This article is sponsored by Manulife Investment Management.
GP-led secondaries emerged from obscurity a decade ago to claim half of today’s private equity secondaries market. Most market participants never anticipated the pace of growth, and many still wonder whether this type of transaction is a passing fad or a durable market innovation.
Right now, the resiliency of the segment is being tested amid public market volatility, interest rate hikes and nagging inflation. This leads to an existential question: were GP-leds a function of a buoyant economy and abnormally low interest rates, or do they represent a true private market innovation that will survive the downturn and continue to play a role in the future?
We argue that GP-led secondaries will continue to be a major component of the secondaries market for years to come. We cite four reasons: the lure of customised liquidity; increasing sponsor adoption; a supportive regulatory framework; and, most importantly, the attractiveness of the GP-led investment risk-return proposition.
1. The lure of liquidity
The drive for liquidity has been a fundamental force shaping the development of the secondaries market for decades. Once invested in a limited partnership, typically an LP received liquidity through sponsor-created distributions. The secondaries market introduced a liquidity mechanism that did not depend upon sponsor action. However, a partnership sale was a blunt-edged instrument – it was an all or nothing choice. In selling a fund interest, an LP was forced to divest exposure to all portfolio companies regardless of its preference for some companies.
GP-led secondaries have refined the secondaries market’s basic toolkit. A GP-led transaction enables a surgically precise way to shape private equity exposure at the asset level. This innovation has been embraced by market participants and is now considered by sponsors to be an additional exit option.
As with any innovation, there has been resistance to the complexity of this new mechanism. However, the rapid growth of GP-led secondaries demonstrates that there was pent-up demand for customised, interim liquidity, a demand that we believe will survive through bull and bear markets alike.
2. Increasing sponsor adoption
While the private equity industry has been growing for decades, the structure of the industry has remained largely unchanged. Sponsors raise commingled funds, invest in portfolio companies, improve company performance and monetise assets through sales or IPOs. When liquidity is returned to investors, sponsors seek to recycle it into follow-on funds. There is a ‘wash, rinse, repeat’ cycle to this rhythm.
By the mid-2010s, the secondaries market had become large enough to force changes on the decades-old private equity rhythm. Early GP-led transactions – often called ‘fund restructurings’ or ‘fund re-capitalisations – raised awareness, as certain sponsors started to see secondaries as part of the capital markets.
Over time, more sponsors began to engage with secondaries investors in new and novel ways. The result has been a burst of additional options and flexibility for all market participants, not only in terms of liquidity but also in terms of performance realisation, incentive re-alignment, ownership structuring and asset-gathering strategies.
The fact that an entire cohort of bankers, lawyers, valuation agents and other service providers now specialise in GP-led secondaries only reinforces the permanence of the structural change wrought on the private equity market. Clearly, this group of specialists has a vested interest in keeping the market operating through ups and downs.
3. Regulatory framework
The private markets have come under increasing scrutiny as more capital has flowed into private partnerships. The regulatory framework for public securities is clearly defined, but the regulatory infrastructure for private securities is still evolving. As an example, the US Securities and Exchange Commission recently reviewed practices specific to fundraising and sponsor-initiated transactions. Their guidelines seem to focus on ensuring market participants are treated fairly and that conflicts are appropriately disclosed.
While a small number of entities have been in the past, or likely will be in the future, flagged for insufficient disclosure or other questionable actions, there is no evidence regulators wish to prevent innovation or curb a functioning secondaries market. In fact, these guidelines provide a framework for a fairer market, which often foreshadows healthier and larger transaction volumes over time.
Vigilance by sponsors, advisers, secondaries investors and other industry participants is of course critical to ensuring innovation and growth is not harmed by bad practices or bad actors. However, we believe it is unlikely that GP-leds bear more regulatory risk than other parts of the PE market.
4. Attractive risk-return profile
For years, asset allocators gained private equity exposure primarily through commingled funds. Over time, two innovations emerged that were added to the allocator’s toolkit. Co-investments enabled concentration to be part of portfolio construction while LP secondaries introduced shorter duration as an attractive attribute.
Both options were welcomed, but each had limitations. Co-investments are typically offered at the time a sponsor purchases a new platform company. This lack of history introduces risk, as the sponsor, management team and company are coming together for the first time. Traditional LP secondaries shorten the J-curve, but the return on these investments is typically bounded by the age and past distribution activity of the partnership.
GP-led secondaries have improved upon the value proposition of co-investments and LP secondaries, effectively creating a ‘sweet spot’ for private equity allocators. Companies in GP-led secondaries are known to sponsors as they have previously owned and typically added value to them. Instead of selling, they have decided to retain the company to capture additional performance. Overall risk is lower through continuity while appreciation potential remains high.
GP-led deals typically model to 2x-plus MOIC and more than 20 percent IRR, and project to a holding period of three to five years. This combination of potentially higher return for lower risk and shorter duration compares favourably with co-investments and traditional LP secondaries. As allocators come to appreciate this unique value proposition, we believe demand for GP-leds will continue to grow.
For decades, the secondaries market delivered fund-level liquidity through LP secondaries. This served as an important release valve for the PE market; however, fund-level liquidity could only be used to shape private equity portfolios broadly and was a blunt-edge instrument. The introduction of GP-led secondaries vastly improved the asset allocator’s toolkit, offering customised, interim liquidity for concentrated positions within funds, and has become much more akin to a surgeon’s scalpel.
LP secondaries can offer an attractive value proposition, enabling investors to capture the ‘beta’ of the secondaries market. GP-led secondaries offer a different investment proposition – the ‘alpha’. We believe GP-led secondaries allow allocators to capture premium returns without taking excessive risk – a proposition that will become increasingly valued over time.