GPs take command in secondaries, says Schroder Adveq

GPs are no longer spectators in secondaries transactions, which provides opportunities for investors, says Christiaan van der Kam, head of secondaries at the firm.

This article is sponsored by Schroder Adveq and appears in the March GP-led Secondaries Special Report by affiliate title Private Equity International.

What trends did you see in terms of GP-led activity in 2020, compared with the traditional LP market?

The secondaries market had an extraordinary 2020, as did many other markets. Certain trends that had started pre-covid were accelerated, with the GP-led market seeing continued strong growth. The overall secondaries market today is unrecognisable from a decade ago in terms of size, and sophistication. It is no longer dominated by LP portfolio transactions as it was until a few years ago, when GP-led deals were the exception to the rule and GPs were merely spectators.

Based on initial statistics for 2020, the market closed on around $65 billion-$70 billion of total volume versus $90 billion in 2019. This reduction is clearly not surprising. What is surprising is that the market closed on $35 billion of GP-led volume and most of that happened in the second half of the year.

In the first half of the year GPs were on the defensive looking to support their portfolio companies by raising liquidity at the fund level with preferred equity and NAV-based lending solutions. In H2 2020, GPs went on the offensive and we never saw the GP-led market so alive. We closed on several attractive GP-led transactions during this time. Most of these transactions were in the form of asset-based deals, involving attractive companies, with GPs looking to create liquidity for existing investors during a time when the capital markets were closed for exits.

What were the main drivers for GP-led transactions, and how will those trends evolve this year?

One clear theme was a flight-to-quality with many high-quality GPs going down the GP-led path for the first time and doubling down on their best companies, in particular through single-asset transactions. The market saw many single asset GP-led transactions in 2020 and we expect more of such transactions in the coming year.

Clearly GPs and advisors selected the better companies for GP-led processes: assets that performed well through covid-19 and which secondaries investors would be able to underwrite. Most GP-led transactions that closed in 2020 were with solid companies managed by good-quality GPs, which is a very different dynamic to the early days of the GP-led market when such transactions typically involved lower-quality companies. We think this flight to quality has created a tremendous market opportunity for secondaries investors.

Certain sectors were clearly of more interest, including healthcare, technology and consumer goods. These sectors performed well through the pandemic and continue to attract a lot of interest. Starting the new year, still in the midst of covid-19, we see a lot of high-quality GP-led dealflow and we expect 2021 to be very busy as well.

Another trend has been deal concentration. Normally, the secondaries market loves diversification, acquiring diversified cashflows through large LP portfolios. The pandemic has pushed the market towards more concentration with many GP-led transactions involving single companies or two, three companies.

This requires a very different investment approach versus underwriting diversified LP portfolios. In our view, concentration favours investors that have an active co-investment or direct investment platform, which can apply the same direct style underwriting approach. We expect this concentration to continue and certainly do not shy away from it.

In today’s environment it is much easier for investors to underwrite concentrated portfolios that perform well through covid-19 than, say, 10-20 companies of which the majority are struggling or where it is still unclear how they are going to come out of the pandemic. The solution is to focus on the better companies – we think those transactions are the ones that will continue to gain traction as underwriting uncertainty continues for at least one to two years.

In terms of GP motivation, besides obvious reasons to reinvest carry dollars in their best assets, the main driver today is to create further runway for their portfolio companies in lieu of exits. In some cases, there is also a need to raise growth capital when the fund is fully committed. Due to the pandemic, there are opportunities to do add-on acquisitions at attractive valuations and create further value going forward. And then there are still the older funds with a few assets remaining that face duration issues.

With GPs now in the driver’s seat in the secondaries market, what does that mean for secondaries investors?

Generally speaking, all secondary investors need to flip a switch in terms of investment approach and asset due diligence. The underwriting of GP-led transactions is very different from traditional LP transactions. Most of the larger secondary investors have become very successful by acquiring LP portfolios out of the global financial crisis and time will tell whether those same groups are as well-equipped at doing GP-led deals. We are truly co-underwriting companies, in many ways, with the GP as the existing owner of the asset. GP-led underwriting is much closer to direct investing than traditional LP investing. This is a more complex and dynamic process to say the least.

Next to the complexities of underwriting GP-led transactions, secondaries investors also need to position themselves differently towards GPs to access the best transactions. In our view, having an active primary and co-investment investment programme is a key differentiator as an investor at the lower end of the secondaries market.

We have over 400 GP relationships at the lower end of the market, and even if we are not invested with all of them, we talk to them continuously about their portfolio companies. This is also helpful when they start a GP-led process.

Intermediaries are running these processes and they will reach out to those investors that are best placed to pursue the transaction. We are not seeing every deal, but we are certainly seeing the ones where we already have an existing GP relationship, and that is particularly relevant at the lower end of the mid-market.

As single-asset GP-leds blur the lines between secondaries and co-investments, what should investors be focusing on in those deals?

We are big fans of single-asset transactions, both as co-investments and secondaries. There are a lot of similarities, and we approach them in the same way in terms of underwriting. Due diligence is key from this perspective. Over the years we have developed a focus on our preferred sectors, and having that expertise is very helpful to understand the ins and outs of a specific industry.

While the lines are blurring between co-investments and single-asset GP-leds, there are obvious differences, not least because as a secondary you are talking about an asset the GP already owns. This obviously is helpful in terms of due diligence.

Furthermore, process and alignment are different. In a single-asset restructuring the lead secondary investors negotiate terms with the GP, unlike in co-investments. Typically, the terms are set to incentivise the GP to sell the asset sooner rather than later with various tiered waterfall structures.

The process is also different, with an advisor involved to tackle the various conflicts and make sure the existing LPs are treated correctly and the highest price is reached.

For Schroder Adveq the quality of the asset is the most important thing and that goes for co-investments as well as single-asset GP-leds. You are entering into a partnership for a number of years so having the right relationship with the GP is critical too.

Being able to shape a transaction along with the GP is important when it comes to GP-leds and setting the incentives correctly is key. You want to understand what is driving the GP – whether it is to create value or to generate carry in lieu of an exit – and if it is a GP you know well, that is easier. We always walk away from GP-led transactions when we are not comfortable with the LP-GP alignment.

How far could growth in the GP-led market go?

Two years ago, few would have believed GP-led deals might eclipse LP transactions by volume. In the short term, the secondaries market will be a 50:50 market in terms of GP-led versus LP transactions. In the longer term, I do not see any reason why GP-led deals should not eclipse traditional LP deal volume on an ongoing basis, as it did in 2020.

As more GPs become aware of the attractiveness of running a GP-led process, and as secondaries investors become more sophisticated, the possibilities continue to expand. GP-leds are inherently more attractive deals precisely because of the GP involvement. One of the main risks in investing comes from information asymmetry, and that risk is reduced where the GP has owned the asset and known it for years. The GP knows the market
it operates in, is aware of any business issues and understands the management team, which is attractive for new LPs.

We could easily see a $100 billion market in the next five years. Everyone is now picking their spots in the market. Schroder Adveq has always invested in the lower end of the market, both in terms of primaries and co-investments, and also GP-led secondaries.

We think that is going to be a good place to be in the coming years.

What opportunities do you see for GP-leds in the lower mid-market, and what additional challenges do smaller deals create?

Investing in the lower mid-market is our bread and butter. Schroder Adveq has been investing at this end of the market for decades in terms of both primaries and co-investing, so that experience is helpful when underwriting companies in secondaries. There is less competition for smaller GP-led deals, but that is not to say it is a more attractive market, just less efficient in terms of process and advisors, requiring a better handle on the right GPs.

We are comfortable playing in that space, and we believe there is going to be a lot more GP-led activity at this end of the market in the coming years, as GPs and advisors become more aware of this opportunity. There are more than 2,500 small mid-cap growth GPs globally, and a lot of them are yet to realise the benefits of GP-led transactions.

One of the challenges with smaller deals is the fact that advisors are inclined to focus on bigger transactions given that they are paid according to the size of deal, but at the same time there is a need for advisors to manage the GP-led process and help navigate all the conflicts at play.