis.
“Everyone would benefit from more standardisation in that regard in Europe: existing LPs would like to know there’s a standard approach to disclosure, and [for] new [investors] there’s comfort in knowing that sponsor X is behaving in the same way as sponsor Y with respect to its existing LP base. GPs also want to know they are doing things the same way as others in the market.”
There can be significant variations within the European market, with a German GP pursuing an entirely different route to a UK GP, for example. However, Rife says the industry will soon harmonise around a more consistent approach. “What’s helpful is that new money investors tend to be global secondaries funds doing deals all over Europe, the US and Asia, and they hold sponsors to pretty high standards on these transactions,” he adds.
While LPs may have to wait some time for specific terms in their fund agreements, they can look forward to more clarity around the way processes should work as deals become more commonplace.