GP-led secondaries: new tools for the private equity allocator
General partner-led, or GP-led, secondaries represent a new strategy within private equity, joining direct investments, co-investments, and fund commitments as an important way to gain differentiated exposure to the asset class.
The unique risk/return and holding period characteristics of a rapidly evolving GP-led secondaries opportunity are just now coming into focus. The inevitable conclusion is that institutional investors should consider specific allocations for GP-led secondaries within their private equity exposure targets.
Don’t neglect expected duration when evaluating potential performance
First, let’s examine how investment success is typically measured in private equity, a review that will help underscore why GP-led secondaries represent such a game changer for private equity allocators. The two most common measures of private equity investment performance are:
- Return on invested capital—Expressed as a multiple on invested capital (MOIC)
- Rate of return on an investment—The internal rate of return (IRR) expressed as a percentage
MOIC, which isn’t dependent on time, represents a raw, brute-force measure of the efficiency of capital over the course of the investment. IRR, which does incorporate the time value of money, represents a more nuanced performance measure of the same investment.
In the early days of private equity, IRR was favored over MOIC by most stakeholders. That preference stemmed in part from generally accepted principles that capital was, in a sense, borrowed from equity investors and needed to be paid back with a time-based return. Additionally, early private equity sponsors understood that it was more advantageous to be held accountable to an IRR given the availability of more levers to improve IRR and fewer levers to improve MOIC.
As the private equity market matured, MOIC gained in popularity as a performance measure. This trend was accelerated in the mid-2000s when the industry moved to fair value accounting for private investments. Moving from cost-based values to mark-to-market valuations made MOIC more relevant to private equity; however, it also made MOIC a more pliable tool and reduced its moral authority as a hard check on investment performance. From that point forward, MOICs could be managed much in the same way that IRRs had been managed over the years.
In our view, MOIC has always been the better measure of investment success for private equity. Recall Howard Marks’ famous quote, memorialized in the title of a 2006 memo, “You Can’t Eat IRR.” However, MOIC based on mark-to-market valuations as opposed to actual realizations can cause confusion unless accompanied by another metric. We would argue that expected duration of the investment is an important element to understand when evaluating private equity performance. In the credit markets, a bond’s duration is the time in years it takes for the bond’s price to be repaid by aggregate cash flows. In an equity context, duration could be considered the time it takes an investment to achieve its total targeted return.
Expected duration of the investment is an important element to understand when evaluating private equity performance.
Bifurcated choices for private equity allocators
Now, let’s apply these concepts to private equity allocators’ investment choices. Direct investments sit at one extreme of the spectrum while fund commitments sit at the other end. Direct investing is considered the highest-returning, highest-risk, and most active method of private equity investing; fund commitments are considered the least risky and least active means to gain private equity exposure. Over the years, co-investments and limited partner (LP) secondaries have come to occupy the space in between the two poles, with co-investing gaining traction as an alternative way to secure the risk/return profile of direct investing and LP secondaries becoming an alternative way to secure the exposure and relative safety of fund commitments. To sum it up, this first generation of investment choices offered allocators options for private equity exposure across a spectrum with each choice representing a different risk/return profile.
First-generation private equity investment choices
While co-investments are close cousins of direct investments, co-investments often are underwritten with lower expected returns given higher frictional costs and more conservative assumptions. Similarly, LP secondaries are close cousins of fund commitments, but LP secondaries offer a materially different risk/return trade-off and, typically, a shorter duration given front-end dynamics of most secondary transactions, including discounted purchase prices of more seasoned assets.
GP-led secondaries: an answer to the private equity allocator’s dilemma
The rise of GP-led secondaries has changed the landscape for private equity allocators by providing more options to access the asset class. Through GP-led secondaries, it’s now possible to invest in potentially lower-risk, higher-returning, and shorter duration investment opportunities by consistently accessing high-performing companies with proven sponsors and shorter expected holding periods.
Through GP-led secondaries, it’s now possible to invest in potentially lower-risk, higher-returning, and shorter duration investment opportunities.
In the best examples of single-asset GP-led secondaries, the sponsor and company management have proven their ability to work together, resulting in strong historical business performance. With meaningful skin in the game, the sponsor has continued incentive for ongoing value creation. In addition, a well-structured GP-led secondary investment aligns the sponsor and new investors and ensures the sponsor’s primary motivation is to continue compounding returns for a three- to five-year holding period. With strong company momentum, sponsor continuity, and sufficient time for asset appreciation, GP-led secondaries can provide an opportunity to achieve premium returns.
GP-led secondaries can shorten duration and improve risk/return
In the asset management world, the high-return, short duration equity investment is a rare species. However, the GP-led secondaries strategy has created a new approach in the middle of the private equity allocator’s spectrum, resulting in an opportunity to access equity investments with premium returns and shorter duration. This attractive combination has the potential to upend traditional thinking about accessing private equity exposure and more specifically asset allocation. We believe GP-led secondaries are a powerful new tool in the private equity tool kit. We believe that, in time, more and more private equity allocators will reexamine their first principles and incorporate them as a foundational allocation in their private equity portfolios. And this will only be amplified as the attractive risk/return and duration characteristics of GP-led secondaries are more fully appreciated. We believe the topic is increasingly important to private equity allocators given it’s of one of the fastest-growing and most dynamic parts of the private markets.
Editor's note: Much of this material first appeared on June 1, 2022, in Buyouts.
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