Sixpoint Partners on getting GP-leds done in a downturn

This article is sponsored by Sixpoint Partners.

What is driving GP-led dealflow in the current environment?

We see two key themes. The first is the continued steady flow of single asset transactions built around trophy assets. The second involves multi-asset transactions where the clear objective is liquidity, due to current challenges in the M&A and refinancing markets. GPs, particularly of older funds, have to take a step back and think about how they can increase DPI or generate liquidity for LPs. Sometimes the GP identifies two or three companies to move into a continuation vehicle, and sometimes it is an end-of-life solution where the GP feels compelled to manufacture a liquidity option for LPs, while also looking for more time and capital to support the remaining assets in the fund.

Is the bid-ask spread inhibiting the ability to get these deals done?

When a deal is first launched, there is generally a bid-ask spread. The sponsor feels they have already marked the company or companies conservatively enough, and the secondary market begs to differ. Then there is slow and steady movement toward one another to get the deal done. 

Obviously, in a market such as this, if a portfolio company continues to perform, that makes it easier to get the price you are looking for. If EBITDA is growing and the lead secondary buyer can underwrite a markup in the next quarter’s valuation, it is easier for them to price the equity at or around “par” because they know they are stepping into an embedded gain post-closing. But in an environment like today’s, that may not be the case. Profitability is flatlining as growth slows, and a secondary investor may seek an optical discount to NAV to make the deal work, particularly if sector comps are down since the last quarterly valuation. 

How does the appeal of concentrated GP-leds compare with diversified LP portfolios in this market?

The quality of assets in concentrated GP-leds continues to be extremely high. You are also getting maximum alignment with these deals in the current environment. The GP is rolling 100 percent and typically also writing an additional cash equity commitment above and beyond that rollover. 

Furthermore, GP-leds offer privileged access to information, enabling thorough due diligence to build conviction. And last, but not least, you are able to buy these superior assets at a far lower valuation today than would have been the case 18 months ago on a revenue or EBITDA multiple basis. 

That said, we have seen some shift toward LP portfolios. Some buyers are getting nervous about making concentrated bets and have shown a preference to buy diversified portfolios with the big discounts available providing their margin of safety. We also see some buyers, who were particularly active in GP-leds from 2020 through the first half of 2022, skew more toward LP portfolios because they have become overallocated to GP-leds, including single asset CVs, within their portfolio. There is room for both types of transaction. Beauty is in the eye of the beholder.

What makes a good GP-led in this environment?

A good GP-led transaction requires a GP who is realistic about where the market is. Of course, you always need great companies led by great management teams in sectors that are going to outperform, but having a client willing to be flexible in this tougher environment is important as well. 

There are sponsors out there that can be very rigid around the valuation and the economic package they want, and that makes securing a deal much more difficult. I would also point to alignment. Buyers are exceedingly looking to see 100 percent rollover with new cash equity commitments on top, particularly if the CV has a need for unfunded commitments. That shows true conviction. A single asset CV can be a franchise-enriching event for the GP, so secondary investors want to see an outsized personal investment by the GP. 

What innovation are you seeing in this market?

We are selectively seeing earn-outs tied to either underlying portfolio company performance or exits. The selling LPs get a kicker if businesses are exited at a certain valuation in a certain amount of time, for example. That is a de-risking tool for the buyer. 

We are also starting to see deferrals creep in, as well as more usage of financing in GP-leds. For example, in a couple instances we have pivoted to preferred equity solutions as an alternative to outright continuation vehicles where the sponsor is focused less on LP liquidity and more on accessing follow-on capital in a cost-effective way. Similarly, we are seeing an uptick in NAV-based loans. 

Do we have visibility on how recent single-asset GP-leds are likely to perform?

The single asset phenomenon has been around for roughly three years. We are just now entering a period where we would expect to start seeing exits from those transactions, and, of course, it isn’t a great environment for exits. My instinct is that the M&A market will revive in 2024 as the Federal Reserve’s tightening cycle comes to an end in 2023. What goes up must come down in terms of interest rates. Over time I think we will settle back into the 2 to 3 percent Secured Overnight Financing Rate range once inflation subsides further, and that will lead to a highly active exit market for all those 2020 and 2021 vintage single asset CVs. 

In the interim, many secondary buyers are sitting on substantial paper gains. It is just a matter of time until those are realized. The only exception may be some of the software-focused GP-led transactions that were priced on revenue-based multiples in 2021 at the top of the market. Underlying business performance may be up since then, but that will be counterbalanced by the decrease in revenue multiples, meaning the equity is unlikely to be marked up.

GP-led deals present various conflict of interest risks. How is the industry addressing these conflicts? 

The good news is there is now a defined playbook for ensuring conflicts of interest are handled appropriately. First, it is important to have an adviser-led process. There will be LPs in the fund with a secondaries business that may be keen to lead, but there needs to be an equal opportunity process, in which outside parties are invited to compete. There is also always an affiliate transaction approval process built into the LPA of every private equity fund, whether that involves LPAC consent or a full LP vote. 

Thirdly, there is now a fairness opinion in almost every deal we do. Finally, you have the rollover option. Liquidity is not being forced on anyone. LPs can choose to maintain ongoing equity exposure and play out the associated upside potential or downside risk. All these things combine to ensure that everyone can get comfortable with the outcome and that these deals can be structured as win-wins. 

How big can this market get?

I think the GP-led segment will continue to represent around 50 percent of the overall market and around half of the GP-led segment will involve single asset deals. We should approach total market volume of $200 billion per year relatively soon. That means we are consistently reaching $100 billion of GP-leds annually, including at least $50 billion of single asset CVs.

Sixpoint Partners is merging into Harris Williams, pending regulatory approval.