Private equity secondaries—investing in GP-led transactions

Secondaries market origins and development: stigma yields to success

The modern secondaries market is a far cry from what it was 20 years ago. Transaction volumes in the early 2000s were fluctuating at low single-digit billions per year. That puts 2019’s $80 billion¹ in some perspective—what other investment markets have grown 40-plus times in two decades?

In the early years, transactions were dramatically smaller, participants were noticeably fewer, and variety was not the spice of life within the secondaries market. The sole reason secondaries existed was to provide private equity limited partners (LPs) with access to liquidity that became necessary as a result of some sort of stress. The wave of LP fire sales in the wake of the global financial crisis represents a prominent case in point; frankly, the secondaries market was viewed as uninteresting, and most people didn’t even know what it was. Those few who did tended to avoid it if they could. Private equity sponsors saw the secondaries market as a necessary evil, with participation of opportunistic vulture investors rather than the upstanding LPs who represented the bedrock of the business. Back then, the only interaction a sponsor would have in the secondaries market would be to reluctantly approve the transfer of an LP interest from an existing investor to an upstart secondaries fund.

Today, that old dynamic has been turned on its head. The unique value proposition of the secondaries market is now widely acknowledged by virtually all its stakeholders, including:

• Limited partners (LPs), who have gained access to liquidity allowing them to more actively manage their private equity exposure
• Secondary investors, who have gained an opportunity to pursue high internal rates of return (IRRs) and attractive multiples on invested capital (MOIC)
• Sponsors, who have gained a new portfolio management tool that allows them to hold high-quality assets for an extended period and continue to reap the rewards of their value creation

Secondaries represent a growing and vibrant opportunity for investors

Annual secondaries transaction volume in billions of U.S. dollars

The emergence of GP-led secondaries transactions

While the purchase and sale of LP interests have long become a legitimate tool for managing private equity exposure, a new use case has emerged that will almost certainly ensure the secondary market reaches new heights in the not-too-distant future. Starting slowly in 2012, and then accelerating in 2015, private equity sponsors began to actively solicit capital from the secondaries market in what has become known as GP-led secondary transactions. Their use of capital—to extend ownership of assets, raise new growth capital to support the assets, and provide near-term liquidity to LPs—has fundamentally changed the secondaries market. In our view, there are now two secondary market segments, each with powerful and unobstructed growth drivers.

Differentiators of GP-led transactions versus LP-led transactions

GP-led secondaries have three key characteristics that distinguish them from traditional LP secondaries investments.

1 The sponsor drives the transaction

GP-led secondaries allow a sponsor to extend ownership of a valuable asset by pulling it out of a maturing fund and moving it into a new fund. The change of ownership is funded by secondaries investors in a competitive process that takes the place of a traditional merger-and-acquisition transaction or initial public offering. It’s a mutually attractive proposition: Legacy fund LPs have the opportunity to take liquidity, the fund’s sponsor gets to retain control of the favored asset, and new secondaries investors potentially participate in the upside of the hard-to-access asset throughout the extended holding period, often an additional three to five years.

2 The underlying asset concentration is higher

A GP-led transaction often focuses on a single fund that holds relatively mature assets. A transaction usually involves transferring an asset or assets from the existing fund to what’s called a continuation vehicle. More frequently in recent months, sponsors have selected a single high-performing asset from an existing fund and offered it in the secondaries market through a newly formed special purpose vehicle known as a single asset continuation vehicle. Whether the net result is a vehicle containing one, four, or eight assets, the asset concentration in net asset value for the new secondaries investors in a GP-led transaction is significantly greater than for most LP transactions.

3 The transaction process is more complex

While LP transactions can be executed relatively quickly and efficiently, GP-led transactions take multiple months to complete. The greater concentration necessitates more and different kinds of diligence, often requiring third-party service providers to provide quality-of-earnings reports, market studies, and other vendor diligence activities. Moreover, GP-led transactions are multistage processes that typically require hiring advisors and procuring consent from existing LPs in lengthy, tender processes.

GP-led deals are driving the secondaries market to the next level

In 2019, the share of GP-led transactions grew to one-third of secondaries market volume. In 2020, the pandemic accelerated this shift, suppressing the volume of LP-led transactions while stimulating the volume GP-led transactions, which rose to half of all secondaries market volume.

GP-led deals represented a majority of secondaries in 2020

GP-led deal volume in USD billions ($), and as a proportion (%) of all secondaries

Five major investment banks got into the secondaries market advisory business in 2020 alone, further fueling growth. The rise of GP-led deals has continued, as sponsors have internalized the value proposition and have begun initiating secondaries transactions with increasing frequency.

Secondaries funds raised roughly $100 billion of the $600 billion raised for private funds in 2020. This is both the highest level ever raised by secondaries funds and the largest percentage of the private markets ever captured by secondaries. Despite this surge in funding for secondaries, knowledgeable market participants assert the secondaries market is still undercapitalized for GP-led deals, which begs the question, who’s going to step in and fund this growing deal flow? In our view, the emerging trend in the supply-and-demand dynamic puts secondaries investors in GP-led transactions at a distinct advantage.

A threefold value proposition for investors in GP-led deals

GP-led transactions carry a set of attributes that offer a distinct value proposition to market participants and have made them attractive to secondaries investors. The main elements of the value proposition are threefold: They allow for surgically precise portfolio construction, they offer an attractive risk/return proposition, and they create mutually beneficial value-added partnering opportunities with top-tier sponsors.

1 Better portfolio construction

GP-led transactions enable secondaries managers to construct portfolios with a greater degree of precision than is available in the traditional secondaries market of aggregated LP positions. While GP-led transactions’ higher concentration places a greater burden on diligence, it creates an opportunity to shape a secondaries portfolio by sector, geography, company stage, and risk type. This ability to curate a portfolio from among a wide variety of investment choices will broaden the return outcomes for secondaries market investors, potentially elevating those who select assets carefully over those who invest indiscriminately in an effort to play it safe by overdiversifying and achieving a sort of secondaries market index of returns.

2 Higher return opportunities

GP-led transactions offer an array of potentially higher-return investment opportunities relative to traditional LP secondaries investments. In today’s secondaries market, the typical LP portfolio transaction is underwritten at an unlevered 1.3x–1.6x MOIC and a 12%–16% IRR.²

The emergence of GP-led transactions in recent years has improved the risk/return trade-off for secondaries transactions, creating a new kind of secondary alpha. GP-led transactions offer the potential for unlevered MOICs of 1.7x–2.2x and IRRs of 15%–22%.² A skilled, active, informed, and diligent secondaries manager can access these returns by considered curation and construction rather than by ratcheting up risk.

3 More aligned investments

GP-led investments generally produce greater alignment between counterparties than traditional LP secondaries investments. An LP-led transaction sets up a price negotiation in a zero-sum game. The parties are trading risk positions with the result being that one party assumes full risk while the counterparty sheds it completely. By contrast, in a GP-led investment, a secondaries investor’s counterparty, the sponsor, continues to bear risk through its capital contribution to the investment after consummation of the transaction. This allows the secondaries investor to act as a capital partner to the sponsor, including potential follow-on investment opportunities that could become proprietary if collaboration and trust have been established.

What’s next for secondaries investors: private credit and more

Achieving liquidity for private assets isn’t a straightforward exercise, and the secondaries market has long been characterized by solutions-oriented transactions. Private assets have historically been held in a variety of structures by different types of investors with different needs and different constraints, and this constant push for innovation to achieve varying goals is ultimately what’s brought about a robust GP-led market.

We believe the secondaries market’s wiring for creativity is a strong foundation for its continued growth and the expansion of its footprint into areas such as private credit. With the dramatic rise in sponsor-led direct lending since the global financial crisis, a private credit secondaries market is already taking root. While it’s not registering in the transaction stats relative to private equity GP-led or LP-led transactions, it can be seen in the innovative credit portfolio deals taking place across credit platforms, business development companies, and financial institutions. Just as secondaries have converged with mergers and acquisitions, so too will secondaries converge with other categories of investments. We expect that we’ll see secondaries move into structured credit (collateralized loan obligations and collateralized fund obligations), asset management (GP stakes), and perhaps public equity (special purpose acquisition companies).

Most important, we expect to see secondaries—this formerly unloved orphan of the private equity markets—evolve into the belle of the asset management ball. As we’d expect from a market characterized by innovation and creativity, we see more exciting opportunities ahead for secondaries investors.

1 Evercore, January 2021. 2 Manulife Investment Management as at June 30, 2021. Gross MOIC and IRR ranges are based on the subjective views of the authors and subject to change.