Sponsors accept ‘first dollar loss’ to counter rich GP-led terms

Buyers are proposing fresh ways of ensuring sponsors stay aligned, according to a panel at PEI's Investor Relations, Marketing & Communications Forum.

Buyers are proposing fresh ways of ensuring sponsors stay aligned on GP-led deals – and some are going along with it.

Speaking on a panel at PEI‘s Investor Relations, Marketing & Communications Forum last week, a New York-based secondaries advisory partner said that growing numbers of sponsors are agreeing to take the initial economic hit if a deal underperforms.

“[Buyers are saying,] ‘if you think you are entitled to 30 percent carry then guarantee us first-dollar-loss if the portfolio falls below our purchase price’,” he said. “We’ve seen that in a couple of transactions and the GPs have been willing to do it.”

Terms on GP-led deals have become increasingly favourable to sponsors over the past year, the panel agreed, as covid-19-related disruption in the first half of 2020 and continued slowness of the LP stakes market has led to an increase in buy-side demand for high-quality, concentrated deals.

One secondary advisory managing director pointed to an increase in single-asset deals with a super carry tier – a profit share that goes beyond 20 percent – and deals in which carry can be triggered by a hurdle based on both multiple and internal rate of return. One deal in market has premium carry and no hurdle, one of the panellists said.

“When we see heavy misalignment, it’s a non-starter for us,” added a Chicago-based partner with a secondaries buyer. “That doesn’t just mean ‘is the GP rolling their economics’ but is the GP really aligned with us and the management for X number of years?’”

The panel was held under Chatham House rule.

In March, advisor Campbell Lutyens noted that one-third of buyers reported an average GP commitment of greater than 5 percent of total transaction size on GP-led deals in last year. Nearly 25 percent said that more than one quarter of the GP-led transactions they completed last year included a cross-fund investment from the GP’s latest flagship fund.

“If the secondary investment goes poorly and has the potential to negatively impact the GP’s flagship fund return, it’s a pretty powerful alignment tool,” said partner Gerald Cooper.

According to research by investment bank Evercore, complex secondaries transactions accounted for 50 percent of all market activity during 2020 – equivalent to around $30 billion. This is the first time they have reached parity with traditional LP portfolio sales.