The rise of GP-led secondaries

September 2021 | SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2021 Issue

The second half of 2020 saw unprecedented deal volume for so-called ‘GP-led secondaries transactions’. Once a niche strategy employed to realise value from tail-end assets or ‘zombie funds’, GP-led transactions have become a well-established, mainstream tool for sponsors to proactively manage portfolios, including their highest-performing assets. For the first time, GP-led transactions made up most secondaries transactions in 2020, accounting for 53 percent of total volume according to Evercore, with high-profile sponsors such as Thomas H. Lee Partners, Summit Partners and CapVest implementing transactions in H2 2020.

Whereas secondaries describe the now very large market segment that encompasses a broad range of transactions whereby private fund investors can realise all or part of their holdings in the absence of an exit by the underlying fund, the ‘GP-led’ subcategory achieves the same liquidity for investors through alternative transactions created by the fund sponsor itself.

GP-led secondaries explained

The most common form of GP-led transaction involves the sponsor setting up a new fund known as a ‘continuation fund’ and transferring one or more assets (or a portion of assets) from an existing fund to that continuation fund. The catalyst for such a transaction is often the existing fund having insufficient time – they are typically fixed term funds – or additional capital available to fully execute the portfolio strategy.

Capital is raised for the continuation fund from one or more specialist secondaries investors. Limited partners (LPs) in the existing fund also have the choice to either cash out or participate in the continuation fund by ‘rolling’ their existing interests. The result is a continuation fund that is tailored to the portfolio transferred, with refreshed incentives for the GP.

The secondaries market, including traditional LP trades, preferred equity transactions and tender offers as well as GP-led deals, has been steadily growing for the last few years, with aggregate market volume increasing from $37bn in 2016 to $85bn in 2019, according to Campbell Lutyens. Secondaries fundraising has also been increasing, with Evecrcore estimating $113bn of dry powder as of December 2020.

Then came the global pandemic, and most secondaries activity almost came to a complete halt in the second quarter of 2020. Traditional sales of LP positions became difficult to value with confidence and preferred equity and net asset value (NAV) financing (which were less sensitive to underlying valuations) replaced these as alternative sources of liquidity for both portfolios and investors. But it was GP-led transactions that became the story of 2020. Blue-chip sponsors explored the strategy in droves, with unprecedented transaction volume cementing the strategy as an exit alternative, a liquidity solution and a sponsor management tool. Evercore estimated secondaries transaction volume was up 126 percent in H2 2020 compared with H1 2020, driven in large part by GP-leds, which accounted for 59 percent of the H2 transaction volume.

GP-led transactions come in several varieties, with different transaction rationales. They may involve a dozen portfolio companies transferring to the continuation vehicle, from multiple existing funds, or a single asset moving to a new vehicle. The latter is a recent innovation, typically involving ‘home-run’ companies that have already performed well but require more capital to reach their potential. Existing investors realise strong returns, with the option to continue their investment, and new investors can gain access to attractive assets. Thus, GP-led transactions have come a long way since the origins of finding willing buyers of a fund’s remaining assets that the sponsor has been unable to realise during the original 10-year term, plus extensions.

Issues arising

However, GP-led transactions are not without their challenges. Firstly, GPs sit on both sides of these transactions, and so there are almost always conflicts of interests that must be mitigated and managed. Usually, LP advisory committee or other LP approval is required to approve the management of such a conflict and, as a result, the underlying transaction narrative must stand up to existing LP scrutiny, as well as make sense to new investors. Given the inherent conflict, additional valuation evidence, including independent valuation opinions or arm’s length pricing may be required.

A combination of workstreams, including establishing a new fund, raising capital and implementing an M&A transaction to transfer assets to the new fund, will keep the sponsor and various advisers busy, often over a number of months. Tax and regulatory advice will be pivotal to structuring the transaction. LPs will require adequate disclosure, and the process will need to be closely managed to accord with the GP’s fiduciary duties. In the US, potential Securities and Exchange Commission (SEC) scrutiny will be top of mind. Accordingly, it is crucial for sponsors and other parties involved in these transactions to obtain expert advice and take the time to carefully navigate each of these interconnected transaction steps.

Looking forward

What next for GP-leds? 2021 has started strongly for the sector and industry experts expect 2021 to be a record year, with the global head of Blackstone’s Strategic Partners, Verdun Perry, predicting transaction volume in excess of $100bn for 2021. In terms of the buyside capacity to execute this volume of deal flow, market commentary during 2020 was that the limiting factor was not the availability of financial capital but human resource. Secondaries Investor estimated in June 2021 that at least 70 funds were in market targeting $84bn in aggregate, some of which will be focused entirely on GP-led transactions.

Inevitably, GP-led transactions will continue to evolve at pace. M&A technology, such as warranty and indemnity (W&I) insurance, is now being used more frequently on these deals. The range of buyside participants and specialist players in the market continues to grow. Certain concentrated deals are being run on accelerated timelines and key, repeat sponsors are emerging and implementing multiple GP-led transactions, such as Clearlake, which at the time of writing has implemented four single-asset deals since 2020. There have even been a few ‘continuation funds of continuation funds’, such as Wind Point’s recent GP-led on a 2018 continuation fund, which closed in July 2021. This fast-growing sector looks like it is here to stay. Since the latter part of 2020, then, the question has become: which sponsors are not looking at GP-led transactions?

Jacqueline Eaves is a partner at Kirkland & Ellis International LLP. She can be contacted on +44 (0)20 7469 2090 or by email: jacqueline.eaves@kirkland.com.

Jacqueline Eaves

Kirkland & Ellis International LLP