Christophe Simon
Managing Partner - Private Funds Group
The volume of secondary transactions is accelerating due to the sheer volume of primary deals in recent years, compounded by the need of many LPs to realize liquidity. But Christophe Simon warns that investors looking to take advantage of the growing number of deals in this market need to have the expertise, resources, and relationships to ensure that GP and LP interests are aligned.
Bright outlook for secondaries against a gloomy backdrop
Against the current troubled backdrop of inflation, recession, war and the pandemic, the secondary market in private equity is looking remarkably bright. That puts pressure on GPs to work more closely than ever with LPs to keep their interests aligned.
There are a number of reasons for this optimistic outlook, factors that affect both the LPs and the GPs.
First, the recent rapid growth of the secondary market is in part an almost mechanical outcome of the spectacular increase in recent years of the amounts raised by private equity firms in their primary funds. One could consider therefore these ample primary funds to be the reservoir for future growth of the secondary funds going forward.
Those demands by LPs for liquidity are themselves on the increase because of the so-called “denominator effect” being exacerbated in turbulent market conditions. This effect kicks in when an institutional investor’s liquid assets fall in value, causing the relative weight of any unlisted or private assets to increase in the asset mix, prompting the investor to lighten up on unlisted assets to remain within their own allocation guidelines.
GP-led transactions on the rise
A second reason for the current growth trend in secondaries is driven more by the GPs themselves. In pre-Covid times, there were a variety of relatively accessible exit routes for funds looking to realize the value of the companies in their portfolios. But as the IPO and the M&A markets have effectively shrunk in the last couple of years, secondary sales have provided a welcome means for the GPs to sell companies that they consider ripe for exits.
The third reason to mention is the counterpoint to the second. With M&A and IPO exit routes looking restricted, a GP-led secondary transaction can be a powerful tool to hold on to a buyout fund’s most promising assets for longer, delivering further upside for any LP investors not under pressure to seek liquidity. Indeed, this is the reason that so many of the GP-led transactions this year have been focused on single-asset deals, an estimated 47% of them, according to recent market studies.
There’s therefore every reason for secondary fund sponsors to be feeling optimistic about the opportunities ahead in 2023, taking heart from recent forecasts that the secondaries market would rise to over $150 billion in volume next year, up from an estimated total $115 billion this year.
Not a market for everyone: expertise, resources and relationships required
But even if they’re feeling ebullient about the 2023 outlook, only a limited number of players have the expertise, the resources and the relationships required to take full advantage of the opportunities.
GPs considering launching a sponsor-led deal need to do their homework carefully. GP-led funds (notably continuation funds) have had some critical press recently, as journalists have questioned whose interests are truly served by such transactions.
In fact, as highlighted by that list of reasons for growth listed above, a well-structured secondary transaction can – and should – align the interests of both GP and LP. To ensure this is the case, GPs need to respect some “red flags” that LPs will be watching for. For example, GPs must ensure that their LPs understand the rationale driving the transaction. They will, quite understandably, be wary of any indications that the GPs are simply looking to crystallize their carried interest. To ensure the deal is carried out in full transparency, it’s therefore important for the GP to engage an M&A advisory boutique to keep the information flowing to all the stakeholders, notably around the investment thesis, the timeline and, of course, the pricing.
Another issue facing LPs, of which GPs need to be aware, is the question of “bandwidth”. Most LPs are well accustomed to the slower pace of approval for complex primary buyout investments. Secondary deals tend to be executed a lot more rapidly. As the number of those transactions increases, so some LPs are finding themselves swamped with multiple demands for decisions, putting them under unwelcome pressure.
GPs need to be sure to address these “red flag” concerns from their LPs because there is a clear reputational risk for any sponsor that misjudges the situation. The obvious pitfall lies in the fact that the GP is both seller and buyer in a GP-led transaction. Some LPs will be eager to seize the “liquidity window” that such a deal opens. But others who don’t require the liquidity of a timely sale might be keen to remain invested, sensitive to the same story of continued growth for the asset that the GP has spotted.
It’s fair to say that there will be a degree of self-regulation preventing abuse here, because no GP can afford to alienate the same LPs to whom they will be pitching their next fund. To be sure, many LPs are vigilant in their own right, for example by insisting that GPs reinvest their carried interest realized from the primary deal alongside other investors in the secondary deal. But a GP’s self-interest in protecting its reputation notwithstanding, GPs should be sure to clearly make its case to its own Advisory Board and obtain explicit approval for such a deal.
To ensure a continued bright market, GPs and LPs alike need to keep their interests aligned.
