This article is sponsored by Evercore.
The GP-led secondaries market has evolved considerably over the past decade. In the mid-2010s, the market formed predominantly as a tool to restructure end-of-life funds. Today, sponsors have access to a robust “secondary” toolkit to actively manage their portfolios and LP liquidity, including fund wind-down transactions, tender offerings, fund-level financing solutions and continuation funds. A market that was once stigmatized by its affiliation with “zombie funds” and struggling managers is now dominated by blue-chip sponsors holding onto their best assets.
The most significant market development, which has resulted in an explosion in deal activity, has been the advent of the single-asset continuation fund. In the two-and-a-half-year period from H2 2020 through year-end 2022, single-asset deals accounted for $64 billion of transaction volume (roughly 45 percent of the GP-led market) compared to merely $9 billion (roughly 16 percent of the GP-led market) in the preceding two-and-a-half years. Over this period, the single-asset market grew by a factor of 7x and is responsible for approximately 65 percent of the growth in the broader GP-led secondary market.
The explosion of single-asset activity should come as no surprise as it offers several benefits to the transaction constituents:
• Solves the problem of sponsors having to sell “early winners” to generate distributed to paid-in capital (DPI) – 60 percent of the GP-led transaction volume in 2022 originated from funds aged one to six years;
• Offers additional time and capital to support growth, which means more flexibility for sponsors to create value (eg, GPs ordinarily reluctant to invest new equity shortly before an exit);
• Represents a credible exit alternative, which is particularly valuable in a challenging environment for traditional exits (ie, IPO, M&A);
• Attractive for management teams – ability to generate partial liquidity and limited involvement in diligence;
• Provides LPs with optionality that would not otherwise exist for traditional exits;
• Lowers the overall friction cost and aggregate economic drag for LPs with a long-term mindset compared to LPs that could be on both sides of a sponsor-to-sponsor transaction as investors in the buying and selling funds (ie, multiple distinct realizations/taxable events);
• Gives buyers access to some of the best PE-backed assets with great sponsor alignment.
Notably, the proliferation of the single-asset secondary market is disrupting the sponsor-to-sponsor M&A market, which has long been the beneficiary of private capital inflows and an expanding private equity ecosystem. Sponsors are asking themselves, “Why sell a great asset to a competitor if they’re underwriting to the same returns?” Interest has only grown further in recent months with credit markets tightening because of a key structural advantage: the ability to maintain the existing capital structure.
Today, it is rare to find an established sponsor who has not at least considered exploring a single-asset secondaries transaction, as deal activity across the spectrum of GPs (size, geography) has demonstrated the market has staying power. The only governor on growth is capital formation. The question from sponsors now is “how” not “why” when it comes to raising a single-asset continuation fund.
How investors are adapting to the opportunity
Despite widespread adoption, the single-asset secondaries market has experienced growing pains, as many investors face capital constraints in this segment of the market. One of the guiding principles of secondary funds is to mitigate the J-curve, which has meant purchasing diversified, cash flowing LP portfolios (often at a discount to NAV). That strategy has broadly generated strong, consistent track records for the largest investors in the market over the past 15-plus years.
The transition to investing in concentrated transactions is a marked shift that brings with it challenges. First, secondaries funds are hesitant to deviate too far from their “bread and butter,” which has been at the core of their success in terms of returns and fundraising. More importantly, secondaries funds typically face LPA restrictions related to concentration limits (based on percentage of fund exposure in a single company and aggregate percent of fund exposure in single-asset deals). Notwithstanding, it is difficult to ignore what has become a material share (and fastest growing segment) of the secondaries market and what may end up driving differentiated return outcomes for the early movers.
To adapt to the evolving opportunity set, investors have taken steps. These include bringing their check sizes down to build more diversified portfolios, negotiating more flexible investment mandates with their LPs (ie, relax concentration limits) in the latest fundraising cycle, and in some cases raising overflow vehicles or separate accounts specifically geared toward concentrated GP-led transactions. Other investors have gone all-in on the strategy, raising funds exclusively focused on single-asset deals.
Despite these developments, the market remains undercapitalized, which has led to a flurry of new entrants ranging from multi-strategy private equity firms looking to acquire or establish their own secondaries teams, opportunistic hedge funds, family offices, endowments and foundations with flexible investment mandates, or sovereign wealth funds writing large checks alongside existing sponsor or secondaries manager relationships.
Percentage of GP-led transaction volume in 2022 that originated from funds aged one to six years
Amount of transaction volume single-assets deals accounted for from H2 2020 through year-end 2022
Recently, there has even been a push for retail vehicles to start investing directly in single-asset deals. As evidence, in the past two years, Evercore Private Capital Advisory has raised capital from more than 250 distinct investors as part of its GP-led advisory business.
Potentially the biggest capital unlock though may come from pockets of capital traditionally reserved for co-investments. In the early days of the market, most investors with direct investing or co-investment programs were unwilling to pay GPs economics on a single company. Many investors are now reconsidering their stance as the lines blur between single-asset deals and co-investments. This trend should accelerate if data around net performance/loss ratios end up comparing favorably to co-investments.
Evercore expects continued expansion of the investor universe because barriers to entry are low and quality opportunities remain abundant. Growth has been impressive, but capital formation needs to catch up for the trend to sustain.
Is there a risk of a single asset bubble? Should single-asset deals be benchmarked differently?
Amidst the sudden and dramatic growth in the single-asset market, a skeptical investor might question whether there is risk of a bubble forming. Specifically, one can point to a significant portion of single-asset deal activity coinciding with peak valuations in 2021. While absolute returns for investments in that vintage year may lag, secondaries investors are building diversified pools of single-asset deals, which should reflect the “greatest hits” of private equity. It’s difficult to imagine a material valuation reset of those portfolios in a world where the broader private equity market is performing, especially given the positive selection bias and skew toward recession-resistant, stable businesses.
Notwithstanding, it’s fair for prospective LPs to rethink benchmarking the asset class, given the portfolio composition is more akin to that of a direct private equity fund in terms of cash flow profile and diversification. However, there are some key differences in the risk profile:
• The strategy is to back sponsors buying assets that they already own and know well – this limits leakage resulting from imperfect or incomplete information in diligence;
• Single-asset funds offer significantly greater diversification across sponsor (ie, no “key-man” risk), sector, geography and company size;
• Lower look-through leverage – many single-asset deals involve maintaining the existing capital structure rather than maxing out leverage, which is more typical in a traditional LBO context.
The secondaries market has very much evolved into a “crown-jewel” strategy, whereby secondaries investors are backing high-quality sponsors targeting their best assets to hold longer. Most sponsors are only targeting one or two “winners” to sell into this market. Our expectation is that, on average, this positive selection bias will result in a portfolio of single-asset investments having a lower loss ratio and stronger risk-adjusted returns than that of direct private equity.
Arguably, the best proxy for single-asset deals is cross-fund investing, which has historically seen similar outperformance. Only time will tell, but the next fundraising cycle for secondaries managers has breakout potential if investors are able to print realized track records that prove out this thesis.