Keeping up with the rapid expansion and evolution of the secondaries market
It’s no secret that GP-led secondaries have really taken off in the past few years, with a significant boost through the pandemic. The more challenging exit conditions and difficulty of conducting due diligence through the most restrictive periods of COVID containment led to a significant rise in single-asset GP-led deals in particular. So how is this changing the secondaries market? And how do non-secondary LPs view this development?
“Over the past few years, the definition of secondaries has changed significantly,” says Neal Costello, Managing Director, AlpInvest Partners. “It’s not even that long since it was considered a niche market, yet it’s now grown into a mainstream investment category. This has prompted new entrants and the scope of what you can do as a secondaries player has really broadened.”
The first half of 2021 was exceptionally busy on the secondary deals front, with a record-breaking US$48bn of transactions done, according to Evercore figures – for comparison the whole of 2020 saw US$60bn, and 2019 US$80bn. Yet of the US$48bn, well over half – 63% - were GP-led deals, versus 53% in 2020 and just 33% in 2019. And single-asset deals, in particular, have led this growth, accounting for $12bn in H1 2021, against US$5bn in the whole of 2019.
“The shift in the opportunity set has been significant,” says Greg Holden, Partner at Adams Street Partners. “A few years ago, around 70% of what we were seeing was in LP positions and the rest in GP-leds. Nowadays, GP-leds are more than 50% of total deal flow.”
These deals have clearly gained a lot of market acceptance as GPs now perceive them as a way of holding on to good assets at a time of high valuations, greater difficulty of conducting due diligence on new deals and providing the option of liquidity to LPs without having to sell assets with further upside. Many LPs are very supportive of the development, too. “We wouldn’t lead on a GP-led deal,” adds Sarah Farrell, Managing Principal - Private Equity Group at Allstate Investments. “We don’t have the team bandwidth and, as an insurance company, we prefer not to underwrite more risk than we plan to sit on. But they are interesting because we want to follow high-quality, high-conviction GPs who want to put their crown jewel asset into a secondary – yes, the pricing will be punchy, but you won’t get skeletons falling out of the closet because the manager knows the asset well.”
We want to follow high-quality, high-conviction GPs who want to put their crown jewel asset into a secondary
As Farrell notes, however, resourcing the steady wave of GP-led deals can be an issue. “The ability to invest in the best performing companies alongside highly-aligned GPs means the rewards are more than worth the effort, but these can be pretty intense,” says Paul Newsome, Partner and Head of Investment Solutions at Unigestion. “You need a team dedicated to the deal, you need to do multiple calls with the GP and management team, negotiate terms and put the structure together – the effort per dollar invested is much higher than for an LP-led deal.”
“GP-led deals are more expensive from a time and money perspective than LP-led transactions,” agrees a seasoned secondaries investor. “That’s particularly so when you consider the proportion of a fund it represents when compared with an LP deal.”
Yet this issue is even more of a challenge for existing LPs, many of which may have limited resources, when they are tasked with making a decision about whether to roll or sell a position – and this is particularly the case when several GPs in a portfolio initiate these deals.
Other concerns around manager motivations in the rush to GP-led deals are also increasingly emerging as the market ramps up. “GPs do need to be careful, especially when they are putting forward their reasons for doing this,” adds Mark Nicolson, Head of Primary Investments at abrdn. “My concern is that there is almost an abuse of the use of continuation funds creeping in. We’re seeing some instances of proposals for continuation vehicles for assets in funds that are just outside their investment period but there’s still plenty of time and capital left in the fund. We’re also seeing premium economics creeping in when there’s actually a better solution.”
And, as past experience has shown, these deals can present issues if not structured fairly – the SEC has fined some firms for selling assets below their true market value and some deals have been aborted for similar reasons. Yet secondaries players counter that there is much more standardisation to the way these deals are being run nowadays and that information flows have improved significantly.
“At the beginning of the market’s development, no-one was used to the process, but today it is well understood,” says Valérie Handal, Managing Director at HarbourVest. “The more successful processes recognise that you are buying concentrated portfolios and need to do M&A-style due diligence so they provide you with the information you need to really dig deep in the companies and they give you access to management.”
The current environment is also helping when it comes to reaching valuation agreements. “There is a ton of liquidity in the market right now and that provides you with lots of price points,” says Elias Korosis, Partner at Hermes GPE. “There is no shortage of data points you can access to ensure that everyone is treated fairly – if we were in an illiquid market and you were trying to transact at the bottom of cycle, it would be different, though.”
With so many of these deals reaching completion – and as their size continues to increase – concentration risk is a potential problem for serial GP-led deal-doers. This is prompting many secondaries players to proactively hunt out more traditional LP positions once again. The EIF, for example, is getting interest in positions that aren’t even currently for sale. “We were about to put a large portfolio on the market in March 2020, but we had to pull back,” says Joaquín Alexandre Ruiz Tarré, Head of secondaries at EIF. “We’re now getting quite a few calls from interested buyers – appetite for LP positions is definitely growing and we plan to restart our sell-side activities soon.”
“LP-leds are very much in demand,” says a Head of Secondaries at a bank’s alternative investment arm. “This is particularly so at the larger end of the market. At a time of high GP-led activity, diversification is clearly something to be prized.”
Yet these deals are more scarce than most would have expected at this stage of the cycle, largely because valuations have recovered so quickly. “Sellers have been sitting on portfolios during the COVID crisis and holding out for better pricing,” says Patrick Knechtli, Head of Secondaries at abrdn. “We ran a sales process earlier this year that was specifically designed to capture the fact that there weren’t many diversified fund portfolios available while buyers were hungry for them – and it turned out we timed it right.” Yet as fundraising cycles are shortening, many believe that more diversified portfolios will start to emerge as LPs look to free up capital to invest in new funds and to avoid GP concentration risk.
Secondaries players are clearly broadening their horizons to incorporate a range of deal types when building portfolios. Many are actively seeking new hires with more direct deal and M&A experience to ensure they have the right skills to evaluate concentrated GP-led deals – a clear sign that these deals are expected to persist in the market as a fourth exit route. GPs are also structuring funds targeted specifically at these new deals while some secondaries players are raising pockets of capital for GP-leds.
Yet for many, having a mix of GP-led and LP-led transactions in a portfolio can create both steady returns and a boost to performance. “Never underestimate the power of the duller LP portfolio, which can generate cash every single day of the week,” says Carlo Pirzio-Biroli, Managing Partner and CEO of Glendower Capital. “But when you look at high conviction single-asset transactions, you can conduct enhanced due diligence and isolate risks, such as COVID exposure, and aim for attractive multiples. We look at both to optimise portfolio construction, but different LPs may have a different appetite for either category.”
As a relative newcomer to the market, private debt has not yet seen secondary deal activity on a par with private equity. But this is changing, says Toni Vainio, Partner at Pantheon Ventures. “Private debt now has assets under management of over $1tn and this is growing by close to 10% each year,” he says. “More investors are now in what is an illiquid asset class and inevitably LPs need to rebalance their portfolios over time, which is leading to the development of the private debt secondaries market.”
While this may be similar to some of the reasons underpinning the growth of the private equity secondaries market, private debt differs in one key respect – GPs run shorter duration funds and they do not control exit timings. “If you have typical fund terms of seven years, investment periods of up to four years, and legal loan durations of 5 to 7 years, it’s quite likely that you will have a number of positions left at the end of a fund’s term, requiring GPs to manage portfolios more proactively,” says Vainio. That means opportunities for secondary deals for some of the earlier vintage funds raised in the middle of the 2010s, in particular as LPs seek liquidity to invest in the ever-growing private debt landscape.
And for investors going into private debt secondary deals, they can have some attractive characteristics, according to Vainio. “The secondary deal risk profile can be superior to that of a primary investment. In new loans, we see significant adjusted EBITDA on the way in and peak leverage because it’s a new investment,” he says. “If you buy three years into a loan’s life, leverage has typically come down and you can price risks such as COVID exposure into the deal. On average, the remaining loan duration to maturity is less than four years when you buy through a secondary, which means there is less duration risk.”
It may be starting from a low base, but private debt secondaries have grown significantly in the past year, with fund transactions worth US$1.1bn in H1 2021, up over 177% on the same period in 2020, according to Setter Capital figures. And this may well grow further as GP-led technology developed in the private equity market becomes adopted by private debt players and investors. “There’s still more to do to educate GPs on what GP-led deals can bring,” says Vainio. “But that will come.”
