Does everyone win in GP-led deals?

Taking a deep dive on the new favorite of the secondaries

Secondary private equity deals initiated by GPs have rocketed since the start of the pandemic and they are often badged as solutions that benefit all participants. But is that really the case?

GP-led transactions have been a growing part of the secondaries market for some years now, but they have exploded since the start of the pandemic. In 2020, the total value of direct secondaries even surpassed that of more traditional LP trades for the first time ever, accounting for 52.5% of dollar volume of the market, versus just 34.2% in 2019, according to Setter Capital figures.

“The past 12 months has been extraordinary in every way in the secondaries market for deals,” says Nash Waterman, Managing Director and Head of AIP Private Equity Secondaries at Morgan Stanley Investment Management. In the early stages of the pandemic, it was far from clear how long deals and, in particular, exits would need to be put on ice.

As a result, GPs started exploring their options for realizing investments and generating liquidity for their LPs.

“There was the potential for the market to go into freefall,” says Waterman. “While it actually recovered pretty quickly, the interim period caused GPs to become more aware of how they could use how single-asset GP-led deals. Once they had that information and markets improved, they began to see these deals as a tool that would allow them to hold on to their best assets. This has led to a significant increase in single-asset deals.”

Changing views

The development of new liquidity solutions in secondaries market has clearly shifted GP views of the market. Where in the past, GPs may have had secondary deals imposed on them, now many see the market more positively. “Executed well, GP-led deals can be a win-win-win situation,” says Jeff Hammer, Senior Managing Director and Global Co-Head of Secondaries at Manulife Investment Management. “In the old days, sponsors would sit on the sidelines when an LP trade came up and they had to ask the question of whether they should allow a secondary fund into their LP base. They would often ask: what’s in it for me? The market has grown steeply in recent years because GPs can now use the secondaries market for their own purposes as well. It’s a win for the buying and selling LPs and it’s now also a win for GPs.”

Indeed, secondaries players say the development of GP-led deals provides optionality for everyone - GPs can keep their best assets and expand their LP base, while LPs are offered liquidity and/or deals in a way that takes account of investors’ different time horizons and return objectives.

Challenging for some

It’s clear that secondaries investors fully back the growth of these deals. After all, they can offer access to some of the best performing assets managed by some of the best performing GPs. But what about the LPs that aren’t secondaries specialists?

For these investors, GP-led deals present some issues. “GP-led deals are here to stay,” says J. David Enriquez, Head of Private Equity at New York City Retirement Systems . “But they do present investors like us with a number of challenges. We are a six-person private equity team managing a $25bn private equity portfolio, so we have a full pipeline of work. Every time we get a GP-led liquidity option, it’s like a 70-hour homework assignment – we need to analyse it and really understand what’s on offer.”

Part of the issue is that there is little standardization - perhaps necessarily so – across GP-led deals. “Unlike a limited partner agreement in which there is a core set of terms and economics and where you would only have to negotiate about 15% to 20% of the terms,” adds Enriquez, “in the GP-led market, every deal is different. We welcome the optionality, but it puts some stress on our resources.”

Enriquez is not alone. “It’s a struggle and it’s growing,” says Steve Moseley, Deputy CIO and Head of Private Markets and Alternative Investments as Alaska Permanent Fund Corporation. “LPs have accepted continuation vehicles of all shapes and sizes now and so it’s too late to turn this around. We’re obliged to absorb and adapt to the market, but it is eating up a lot of bandwidth.”

“We have several GP-led secondary deals a month land on our desk,” adds Scott Ramsower, Co-Head of Private Equity Fund Investments at the Teacher Retirement System of Texas. “This usually means we have to at least vote as an advisory board member and also make a decision on whether to hold, roll, sell or even co-invest. We have 22 people managing $31bn of private equity investments and even we struggle with the workload.” Both Moseley and Ramsower also have concerns about GP-led deals cannibalizing co-investment opportunities.

It’s a struggle and it’s growing. LPs have accepted continuation vehicles of all shapes and sizes now, so it’s too late to turn this around. We’re obliged to absorb and adapt to the market, but it is eating up a lot of bandwidth.

- Steve Moseley, Deputy CIO and Head of Private Markets and Alternative Investments at Alaska Permanent Fund Corporation

A runaway train?

Yet these issues don’t necessarily mean that LPs are hostile to the development of GP-led deals. “We originally fought hard against them,” says Ramsower. “We’d prefer GPs to go fishing for new assets, but it’s clear that the market has voted and they are here to stay. We’ve done a 180-degree turn, shifting from trying to slow the train down to directing it by focusing on making sure that all the right boxes are checked, from governance and alignment through to questioning whether the deal rationale makes sense.”

This pragmatic approach is common to other LPs, too. “We’re looking at how we can take advantage of continuation funds in an effort to respond to a development that has been thrust upon us,” says Moseley.

And there may even be some silver linings. “It’s clear that GPs want to hold on to assets for longer,” says Ramsower. “As trends go, it may not be the worst at a time of high valuations; it may be better to hold than to find something new.”

“I tend to look at these deals in a similar light to leverage,” adds Enriquez. “If they are done the right way, they can enhance returns or the capital structure of a deal. But you do have to spend time evaluating them – if they are off market and there is no long-term strategic rationale, things can go sideways. I think there will be an evolution in the market where institutions and LPAC members will start to provide feedback more assertively.”

The predictions are that GP-led deals will continue to flourish. Waterman, for example, says they are “taking on secondary buyouts, which are an enormous part of the market”. And given their relative nascence, it’s perhaps unsurprising that they are taking some effort on the part of LPs to assess. As the market develops further, there is likely to be at least a little more standardization in process and deal structure that should reduce the burden currently felt by resource-constrained non-secondary LPs. However, those involved in these deals might do well to consider some of the issues faced by these LPs when presenting them with a new transaction.

^{*The Wall Street Journal reported that J. David Enriquez’ last day at the NYC Bureau of Asset Management was May 7, 2021 and PEI subsequently reported that in June he will be joining Rothschild Five Arrows, the merchant banking group of Rothschild & Co.}