Today’s secondaries market is highly specialised, with a diverse base of buyers defined not only by their return expectations, but even more so by their “structure of choice”. The increasing diversity of buyers means that limited partners and general partners have a broader menu of options available to them to address a myriad of portfolio objectives and needs.
Among the key drivers of a secondaries transaction are: (i) the need for immediate cash generation to provide either liquidity for LPs or capital solutions for GPs; (ii) LP portfolio rebalancing to alleviate the administrative burden of managing too many portfolio positions; and (iii) a GP’s need to amend specific terms such as fund life or distribution recycling.
LPs exploring a secondaries market solution can pursue different transactions based on their respective needs for liquidity due to the broadening of secondaries products in the market. A common pricing concern is the discount, if any, that an LP might have to incur. Certainly, many LPs who desire liquidity from an existing portfolio are unwilling to incur the losses from a straight secondaries sale. To address the “seller’s dilemma” scenario, LPs can pursue a “dividend recapitalisation” transaction.
In this type of transaction, LPs secure a one-time distribution funded from the proceeds of a debt or preferred equity financing against a defined subset of their overall private equity portfolio. The resulting leverage from such financings is superior to a straight sale in terms of maximising value and minimising face value losses, particularly when the underlying fund portfolio is highly diversified. The cost of capital is attractive, and the LP maintains its upside in the portfolio. In recent years, GPs have also relied on recapitalisations at the fund level to secure follow-on capital for their existing portfolio.
The investor base for dividend recapitalisations includes traditional lenders who can support the acquisition of a diversified pool of assets by a traditional secondaries buyer. If the pool is sufficiently diversified, the leveraged financing will likely be structured with traditional debt terms. If the portfolio is concentrated in just a few assets, a traditional bank is unlikely to lend against such a pool. An alternative, attractive financing approach now exists: preferred equity. The limited partner can consolidate the private equity fund positions into a special purpose vehicle, and the SPV can issue preferred equity, the proceeds of which will fund the dividend to the limited partner.
Many institutional investors with mature private equity programmes own funds that have grown stale and are deemed to be non-core. A limited partner seeking to eliminate the asset management and administration requirements for such funds through a secondaries sale would normally suffer a material discount to its capital account balance. In this scenario, LPs can again utilise the SPV structure. Instead of raising SPV-level leverage, the LP can sell a portion of the SPV to a secondaries buyer. Transaction terms can address the return and pricing requirements for both the LP and buyer, such as a tailored distribution waterfall, cash earn-out incentive or profit-sharing arrangement. Another key benefit of a structured solution is that a partial sale of the SPV does not constitute a “transfer” of ownership in the traditional secondaries market sense, which would require additional documentation and general partner transfer consent of the underlying funds.
Unique seller dynamics call for unique solutions. As the secondaries market evolves and expands, institutional limited partners can take advantage of the broadening set of liquidity products available to them.
Shawn Schestag leads Sixpoint’s secondaries advisory business and has 14 years of investment banking experience, focused on private equity. Prior to joining Sixpoint Schestag spent seven years with the private fund group at Credit Suisse where he was a senior member in the secondaries advisory practice. Sixpoint Partners is a registered broker/dealer with has offices in Chicago, San Francisco and Hong Kong, in addition to its New York headquarters.