Replacement is inherent to the structure of private equity investments. After a fund’s lifetime ends the investor needs to find a replacement to maintain exposure to the asset class. In the event that an investor is not satisfied with the size of the allocation or the quality of the fund, the investor can sell his stake on the second-hand Secondary market.
Assets under management in the Secondary market have grown significantly in recent years in line with private equity. As a result, the volume of private equity transactions traded on the secondary market also increased (see figure). Furthermore, fund managers more frequently employ complex structures to invest their capital, which might have an impact on investors. Participants in the secondary market utilize two structures for their transactions.
- Traditional Secondary transactions (LP transactions)
In Limited Partner transactions (LP transactions), the private equity investor sells a portion of their portfolio to a Secondary fund. This often happens at a discount, allowing the fund to report high returns early on. To illustrate, the discount averaged 16% in the second half of 2022, directly resulting in a multiple of 1.2x.
Investors choose such transactions upon (i) a marginal residual value in the fund, (ii) the expiration of the fund term in a fund-of-funds, (iii) a need for liquidity or (iv) rebalancing. The latter reason played an important role in 2022. After price declines in capital markets led to increased relative exposure to private equity, institutional investors sold their holdings to rebalance their portfolios (the so-called “denominator effect”).
- Complex Secondary transactions (GP-led transactions)
In a GP-led transaction, the private equity fund manager is looking for liquidity. These situations arise when (i) at the end of the fund term one intends to sell the remaining companies in the portfolio or (ii) when the fund manager wants to realize profits while maintaining control, because the company in question still has a lot of upside potential.
The volume in GP-led transactions depends on the amount of available capital, the number of companies offered and the development of (complex) transaction structures. These factors have contributed to explosive growth in the market segment in recent years. As such, GP-led transactions offer a solution for fund managers to generate liquidity while at the same time continuing to implement value creation initiatives.
Moreover, investors in the fund can continue to invest in the portfolio company with the manager if they prefer this to early liquidation. This makes it seem like a win-win situation for all parties involved. However, in practice, GP-led transactions often prove to be a breeding ground for conflicts of interest in the following aspects:
- 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.
Impact for investors
Recent developments in the Secondary market are impacting virtually all Private Equity investors. First, an increasing proportion of fund managers are using GP-led transactions. This requires investors to determine whether they want to “roll over” their stake. However, because of the short evaluation period, many investors are unable to examine the transaction and proceed with a ‘mandatory’ liquidation.
In addition, the increase in GP-led transactions is changing the risk profile of investments in the Secondary market. For example, traditional LP transactions result in a widely diversified portfolio with hundreds of underlying holdings, while GP-led transactions tend to be more concentrated by nature. This concentration requires more capacity of the Secondary party to conduct thorough research on the portfolio companies.
Bluemetric Insight | The continued growth of the private equity industry has led to an increase in (complex) GP-led transaction structures in the Secondary market. This development has important implications for private equity investors. Investors who are able to evaluate the “second-hand” transactions can potentially add value to their portfolios.
Also, the selection of Secondary fund managers will become more challenging, as GP-led transactions tend to be more complex in nature. Nevertheless, Secondary funds remain a valuable addition within a private equity portfolio because of their (i) broad diversification, (ii) resilience at times of market volatility and (iii) accelerated distributions. However, the implementation will require more attention in the future.
Recent Comments