This article is sponsored by Sixpoint Partners
What are the top three trends you’ve seen recently in the area of capital formation and new entrants for the private secondaries market?
Shawn Schestag: The first trend is the obvious uptick in strategies that are dedicated to GP-led solutions. The segment is outgrowing the capital available for GP-leds, so investors realize this is a very attractive segment in the market where they can generate alpha. There has been a greater supply of these transactions than available dry powder to pursue them. Also, any private equity firm that now views themselves as an alternative asset manager probably started off with a monoline buyout strategy, then built a private credit business or real estate business or an infrastructure or growth business, and now they view the secondaries business as a new leg of the stool.
The second trend we are seeing is an increase in overage vehicles, also known as annex vehicles or sidecars – namely, the parallel vehicle that sits side by side with the main fund that gives the buyer additional dry powder for individual deals. A number of overage vehicles that secondaries funds are raising are dedicated to writing larger checks to GP-led continuation vehicles.
The third trend is the increase in the number of dedicated secondaries funds pursuing credit secondaries transactions. Credit has for a long time been viewed as a huge opportunity because the size of the credit market is substantial, yet it’s thinly penetrated from a secondaries standpoint. So as a lot of the secondaries fund platforms have matured, credit is a natural adjacency. With the advent of the GP-led market, secondaries investors have become very good at underwriting specific companies, as opposed to LP portfolios. And the underwriting work for credit portfolios has parallels to the work on an equity portfolio.
Why is the number of single-asset opportunities in the private secondaries market increasing? How does this affect the market?
Andrew Gulotta: In most single-asset transactions, the portfolio company is being hand-selected by the GP because they believe it’s their best asset or the asset with the most material upside. The sponsor believes they have a winner. They can sell the business today and book a great return. But they also believe that upside remains since they’ve already effectuated their value creation plan by upgrading management, consolidating a sector, or upgrading systems. So, on a risk-adjusted basis, this is the most superior opportunity they have within their portfolio today. The single-asset continuation vehicle allows the sponsor to generate an attractive return for their LPs that want liquidity. But they continue to control that business and capture any upside going forward.
These opportunities have gained market acceptance because they provide a win-win solution for a portfolio company investment that has “outgrown” the fund in which it resides. There is a growing appreciation that these transactions deliver an attractive liquidity event for existing LPs while providing the GP the opportunity to continue to pursue its value creation strategy for the underlying portfolio company. For secondaries buyers, these are more labor-intensive due diligence processes, because these opportunities are more akin to direct investing. They have to pick and choose earlier in an auction process where they’re going to allocate time and resources.
How does risk from broader economic forces – rising interest rates, energy price fluctuations or geopolitics – affect buyer underwriting and due diligence in the private secondaries market?
SS: There’s a higher risk premium in the world in which we’re operating today. On the LP portfolio side, generally, everything is still pricing off Q3 of last year. If you’re buying beta – a big, diversified pool of LP positions – the average portfolio discount is materially larger than it was at the beginning of the year. On the GP-led side, it’s more of a micro view: you’re looking at specific portfolio companies and how they’re valued compared to public-company and M&A comps, or with a discounted cash flow analysis valuation.
If you’re a buyer looking at a GPled, you’re trying to triangulate what’s an appropriate price for an asset based on all that information. But you’re also scrutinizing projections more because you may be concerned about the corporate impact of higher interest rates or rising input costs.
Secondaries investors are coping with macroeconomic drivers – whether it’s interest rates or geopolitical risk – with a general migration toward defensive industries such as health care or essential industries such as companies that support infrastructure or the utilities sector. Also, secondaries investors would prefer lower-leverage companies, just to add that margin of safety.
What are the key structural issues that GPs need to address in a GP-led secondaries offering?
AG: The limited partnership agreement (LPA) that governs the selling fund in these transactions will require a consent process, and the vast majority will be through limited partner advisory committee (LPAC) consent. The LPAC will opine on affiliate transactions and inherent conflicts of interest. They’re really consenting that the GP has satisfied its fiduciary obligation and standard of care – that it operated in the best interests of the LPs. So a red flag would be if the GP never ran a process – if it didn’t hire an advisor and didn’t run a competitive auction to get a third-party validation of the price. In some cases, there’s an expectation from LPAC members that the GP will both run a process and get a fairness opinion.
One inherent conflict is that the GP will have an economic incentive in the continuation vehicle. So GP communication with the LPs, and having a proper process that builds in transparency and symmetry of information is really important. The would-be sellers in a secondaries transaction, the LPs, should have the same access to information and access to the same data room that was provided to the buyers.
One structural consideration is what the rollover option looks like – whether the LP comes in heads-up with the new secondaries investors, or you offer another rollover option where the LPs can effectively maintain the same economic terms that they had in the prior vehicle. Another growing consideration in most GP-leds today is whether the sponsor will also refinance the debt of the relevant portfolio company or companies simultaneously. We are also seeing an increase in the desire to cash out minority shareholders, legacy shareholders, outside of the GP’s incumbent ownership. Such transactions look much like a “re-LBO” of the asset or assets.