GP-led secondaries: Stigmatized no more

The $1 billion deal that saw Lexington Partners take out a string of LP positions in an existing BC Partners fund and commit capital to the private equity firm’s latest vehicle has been hailed as watershed moment for the global secondary market. But it took 15 months for the GP to move from discussion to execution, not least because the transaction represented unchartered territory: secondary staples were for managers in difficulty, or so the industry thought.

BC was raising its 10th fund when two advisors made an initial approach in May of last year, according to sources familiar with the situation. A handful of LPs had decided not to re-up for the new fund and at the same time there was demand among secondary investors for the GP’s ninth fund from 2011, which has EUR6.7 billion ($7.9 billion) in committed capital. (Investments include Acuris, AVCJ’s parent company.) Why not take the opportunity to reshape the LP base by giving these LPs the chance to get out and others the chance to get in?

Campbell Lutyens won the mandate to run a process under which a secondary investor would make a tender offer to all LPs in Fund IX and for every EUR1 sold in the secondary piece it would put EUR0.50 into Fund X. BC held off until it was clear that Fund X wouldn’t hit the hard cap – so there was no danger of the staple cannibalizing other demand – and invited bids in April. Lexington prevailed over five other final bidders after agreeing to buy interests of up to EUR1 billion.

The eventual take-up was about half that and the primary staple brought the total to approximately $1 billion. It is the largest-ever deal of its type, but what registered with the industry was the pricing: the selling LPs received a 14% premium to net asset value (NAV) as of March, which equates to a net IRR of 19% and a multiple of 1.5x. It stood in stark contrast to the archetypal stapled secondary, where deep discounts are paid to support stuttering fundraising processes. 

The next big thing?

As a result, the trickle of inquiries about GP-led secondary transactions – driven by strategic thinking rather than survival – has become a steady flow. EQT Partners and Partners Group have agreed a similar transaction to BC and Lexington in support of EQT’s latest Asian fund, while Warburg Pincus is in the process of selling a strip off its most recent global fund comprising interests in Chinese and Indian companies. More deals involving high-quality managers are likely to follow.

"The transactions we are seeing and talking about have nothing to do with problems in a portfolio or with a GP. It is more GPs thinking creatively about how they can solve liquidity problems, providing a service to LPs and benefits to themselves. In several years, I would be surprised if the advisory committee members of any successful franchise aren’t asking the GP why it isn’t considering transactions like these,” says Matt Jones, a partner with Pantheon’s global secondaries team.

Jones goes so far as to suggest that one or two more high-profile deals will close by the end of the year. Tim Flower, a managing director with HarbourVest Partners in Hong Kong adds that he’s been receiving calls from well-known Asian managers looking for more information, although for now they are curious rather than keen to transact. “They want to know how these deals get done, what are the different ways of doing them, and what are the pitfalls,” he explains.

GP-led transactions account for about one quarter of global secondary deal flow, up from close to zero five years ago. Just as it took time for PE firms to accept that traditional LP secondaries don’t represent an automatic black mark against them, recognition that GP-led deals are essentially another liquidity mechanism for investors has been gradual. The global financial crisis has also played a role in this evolution.

After a smattering of activity from the early 2000s, GP-led transactions moved into a new phase in 2011-2013, characterized by firms that had significantly underperformed and failed to raise new funds. The term “zombie manager” entered the private equity lexicon. More recently, the focus has shifted to funds that were not undone by the crisis but ran out of time because of it.

Andrew Sealey, managing partner and CEO of Campbell Lutyens, points to ICG as an example. The firm’s 2007 vintage fund had performed well but was nearing the end of its life and still held nearly EUR1 billion in assets, having been slow to deploy in the early years. ICG was not in trouble, but it saw upside in the 2007 vehicle and wanted more time to realize it. In early 2016, the assets were sold into a new fund, with LPs asked to roll over or cash out at a premium to NAV.

"The trigger for what has happened in the last year and what is happening now is the amount of money that was raised and invested in 2006-2008 hitting end of fund life. The global financial crisis could have sucked at least 24 months out of a fund’s development,” says HarbourVest’s Flower. “At the same time, it’s a more intermediated and efficient market. Anyone with a fund that is in year 8-10 and with meaningful NAV is receiving calls from advisors.”

Restructurings and tender offers sit at either end of the spectrum for fund-level deals: the former requires the removal of assets into a new vehicle – with new terms and new incentives for the management team – while the latter takes out LP positions without changing the fund itself. Selling a strip off the portfolio, whereby a percentage of some or all investments is carved out and placed into a new vehicle managed by the GP and backed by secondary players, is an example of an asset-level transaction. It delivers partial liquidity with minimal disruption.

Other less common liquidity options include private equity firms carving out balance sheet assets into third-party vehicles that generate management fees and carried interest, and issuing preferred equity to investors who provide additional capital – which goes into the existing fund, following a renegotiation of terms – to support portfolio companies.

Time and money

The traditional motivating factors for the GP have been time and money: more time might be required to manage out an existing portfolio. Key team members need to be retained and the fund is either underwater on carried interest or doesn’t include certain individuals in the economics, so GPs want to reset and re-incentivize; or they are seeking to kickstart a new fundraising process.

However, several industry participants note that the higher-quality GPs now coming to market are positioning secondary transactions as options that may meet the needs of all concerned. A restructuring pitch might read: we want a multi-year extension because we believe there is more value in the portfolio, but we understand some of you can’t or don’t want to rollover, so here is a liquidity solution. For a tender offer and staple: we know some of you are not planning to re-up and there is interest from secondary investors, so will offer everyone the opportunity to exit.

"A lot of the earlier deals were fund restructuring transactions where there were some very material changes to the fund; what we are seeing more frequently now is a free option for investors. If they don’t want to sell, nothing changes,” says Brian Mooney, a managing director at Greenhill Cogent. “And if a GP leads the process, it is more involved in the due diligence and that extra transparency means buyers can often be more aggressive in pricing. Also, the transaction might be large enough to attract a new universe of buyers, such as sovereign wealth funds or other strategic LPs who may pay a higher price than dedicated secondary funds."

There are plenty of examples of secondary deals failing because LPs felt that their interests were not being served. In 2014, Australia’s Ironbridge Capital offered investors in its first and second funds the opportunity to exit their positions or roll over into a new vehicle holding the assets – and participate in a stapled secondary for a new vehicle. Some LPs responded angrily, saying that Ironbridge had no right to demand a primary commitment as a condition of rolling over.

The proposal was dropped and the transaction became a standard secondary sale led by HarbourVest. The situation damaged Ironbridge’s relationships with LPs and it would almost certainly count against the GP in any future fundraising activity. At is stands, Ironbridge has yet to return to market with a product for institutional investors.

"A GP that is using a staple to kick off the fundraising process might already be in a tight spot. If the staple doesn’t work out it can be devastating,” says Jason Sambanju, who previously covered Asian secondaries at Paul Capital and Deutsche Bank before striking out on his own this year with Foundation Private Equity.

BC, by contrast, deliberately timed the staple so it came at the tail-end of the fundraising process, by which point EUR5.5 billion had already committed to Fund X through conventional channels. There was an awareness of the stigma attached to these transactions and consequently an effort to position the deal as active platform management.

The tender offer wasn’t without risk. There could have been little appetite for the deal among the existing LPs, which means all the work that went into the process would have been for nothing. “Establishing the quantum in these situations is hard, even when the GP gives you guidance,” says one secondary investor. “There are other groups involved that might be competitors. You need to understand the LP base, you need to know who might be tricky."

But there was confidence in the process, not only because the sellers were getting an attractive premium, but also because the rationale behind the deal was clear. In addition to understanding what investors want, transparency and effective communication are essential components to any GP-led secondary transaction. The more reasons a prospective seller or buyer comes up with to question a deal, the less likely they are to support it.

It is important to understand the motives for a transaction and to ensure alignment of interest between the GP and any incoming investor,” says Pantheon’s Jones. “For example, if a GP is talking about taking a huge amount of carried interest off the table through a transaction, that would be problematic for secondary investors."

Alignment issues

The Warburg Pincus strip sale is described by several investors as harder to understand. The private equity firm’s Asian investments in its 11th fund, which closed at $11.3 billion in 2013, are said to have an NAV of $5 billion. The plan is to carve out $1 billion and place it into a separate vehicle, which will be supported by new investors. Apparently, this will help Warburg placate a few LPs that are asking for liquidity and right size a fund that is overweight Asia.

To some, it amounts to an exercise in locking in returns and most of the risk sits with the buyers. One of the challenges inherent to strip deals is the buyer has a different base from other investors in the same set of companies. Could a scenario transpire in which the interests of the secondary vehicle diverge from those of the main fund, such as an exit that meets the return expectations of one but not the other? This question forms an important part of due diligence.

"A buyer may be cautious in some cases. For example, would they provide the GP a reset carry structure on the new vehicle based on the price paid for the strip? If so, there may be very clear conflicts of interest between the two funds,” says Greenhill Cogent’s Mooney.

Regardless of skepticism in certain quarters, the Warburg Pincus deal is expected to close on target. A smaller strip transaction in which Lexington Partners and Madison Capital acquired a set of positions from Sequoia Capital India was also completed last year. Funds raised by these firms are typically oversubscribed, so it is difficult to envisage them coming under serious pressure from LPs to return capital. Perhaps their activities reflect the broader evolution in the market: GPs proactively looking to secure liquidity when the opportunity arises.

Certainly, investors expect to see more of these transactions in Asia – the result of wider understanding of secondaries and increased supply. According to Lucian Wu, a managing director at HQ Capital,  his firm’s research indicates that there is $1 trillion of primary commitments in the region and 20% of that is in funds at the end of their 10-year stated life.

"Top quartile funds in Asia Pacific have unusually high levels of retained assets because the exit market has been more difficult than in Europe and the US – there is arguably a greater requirement for these types of transactions,” adds Sealey of Campbell Lutyens. “Everyone has been saying that someday the Asian market will catch up and they have been disappointed. Now, I think it’s exciting."

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• Topics
• GPs
• LPs
• Secondaries
• Secondaries
• Asia
• Lexington Partners
• BC Partners
• Campbell Lutyens
• EQT Partners
• Partners Group
• Warburg Pincus Asia
• Pantheon
• HarbourVest Partners
• Ironbridge Capital
• Foundation Private Equity
• HQ Capital