Learning from failure

Recent failed restructurings have not been in vain: secondaries is an evolving industry and learning from its early missteps.

First-half deal activity may have slipped, but a shining light in the darkness is the GP-led space. Such deals rose to about 30 percent of the secondaries market from 20 percent a year earlier, according to Greenhill Cogent’s mid-year report.

Several GP-led processes have fizzled in recent months, the most recent being First Reserve’s failed restructuring on its 2006-vintage Fund XI. After speaking to several industry sources, here are three lessons and observations when aiming for a successful GP-led deal.

1. Public pensions can make the process bumpy

Fund restructurings are inherently more challenging when there’s a large, influential public institution in the mix. In the case of First Reserve, the California Public Employees’ Retirement System’s resistance to the proposed restructuring was enough to deter other LPs from selling their stakes. CalPERS wrote to First Reserve in the belief that a decision was being made “lacking the full picture,” said a spokesperson for the pension. “[It was] another example of of CalPERS’ efforts to hold private equity firms accountable.”

2. Public exposure can make things awkward

It’s a Catch-22 scenario … well almost: candidates for fund restructurings tend to be more mature vehicles, which are likely to have higher public markets exposure. The daily visibility into pricing and hence the fluctuating real discounts to NAV can make closing a deal in volatile public market conditions more challenging, sources tell me.

Of course this can cut both ways: after an offer is made, LPs essentially have a put option on the buyer, and if markets fall the buyer may be paying a premium for assets in a deal they’re bound to. While LPs can simply turn down an offer if real valuations aren’t moving in their favour, buyers are bound by deal documentation and are unlikely to have requested exit clauses in the first place.

“GPs want to go to the LPs and say, ‘We’ve sought a solution and it is lock-tight,’” Gabriel Boghossian, a partner who leads secondaries deals at King & Wood Mallesons, told me. “The GP is not going to co-operate if [a buyer] seeks to add more conditionality.

3. Communication with LPs is a subtle art

Experts who work on GP-led deals always say early LP communication is key. This is easier said than done. A secondaries buyer may want to set up a face-to-face meeting with potential selling LPs to show them they’re not trying to fleece them, but has to be careful not to step on the GP’s toes or the advisor’s for that matter.

“I think some of these [GP-led restructuring deals] fail due to lack of trust,” Michael Suppappola, a partner at Proskauer Rose recently told Secondaries Investor. “Generally, LPs want to understand that they won’t be adversely affected by a deal.”

Sources also point out a couple of other lessons: advisors can never carry out enough due diligence on a deal before agreeing to take it on, regardless of whether this results in hours of unpaid work and deciding not to take on the deal. A fund candidate should also be returning above cost, or LPs are more likely not to sell in the hope they will at least break even at some point in the future.

The counter-argument to all the above, of course, is that a failed GP-led deal isn’t necessarily a bad thing. A lack of LPs wishing to sell can easily be read as a vote of confidence in the portfolio or GP. But that’s a pretty expensive and time-consuming way for a GP to get a pat on the back; and certainly not something to please buyers and advisors in these complex deals.

What other lessons can be learned from failed secondaries deals? Let me know: adam.l@peimedia.com