Schroders: Don’t overlook the lower mid-market

Secondaries investors can find unparalleled alignment in GP-led transactions with lower mid-market managers, says Christiaan van der Kam, head of secondaries at Schroders Capital.

This article is sponsored by Schroders Capital.

Christiaan van der Kam, Schroders
Christiaan van der Kam

Why do you think the lower mid-market offers the best opportunities for GP-led deals today?

The lower mid-market is largely underpenetrated in terms of GP-led deals. It’s also where the opportunity to create value is the greatest, due to the nature of both the GPs and the underlying assets.

Firstly, there are significantly more smaller GPs than large-cap players. Many of the smaller GPs have not completed a GP-led transaction so far, but at least one or two companies in each of their funds have the potential for a continuation vehicle. Smaller sponsors are usually the first institutional investors in a company. Having done most of the heavy lifting to improve operations, profitability and growth, they are best positioned to continue managing the assets into the next phase. In addition, they have built a strong relationship with the management team, which is crucial for future success.

Secondly, smaller GPs are likely to be in the earlier stages of building their own net worth. From an alignment perspective, the economics in the continuation vehicles are much more relevant for them compared to their larger peers. A GP-led transaction enables a lower mid-market manager to generate mid-cap carry in a single company. The motivation for the GPs to make the transactions work is very high and creates, in our view, unparalleled alignment.

Lastly, in terms of the assets, there is meaningful value-creation potential in the lower mid-market due to the modest size of these companies and the step change in valuation that can be achieved. If a company’s earnings grow from $10 million to $25 million, and to $50 million in the next stage, the market of potential acquirers expands significantly.

How are you finding competition for GP-led transactions in the lower mid-market?

There is a very limited number of secondaries players that can and want to lead on transactions, especially in the lower mid-market. Most GP-led investors prefer to invest with sponsors they know well, so competition is specific to the deal.

Competition in the GP-led market is different from LP secondaries. In LP secondaries, investors have access to similar information on diversified portfolios and compete in broad auctions, which means price, speed and size are more important. In GP-leds, knowledge of the asset can create an edge. Investors who know the history of an asset and have seen how the GP has managed it first-hand will inherently have an advantage. That can’t be replicated in LP secondaries.

Is the GP-led market still more attractive than the LP stakes market?

The turmoil in financial markets and downward pressure on secondaries valuations means both GP-led and LP secondaries have become more attractive recently. We are still of the opinion that the GP-led market offers better opportunities for investors given the quality of the companies that can be accessed through continuation funds and strong alignment with the GPs.

LP secondaries pricing has certainly come down, but net asset values have still not been marked down relative to public markets. Portfolios may be 10-20 percent cheaper, but are priced against a NAV that might be inflated. Furthermore, larger and diversified portfolios do not have the same upside potential that a GP-led transaction has.

How can a focus on GP-led deals align with sustainability and impact objectives?

Interestingly, we have found that our GP-led strategy aligns very nicely with our sustainability and impact objectives as a firm. Schroders has great ambitions when it comes to sustainability and impact, and we think we can play a small part through our GP-led strategy. In fact, more than 80 percent of our GP-led transactions in the last few years support at least one of the UN’s Sustainable Development Goals. This is not a coincidence. Part of the reason why these companies are star assets is because they, in our view, are supporting sustainability and impact.

The advantage of a GP-led strategy is that it allows us to target specific sectors and industries, unlike the LP market where it’s difficult to be focused on sustainability and impact. This also explains why our next secondaries fund will be an Article 8 fund under the Sustainable Finance Disclosure Regulation.

With so many opportunities in the market, how do you triage deals to pick the best ones?

We target attractive business models, best-in-class management teams, and those that have performed strongly with further runway organically and inorganically. Besides asset quality, we rigorously assess a GP’s motivation for the continuation vehicle.

What is actually driving the GP? Answering this question requires deep knowledge of the GP and asset(s). We always ask ourselves: does the GP truly believe in the prospects of the company? Is the GP-led another way to create an exit for the older fund and roll unrealised carry into a safer GP commitment? Or is it another way to generate incremental management fee streams?

We have to become convinced during diligence that we are gaining exposure to a great company and that it would be too early for the sponsor to sell it. As the GP has done really well with the asset, has built an incredible relationship with the management team, and has created a great platform, it should not sell to a third party at the moment.

How much of the capital provided is for company expansion?

Typically, 20-30 percent of a GP-led transaction is reserved for inorganic initiatives. Once a company has scaled initially and a strong platform has been created alongside a good management team, it’s often a great time to pursue inorganic growth. This fits well with the timing of a GP-led transaction.

In the first years of acquisition, GPs and management teams are too busy building the core business and solving basic problems. Typically, after two to three years, the company is ready to pursue inorganic growth. But often the fund that owns the company is either fully committed or cannot invest further capital. Plus, it will take a couple of years to integrate the add-ons, which spans beyond the fund life.

Pursuing inorganic growth through a GP-led makes a lot of sense because follow-on capital is usually raised as part of it. In the current environment, with credit markets especially challenging for smaller companies, the ability to raise new capital through a GP-led is even more valuable.

What are the best ways to create alignment and mitigate conflicts of interest?

If there’s a way to make sure the sponsor has more to lose than we do, then we think that’s good alignment.

“Pursuing inorganic growth through a GP-led makes a lot of sense because follow-on capital is usually raised as part of it”

Any carried interest generated by the sale of the company that flows out of the older fund should be rolled into the new continuation vehicle. On top of that, we want to see the sponsor invest new equity. We prefer that not only the GP but also the management teams are well-aligned financially. Furthermore, we often see that sponsors will invest out of their latest fund, which we perceive as a positive, although less relevant than, for instance, a sizeable new GP commitment.

In terms of conflicts, GP-leds are complex transactions and it is clear that the GP has to be held accountable in a manner similar to an outright sale of the company. This includes running a third-party sale process managed by an adviser as part of the continuation fund. There needs to be an external price setting mechanism and fair negotiations on all terms of the transaction. Moreover, it is important that the GPs involve the advisory board of the selling fund early on in the process and offer existing investors the option to roll into the new vehicle at similar terms.

Are predominantly GP-led funds able to deliver the same secondaries ‘experience’ to investors?

Investors should be transparently informed about the differences between GP-led transactions and diversified LP secondaries. The risk profile is a little bit different, with GP-leds being more concentrated but on the other hand, they involve assets that the GP knows well. In addition, the cashflow pattern of a GP-led transaction is different from an LP portfolio, but we think the upside potential more than makes up for that.

In a GP-led you’re not going to see cashflows after three months, but some do generate value very quickly, and underlying assets are already sold after a year or two. Furthermore, we take a balanced approach to our GP-led strategy, including also multi-asset transactions and tender offers, both offering more diversified cashflows.

We create a GP-led portfolio for our investors that has similar benefits of traditional secondaries funds, ie, lower risk through diversification and a shorter holding period. We limit our exposure to a single company, sponsor, geography or sector, and target at least 80-100 companies for our secondaries fund.

While fundraising, we find that some investors really buy into the GP-led rationale, while others may not. It really depends on LPs’ objectives and how they want to invest in the secondaries market. We believe both GP-leds and LP secondaries have distinct benefits, and dedicated exposure to each improves the risk-return potential.