The LP/GP balancing act

Sales of limited partner private equity fund stakes on the secondaries market reached a record high in 2021. Yet, general partner-led private equity secondaries sales outpaced LP sales for the first time, and the growth of GP-leds shows no signs of slowing down.

That expanding market share for GP-led sales versus LP sales is forcing secondaries buyers to recalibrate, adjusting their investment strategies, skill sets and growth plans for a predicted future in which GP-leds hold a dominant share of the secondaries market.

LP rebound

LP deal volume surged to an all-time high of $66 billion in 2021, compared with $28 billion in 2020 and $54 billion in 2019, according to figures from Evercore. The recent LP secondaries sales growth can be traced back to the stock market decline at the beginning of the pandemic, in early 2020.

LP secondaries sales typically slow to a near standstill after large movements in the public equities markets. In the wake of a market downturn, such as when covid-19 first struck, secondaries buyers adjust their offers downward accordingly, says Michael Woolhouse, TPG partner and leader of strategy and investment for the firm’s secondaries investment business. In that situation, LPs balk at any selling because portfolio valuations have not yet been adjusted in line with the downturn – any sales would be at a significant discount.

“Nothing trades hands until whatever is going on in the public equity markets works its way through the GPs’ marks” and to the LPs’ books, Woolhouse says. When the stock market drops suddenly or spikes, there is a lag of one or two quarters before the public equities market movements are reflected in the net asset values of the PE portfolios. “LPs are waiting until things get in equilibrium such that secondaries buyers and the selling LP can get to a deal that both sides are happy with.”

That equilibrium occurred in 2021 – LPs were ready to sell again and the market boomed.

Another influence on LP secondaries has been the overall success of private equity, says Nigel Dawn, Evercore senior managing director and head of the investment bank’s private capital advisory group. As the value of LPs’ private equity holdings has grown relative to their other investments, LPs have been forced to sell PE stakes to rebalance their portfolios.

“It’s almost like they’re a victim of their own success,” Dawn says. “Many institutions were overallocated really because of the growth in NAV. They were so successful that particularly public pensions, endowments and foundations were hitting their allocation limits. That was definitely a strong driver.”

Private equity success has also led to an unprecedented number of GPs coming back to market faster than expected with new funds, which puts pressure on LPs to invest in the new funds. “The secondaries transaction was a way of creating some capacity to allow the LP to reinvest with the managers that they’d invested in in the past and they’d done well with,” he says.

GP-led growth

On the GP-led side of the market, sales volume also reached a record level in 2021 – $68 billion – more than double its 2020 sales of $32 billion, Evercore reported. GP-led transactions made up 51 percent of total secondaries sales in 2021, with LP sales at 49 percent of the market, compared with a 53-47 split in favor of GP-leds in 2020.

GP-led growth came primarily from two sources: innovations in the GP-led sales process and the dearth of LP sales after the covid-19 stock market downturn.

The GP-led growth from innovation has come quickly. Woolhouse says. “Five years ago, most of the secondaries market wouldn’t know what to do with a single-asset deal,” he notes. Yet by 2021, single-asset deals made up half of the GP-led secondaries market and 25 percent of the overall secondaries market.

“We’re beginning to see now the emergence of the GP-led specialist”
Michael Woolhouse
TPG

The innovation factor – particularly its influence on the secondaries market to fully embrace single-asset deals – will continue to drive growth for GP-led sales, he says: “That’s not going away.”

The dearth of LP sales was a lesser source of growth for GP-led deals – more of a cyclical driver. When LPs stopped selling in the wake of the covid-19 driven equities downturn, secondaries investors who had to invest their funds somewhere turned to GP-led deals.

Geopolitical uncertainty and the general lack of initial public offerings have also spurred more GP-led transactions, as PE fund sponsors look to retain control of some of their most successful assets, Dawn says. GP-led transactions allow the fund sponsor to lock in returns, offer liquidity to LPs and provide continuity for the portfolio company’s management team, while accessing the continued upside for the underlying company.

Adjusting to the GP-led world

Overall, secondaries buyers have preferred to put two-thirds of their capital into LP-driven transactions because of the diversification advantages in LP secondaries, and this has driven up demand for LP sales recently as GP-leds take a greater share of the market, Dawn says.

Most PE secondaries fund managers buy both LP shares and GP-led deals, with a certain percentage allocation to each in their funds, Woolhouse says. During the covid lull in LP sales, secondaries buyers invested more in the GP-led side, and now they need to favor the LP side to reach the allocation percentages promised to investors in their secondaries funds.

As GP-led sales take a larger and larger share of the secondaries market, secondaries fund managers will have to adapt, Woolhouse says. The investment skills required for buying an LP portfolio – typically with a look-through exposure to hundreds of underlying companies – are quite different than for buying GP-leds, which can involve sinking $200 million into a single company.

The growing market share of GP-leds will also change secondaries investment vehicles, Dawn says.

“Secondaries funds generally are supposed to be lower risk/lower return, and they’re lower risk because they’re more diversified,” he says. “The shift in the last few years to more concentrated positions – and particularly single-company deals – has made secondaries portfolios more concentrated than has historically been the case, and has made secondaries investors in a sense more stock pickers than portfolio buyers.”

Historically, investors have sought out secondaries funds because they offer shorter durations, greater diversification and J-curve mitigation compared with regular private equity funds, Dawn says. “If you put a significant number of concentrated positions in that, you don’t really achieve that objective.”

GP-led growth will create pressure on secondaries buyers that are trying to maintain a specific allocation of LP- and GP-led secondaries to their investors, and on buyers that have so far avoided the GP-led market, Woolhouse says. Investors will naturally want to go where the most attractive dealflow or volume is.

“That’s a tension I think that is going to continue to play out in this marketplace, and I think it will be pretty fascinating in the years to come,” he says. “We’re beginning to see now the emergence of the GP-led specialist.”