By Hardeep Singh and Chris Gregory, Lincoln International
The GP-led secondaries market is booming and the continuation vehicle structure (GP-led) has unquestionably arrived as a competitive strategic alternative to traditional private equity M&A and IPO liquidity events.
These GP-led transaction processes distinguish themselves from an M&A process in two ways. First, the GP’s net asset value (NAV) for the underlying asset(s), generally as of the most recent quarter-end or “record date,” is disclosed to potential secondaries investors and establishes the basis upon which bids are formulated. Second, both the selling fund and the continuation vehicle (CV) that will acquire the asset(s) are managed by the same GP—who has fiduciary duties on both sides of the transaction and inherent conflict of interest.
GP-led transactions garner greater scrutiny from limited partners (LPs) and the SEC – which continues to dedicate enforcement resources to this area of private funds oversight, given the inherent conflict and increasing volumes of transactions. Sponsors and their advisers should design a transaction process that is transparent and fair to the GP’s stakeholders (limited partner advisory committees (LPACs) and LPs), and is focused on achieving optimal pricing. It should also consider the potential commercial risks, including reputational, legal and regulatory.
Getting NAV right
Participants in a GP-led process formulate and evaluate bids based upon the sponsor’s record date NAV. However, this NAV may or may not be the best indication of the underlying value of the asset.
Sponsors should consider a Goldilocks approach. If NAV is conservative and low, there may be elevated risk of a negative reaction from LPs or bids below expectations. Conversely, NAV set unrealistically high can result in lack of interest from potential buyers and price bids at significant discounts to the record date NAV. A realistic NAV struck “just right” will result in a competitive process with engaged investors bidding at or above NAV, and align bids with the expectations of LPs that intend to elect for liquidity.
Another NAV consideration is that record date NAV may become stale and disconnected from fundamental valuation during the course of a GP-led transaction process. In today’s market rapidly changing portfolio company performance as well as macroeconomic, geopolitical and market conditions resulting from COVID-19 recovery efforts are all important factors to consider in connection with NAV.
One avenue to mitigate the challenges with NAV for all parties, is for the GP to seek external valuation advice and input from an independent, qualified investment bank that is knowledgeable with respect to the asset(s) and company’s(-ies’) industry. This pre-launch NAV “diagnostic” exercise that may be refreshed throughout the process.
Given current GP-led transaction volume and limited bandwidth in the secondary market and LPs, the benefits of getting NAV right are numerous – from lower execution risk, garnering LP and LPAC support for the transaction, better pricing, increased LP election of the liquidity option, and minimizing regulatory and legal risks.
Mitigation of inherent conflicts
The myriad of conflicts faced by the GP in GP-led transactions are complex. Aside from the obvious issue of managing the selling fund and the CV, while having economics in both, the GP is responsible for striking NAV and controlling the transaction process. As a result, GPs have increasingly sought fairness opinions to assist in discharging their fiduciary duties, manage these conflicts and comport with best practices and good corporate governance.
ILPA recommends that sponsors engage an independent financial adviser to provide credible valuation advice with respect to the underlying asset(s) and to obtain a fairness opinion. Fairness opinions in GP-led transactions are now standard practice and as a result, selling fund LPACs and LPs are better informed and have become accustomed to having the ability to review the valuation and fairness opinion materials as part of their election process.
For GPs pursuing GP-led transactions and considering a fairness opinion, two key considerations include:
- Importance of starting early. A transaction process creates a lot of demands on the schedules of the deal team and the management of portfolio companies. Engaging with an independent financial advisor earlier in a transaction process is less intrusive, promotes collaboration while providing ample runway to complete due diligence and be additive to the overall process.
- Finding the right partner. As with any process, the quality and experience of outside advisors that the GP chooses to partner with are critical. It is critical that the investment bank that you engage for the fairness opinion is independent and also has a track record of delivering highly defensible valuation and fairness analyses and carries credibility with the LPAC and LPs. Not only should it have the requisite valuation and fairness opinion expertise but also experience navigating the unique dynamics of GP-led deals and relevant industry perspective and private market expertise.
Hardeep Sing and Chris Gregory are managing directors at Lincoln International