The below article has been published in Investment Officer in August 2023.
Strong growth on the second-hand private equity market has led to innovative transactional structures. A persistent ‘thirst’ for liquidity has potential consequences for all private equity investors. Innovation in financial markets can result in unforeseen consequences.
Replacement is inherent to the structure of private equity investments. Investors who look for exposure to the investment category should continuously identify new investment opportunities. Regularly, an investor (or Limited Partner) commits their capital for a longer term (10-12 years) at a fund managed by the fund manager (or General Partner). During that time, the Limited Partner has no direct access to the requested capital. Should this Limited Partner require liquidity nonetheless, they can (partially) resell their stake in the fund at the second-hand (or Secondary) market.
From simple liquidity solution…
The Secondary market has traditionally been used by Limited Partners to liquidate (a part of) their portfolio early (see Figure 1). They opt for such transactions when (i) there is a marginal residual value in the fund, (ii) they are in need of liquidity or (iii) they wish to rebalance their portfolio.
Figure 1 – Example of LP Secondary transaction structure
In 2022, rebalancing of their portfolio was the most important motivation for 48% of the Limited Partners that resold their stake. After price reductions in public markets led to a relatively increased exposure to private equity, institutional investors proceeded to resell their stake in order to rebalance their portfolio (the so-called ‘denominator effect’).
… to more complex transaction structures
As the private equity industry kept on growing, the Secondary market developed as a source of liquidity for General Partners themselves. Early liquidity for fund managers proved valuable when (i) at the end of the fund’s term, the remaining interests in the portfolio need to be sold, or (ii) when the fund manager wants to realize profits while maintaining control, because the company in question still has significant upside potential. Currently, General Partner (or GP-led) transactions account for approximately 50% of the total Secondary market (see Figure 2).
Figure 2 – Secondary transaction volume (Source: Jefferies 2023).
A prime example is the company Action. In 2011, the originally Dutch discount chain fell into the hands of a private equity fund from the British firm 3i. Although the great success of Action had the potential for significant profit, 3i aimed to benefit longer from the company’s growth potential. Therefore, in 2019, 3i engaged in a complex transaction in which it simultaneously provided liquidity to their Limited Partners while also maintaining control (see Figure 3).
Figure 3 – Example of a GP-led Secondary transaction. (*) Both previous Limited Partners as new capital providers (e.g. Secondary Fund).
Thus, GP-led transactions offer a solution for fund managers to generate liquidity. Additionally, investors in the fund have the option to reinvest in the portfolio company if they prefer this over early liquidity. This seems to create a win-win situation for all parties involved. However, in practice, there are several potential conflicts of interest:
- Valuation: because the fund manager is both the buying and selling party, this leads to conflicts over price.
- Evaluation Period: where the manager would like to close a deal as soon as possible, the investor needs sufficient time to evaluate the proposition.
- Carried Interest: any proceeds after the resale of the business potentially reduce the alignment of interests between the fund manager and the investor.
- Value Creation Plan: towards the end of the fund term, a fund manager can defer intended value creation initiatives. Because the GP has a larger stake in the holding after the transaction, it benefits by implementing the transformation only after the transaction.
For investors, some of the conflicts of interest can be resolved by (i) an independent valuation, (ii) an adequate decision period, and (iii) confirmation that the fund manager is reinvesting its carried interest in the company. However, investors should be confident that managers are not delaying the implementation of value creation initiatives.
Has Pandora’s Box been opened?
According to Greek mythology, Pandora was the first woman on earth, created by the gods. She was given a box (or more precisely, a jar) that she was not allowed to open, but her curiosity overcame her and she opened the jar. This unleashed all the evils trapped inside, spreading them across the world, leaving only hope behind. In today’s world, this myth serves as an analogy for situations where seemingly innocent actions have unintended consequences. Similarly, the recent developments in the Secondary market are affecting other investors in private equity.
Firstly, an increasing number of General Partners are using Secondary transactions to generate liquidity in their fund structures. Investors in these funds must decide whether they want to “roll over” their interest. However, due to the short evaluation period, many investors are unable to properly assess the transaction and are then forced into a ‘mandatory’ liquidation. As a result, they may miss out on further upside potential.
Furthermore, the risk profile of investments in Secondary funds is changing. Traditional Limited Partner transactions lead to broadly diversified portfolios with hundreds of underlying investments, while GP-led transactions are often more concentrated. This concentration requires more capacity from the Secondary party to conduct thorough due diligence on the portfolio companies.
Overall, enough ‘hope’ seems to remain. Investors who are able to evaluate the offered ‘second-hand’ transactions may potentially add value to their portfolios. Nevertheless, the evaluation of Secondary funds will require more attention in the future. While GP-led transactions have indeed brought about certain changes, their impact will remain limited for now.