Ares Management: GP-led secondaries is a buyers market

While significant capital has been raised to pursue the flourishing GP-led secondaries opportunity, supply/demand fundamentals remain highly attractive, says Barry Miller, partner in the secondary solutions group at Ares Management.

Barry Miller

This article is sponsored by Landmark Partners, an Ares Company 

Why do GP-led secondaries represent such an attractive investment opportunity right now?

As we look at it today, we believe the GP-led space off ers extremely attractive risk adjusted returns. Secondaries buyers are able to access the very highest quality assets, partnering with leading management teams, and working alongside top-producing buyout investors. That, to us, is a very compelling opportunity.

The benefits for the GP are also clear. They are able to hold on to those highest performing companies, deploying capital with less risk as it is a proven relationship. This could prove particularly important in a more volatile economic environment. For the LPs, meanwhile, there is the opportunity to take liquidity, if required, or maintain exposure if the conviction is there. The beauty of these deals is that they off er optionality.

Those GP-leds, and particularly single asset GP-leds, have dominated the secondaries industry over the past couple of years. What has driven this explosion in dealflow?

The GP-led market has experienced incredible growth over the past six years, from around $8 billion in 2015 to close to $30 billion in 2020, which was at the time a record. We don’t yet have the final data for 2021, but early indications are that the final tally will exceed $60 billion, which is an extraordinary increase.

There are three primary drivers responsible for those deals. The first is a duration mismatch between a company’s prospects and the fund that it currently resides in. The second is the opportunity to carry out transformational acquisitions where the existing fund does not have the requisite unfunded capital available. Remember, after all, that as the private equity industry has continued to grow, managers have moved from raising a fund every five years, to every four, and then every three. Now we are seeing managers raise money pretty much every year. As a result, a lot of legacy funds don’t have enormous amounts of unfunded available. Continuation vehicles can help solve that problem.

Finally, when a particular asset significantly outperforms, it can reach a point where it represents too much of the NAV of an existing fund from a diversification standpoint and, again, the single asset continuation vehicle can prove the optimal solution.

Do we yet have visibility on how those single asset deals that were completed during the pandemic are likely to perform, particularly if we head into a severe downturn?

The short answer is that it is too early to say for sure. There has been a significant increase in GP-led transaction volume in the last few years. Some of those transactions are starting to move into the harvest phase and, at this stage, the returns look quite promising.

How are you seeing specialization evolve within the secondaries industry?

There is a clear distinction emerging between different types of secondaries funds. There are funds focused on LP solutions and those focused on GP solutions. You can then dig down even deeper on the GP-side, with some firms focusing more on structure and others on single assets. In fact, such is the level of specialization today, that I would argue that any GP looking to execute a sponsor-led deal should ensure they are working with a secondaries buyer focused on those GP-led solutions and who has the necessary experience to do the requisite bottom-up analysis. You need to be able to understand the sectors and the companies themselves, and I think there are relatively few buyers able to do that.

This is where Ares has a clear competitive edge, of course. As part of the leading direct lender to the private equity industry, covering over 900 GP relationships and lending to over 3,000 companies a year, we have access to an incredible wealth of information and understanding of the marketplace. Since having the ability to fully assess manager quality is also important, we have a quantitative research group comprising close to 25 professionals, which is another important differentiator. I think, as a generalist secondaries house, these GP-led transactions would be significantly more challenging.

So, do you expect the GP-led market to continue to grow, even in a more challenging macroeconomic environment?

Absolutely. Private equity funds typically have a 10-year life with two one-year extensions. If we do see a significant slowdown in the market, the need for continuation funds will therefore only grow. The need to access capital to complete transformational acquisitions will also increase in a difficult environment. Meanwhile, if the economy picks up and we continue to see significant outperformance, this problem of assets representing too much NAV will not go away either. In short, as I look at the immediate future, there are clear line of sight opportunities in both an up and down market.

How would you describe the supply and demand profile of the GP-led industry, given the substantial amounts of money being raised?

I think this idea of a supply/demand imbalance is something of a misnomer. Yes, there is an enormous amount of money being raised, but there is also an enormous amount of supply. Just look at the numbers. There is currently somewhere around $160 billion of dry powder in the market, looking to address an estimated $300 billion to $350 billion of supply over the next three years. That equates to roughly two years’ worth of dry powder.

Compare that to the buyout market, where the numbers are closer to five and a half to six and a half years and suddenly the supply/demand fundamentals of the GP-led space actually look very attractive. There is undoubtedly more supply of GP-leds than there is the capital to complete these deals, which will lead to certain opportunities not getting funded. That, of course, means buyers can afford to be highly selective, which is a great position to be in.

What is your approach to asset selection then? This is a heavily intermediated part of the secondaries market, with a strong emphasis on achieving fair value, given the GP’s role as both buyer and seller. How do you ensure you get the returns you are targeting?

First and foremost, we focus on what we believe to be the best managers. Then we look at the underlying companies, their management, their performance and the performance of the industries they are operating in. We look for insight from our direct lending business – Ares Corporate Opportunities – and have conversations with that team as appropriate.

We then put all those pieces together alongside our quantitative research group, to make a decision on whether we can be a total solutions provider – to lead the transaction – or whether there is the opportunity to participate in a syndicate if we believe the asset has strong growth projections but does not represent a situation where we would act as overall lead. Generally, a decision to participate in a syndicate and not lead would be based on sizing.

The secondaries advisory community is reporting that buyers are significantly ramping up their due diligence efforts, particularly spending more time with underlying management teams, given an increasingly volatile economic environment. Has your approach to due diligence changed at all?

Honestly, we have always looked to spend significant time with management. That is one of the advantages of leading and co-leading transactions. Not only do you get access to sponsors, but you also get access to the portfolio companies themselves.

In comparison with the LP secondaries market, transparency is extremely important when it comes to GP-leds and any efforts to restrict that access to individuals or information would be an immediate red flag. Our due diligence process has therefore continued to be rigorous in that sense. What I would say is that we are becoming increasingly selective about the industries we are comfortable transacting in when it comes to building a portfolio.

What changes are you seeing in terms of the way GP-led deals are being put together in the current environment?

One of the big pushbacks that we see from LPs involves the amount of time they are given to make a decision. We are working closely with sponsors to try and elongate that period. Giving someone 30 days or 45 days from start to finish is certainly not enough time. They need longer.

I would add that the current imbalance in the supply of GP-leds and the capital available to transact on them means there is an opportunity, as a buyer, to negotiate. That doesn’t necessarily mean negotiate on the headline price, given that we are always looking to deliver fair value to the underlying LPs, but we do see downward pressure on sponsor economics.

What are your concluding thoughts on how the GPled market is likely to evolve going forward?

We will continue to see substantial growth, undoubtedly. The secondaries industry has been growing robustly since its inception, but the real explosion has come since GP-leds arrived on the scene. The annual growth in transaction volume has been greater than 40 percent since 2015.

Meanwhile, the impact of GP-leds on the overall secondaries industry is only going to increase further. Depending on who you talk to, these deals accounted for somewhere between 50 percent and 55 percent of total secondaries volume last year. I believe that number will continue to grow. Indeed, I fully expect that we will reach $200 billion of GP-led transactions per annum within the next few years.