Direction of the GP-led market


The use by GPs and LPs of the secondaries market is now an accepted tool for active portfolio fund management and for the last few years, has been the fastest growing section of the private equity industry. 

This article looks at the direction of the GP-led market which has experienced extraordinary growth over the last two years and now comprises over half of the secondaries market. 

Continued growth in the GP-led market

The growth in GP-led transactions in recent years is a trend unlikely to slow down, especially given the significant amount of dry powder available to secondary investors following successful and record-breaking fundraises. Secondaries-focused funds raised $63.8 billion in 2021 and in the year before, raised $98.9 billion. In practice, the amount of capital allocated to secondaries strategies is significantly higher than these figures due to $multi-billion allocations on the balance sheet of non-sponsor investors (pension funds, sovereign wealth funds etc.) and a large secondary "fund finance" market that provides leverage to the buy-side.

According to Coller Capital, 86% of LPs believe that the private equity secondaries market will expand in the next three years. Indeed, continued volatility in the public markets and private equity's outperformance of public equity portfolios since the Global Financial Crisis only serves to bolster the attractiveness of the secondaries market as a means by which GPs can delay third party exits to such time as enables the GP to maximise its return.

Alternatives to a traditional exit

As macro-economic conditions deteriorate and the asset level M&A market becomes more challenging from a pricing and deal certainty perspective, more GPs will explore alternative solutions to traditional M&A exits for particular assets.

Single or concentrated asset GP-led continuation funds which give GPs the ability to retain premium assets for longer (especially where there is further runway for value creation) and avoid being 'forced sellers' for assets that may not achieve optimum pricing, will be even more attractive to GPs.

Preferred equity

During the height of the pandemic, preferred equity (alongside other non-dilutive secondary capital) was an attractive product for those GPs trying to capitalise their portfolios, particularly where remaining unfunded LP commitment capacity in the fund was limited. Whilst the interest in utilising preferred equity for these defensive purposes has waned since the return to "normal", if rising interest rates and market instability persists in the medium term, we expect that GPs will increasingly look to preferred equity as a potential way to bolster their portfolios.

Equally, we expect to see preferred equity (or other structured equity products) being used in certain circumstances as an effective tool by GPs to provide interim liquidity to LPs. This is likely to be relevant in portfolios where a typical sale is not currently attractive (on the expectation that valuations may increase from current marks, particularly in portfolios exposed to listed assets) and to bridge the bid/ask spread on GP-led secondaries.

W&I insurance

W&I insurance has been prevalent in traditional M&A transactions for many years and its use as a risk allocation/mitigation tool is well established. On GP-led transactions, the use of W&I insurance is more nascent but is fast becoming an increasingly common feature of such transactions.

The value of W&I insurance from a liability perspective is obvious and is magnified in a GP-led continuation fund scenario where an existing fund managed by a GP gives warranties to a continuation fund managed by that same GP, often into which investors from the existing fund have reinvested alongside a secondary investor. W&I insurance is an effective solution to address liability exposure for the existing fund (and ultimately, its investors) and crucially, avoiding a circumstance where the continuation fund (managed by the same GP and often with overlapping investors) is required to make a breach of warranty claim against the existing fund.

W&I insurance has the added benefit of reducing both any holdback amounts from the purchase price (leading to earlier distributions for LPs) and the likelihood of a GP requiring an LP giveback to fund warranty claims from the continuation fund. Accordingly, it acts to smooth and increase the attraction of GP-led processes.

On concentrated or single asset deals which look more akin to M&A transactions, secondary investors may look for enhanced warranty protection by broadening out the traditional secondary fundamental set of warranties to also include operational warranties that would be typically found on an M&A transaction. W&I insurance is frequently being used to bridge misalignment between the greater level of warranty protection required by a secondary investor and the GP's desire to cap its liability.

Further, in single asset GP-led transactions where management of the underlying business are involved in the sale process (often, in circumstances where their MIP is being crystalised or re-cut) and giving warranties to the continuation fund, they will commonly look for W&I protection against recourse under the warranties, as they would if the sale were to a third-party managed fund.

Deal pricing

GP-led deals are frequently priced by a secondary investor as part of an intermediated auction process, often supported by a third-party fairness opinion (a practice set to increase if the recent SEC proposals are implemented in their current form). However, increasingly, GP-led deals are being priced following the sale of a minority stake in the underlying asset (or assets) to another financial sponsor by way of a traditional M&A process.

Whilst this back-to-back pricing process may extend the overall transaction timeline, it can also facilitate a more efficient GP-led transaction on the basis that diligence, Q&A and disclosure materials from the M&A process can be leveraged by both the secondary investor and, if W&I insurance is used, the underwriter. Price setting through a minority sale can also help to assuage any LP concerns around pricing, ultimately facilitating the transaction.

Pricing mechanics

Traditionally, pricing on secondary transactions is presented as a base price (at a discount or premium to NAV as at an historic reference date) which is adjusted downwards for distributions to LPs and upwards for drawdowns from LPs, between the reference date and completion of the transaction. Notwithstanding this, on single and concentrated asset GP-led continuation fund deals, the trend is however increasingly for lead investors to be asked to price based on a multiple of EBITDA, thus requiring an EV-to-Equity bridge negotiation. 

Consequently, on single and concentrated asset GP-led transactions, deal documents are utilising M&A based consideration mechanics, namely the 'locked box'. It is likely that such mechanisms will become more prevalent in concentrated GP-led transactions, especially where management of the underlying business are involved, and value leakage from the underlying business becomes an area of focus for secondary investors.

Looking to the future

The GP-led market remains buoyant and the regular headlines about successful fundraisings in the space, together with the volume of capital available for deployment to these deals, only fuels this. Given the rising focus of secondaries investors on the underlying assets into which they are investing, we expect the terms on which these deals are done to increasingly look like third party private equity M&A to the extent they relate to single or concentrated assets. We therefore expect a bifurcation of the terms on which fund portfolios are placed into continuation vehicles and those which apply on deals which relate to high performing single/concentrated assets.

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