Neuberger Berman: Giving diligence its due in GP-led deals

This article is sponsored by Neuberger Berman and appears as part of affiliate title Private Equity International‘s GP-led Secondaries Special Report.

What should investors look for in a prospective GP-led secondaries transaction?

Ben Perl: GP-led deals come in many different shapes and sizes, from concentrated single-asset deals to multi-asset transactions. We have even completed transactions involving multiple assets from multiple different funds. While no two situations are the same, in general, there are three key areas that we believe an investor needs to focus on when assessing a complex GP-led opportunity. First, the assets; second, the GP; and third, the structure.

When it comes to the asset, you need to be able to understand the quality and value of the business and the go-forward thesis. If it isn’t the right asset, available at the right price and with the right opportunity in front of it, it is going to be very hard to build conviction around that opportunity. Then you need to think about the ability of the GP responsible for delivering on that plan. Secondaries investors are in a unique situation, in that such investors are performing direct due diligence on these assets but are not control buyout investors. So, secondaries investors need to be able to understand the skills and expertise of the manager. You also need to understand their motivation. Why are they pursuing this transaction?

How is the intrinsic value of an asset in a GP-led deal established?

Then, in terms of structure, you need to be able to set the right terms and have the right governance in place. Again, since such investments are not control investments, investors need to make sure the correct alignment is in place. It takes a lot of time and effort to get these complex transactions right.

Boriana Karastoyanova: Although private equity, and the GP-led market in particular, has moved towards greater transparency and quality of information disclosures, buyers’ ability to interpret that data and build conviction around the asset(s) is varied, shaped by buyer teams’ diligence and investment capabilities as well as informed by buyers’ existing exposure to or experience with similar assets and sponsors. There are multiple factors that can affect the value of an asset.

Buyers need to tap into sector expertise to understand long-term drivers of value creation and risks. They also need to understand a GP’s underwriting style and the level of optimism or conservatism the GP applies in its asset valuations.

Tangible, company-specific metrics should be overlaid with the GP’s interaction with that asset. To do that successfully, investors need access to private markets knowledge. The more touch points within private markets a buyer has (for example, precedent transactions, knowledge of what has and has not worked as well in a specific asset and its peers), the more inference can be derived to form a view. Public equities and fixed income market insights are also useful to how the capital markets could view certain assets, and together with sector expertise, can inform what is the potential buyer universe.

Finally, the ability to triangulate all that data and to ask the right questions to the GP or management team is how investors can establish the intrinsic value of an asset.

BP: As Bori explained, having access to dedicated research teams that cover not just private markets, but also fixed income and equities, helps you better understand why companies are winning and losing and assess value. The challenge is marrying that skill set, of deep fundamental analysis, with the ability to understand GPs and partner with them in a constructive manner.

How is the GP-led process different to LP secondaries investing?

Philipp Patschkowski: There are similarities and there are differences. When it comes to the core analysis of the underlying assets – the pricing of those assets and the understanding of alignment and the GP skill set as it pertains to those assets – these are things that the secondaries market has been doing for many years. Those secondaries investors that have always focused on that kind of bottom-up analysis, typically looking to acquire more concentrated or single line LP portfolios, are well positioned to extend their activities into the GP-led market because they already take a very detailed view on the assets concerned.

However, there are other secondaries investors that have historically focused more on the acquisition of diversified portfolios, often employing leverage and taking a more top-down approach to their due diligence and valuation strategy. Those investors may find it more difficult to expand their skill set into the GP-led space. It might require the retooling of their approach and potentially even adding new teams.

How has the supply of GP-led deals evolved in recent years?

PP: The total volume of GP-leds in 2021 is estimated across the industry at over $60 billion, up from around $7 billion in 2015 – that is a nine-fold increase. This growth is being driven by a rising acceptance of these transactions across the GP community as the underlying technology continued to evolve. The pandemic has further expedited the growth of this market. In an uncertain environment, GPs recognised that the best investments they could make sometimes existed within their own portfolios.

From a structural perspective, those assets needed to be sold. But rather than selling them to their competitors, GPs realised it could be preferable to sell them into a continuation vehicle. In doing so, the GPs are creating a liquidity option for their existing investors, while maintaining the option, both for LPs and the GP, to participate in future value creation of the target companies. Despite this growth, it is important to recognise that only a small percentage of GPs have transacted in this market so far, so we think that there is huge potential for further growth in the future as well.

Has the quality of asset coming to market also changed?

PP: We have seen a very notable increase in quality. Historically, there may have been negative connotations that came with GP-led transactions but that has entirely gone away. Instead, we see blue-chip GPs selecting their highest-quality assets in order to continue to own them.

We have also seen an increase in single-asset deals recently. What are the key differences investors need to take into account with these deals?

PP: Single-asset deals became popular in 2020 in an environment of extreme uncertainty. The market focused on those transactions because it was easier to conduct deep due diligence on a single company and we believe GPs were also handpicking those businesses in their portfolios that were either unaffected by the pandemic or perhaps even benefited from changes to the way business was being conducted.

That trend has normalised and we see that the GP-led market is now roughly evenly split between single and multi-asset deals. But it is also important to note that not all single-asset deals are alike. Some truly fall into the category of a GP-led secondary, with price and terms set to align the secondaries buyer, GP and LPs in order to give the underlying asset additional runway for value creation.

However, we also see transactions that are more akin to a new buyout transaction, with the pricing being set by selling a co-control or minority stake to a different GP. Those deals can feel less like negotiated secondaries and are sometimes less compelling, often feeling more like a new co-investment risk profile with economic leakage. It is important for secondaries investors to understand those differences.

BP: As a buyer, we believe complexity can be your friend. With multi-asset deals there are more businesses to analyse, more industries to understand, more diligence to perform. As Philipp noted, in some single-asset transactions, we see limited complexity and a lot of efficiency. That having been said, we believe there are still attractive single-asset opportunities in the market.

As the market has grown and higher-quality GPs have embraced GP-led secondaries, has the diligence process become more or less important?

BK: Diligence in the GP-led market today is vital. Secondaries investors need to really test the health and sustainability of companies. They need to dig deep into their underlying financials and assess their future performance.

BP: If anything, due diligence has arguably become even more important. With over $60 billion of GP-led transactions that closed last year, investors can and should be incredibly selective. Finding transactions that meet your criteria in terms of asset, valuation, GP and structure isn’t easy. With more high-quality GPs bringing high-quality businesses to market, it is important for secondaries investors to have the right people, processes and resources to evaluate and select the best opportunities. It is incredibly challenging, and it means diligence is probably more important today than it has ever been.

How do GP relationships factor into due diligence?

BP: Relationships really matter. It is important to remember that as a secondary investor, you are partnering with GPs. That is very different than other, direct-oriented investment strategies where investors are purely buying from, not partnering with, the counterparty, in what can be a zero-sum situation. GPs often have a choice and preference in who they partner with in these complex secondaries. But beyond the potential to be a preferred partner, relationships can also help investors better understand a GP’s motivation and provide an information edge or better access during the diligence process. As an investment platform that invested $15 billion in 2021 across various private market strategies, we try and leverage all of that to our advantage.

That having been said, while relationships can be invaluable, they should not be determinative of an investor’s willingness to enter into transactions. For example, we have partnered with many GPs where there was no existing relationship, and we have also declined opportunities with GPs we have relationships with when such opportunities didn’t meet our criteria.

Boriana Karastoyanova is a principal and Philipp Patschkowski and Ben Perl are managing directors at Neuberger Berman