Secondary staples: Structural dynamics

When AlpInvest Partners-led consortium took out an LP position in Southern Capital’s second fund earlier this year, it helped cement improving sentiment around GP-led secondaries in Asia but also propagated a lingering unease about the more ambitious facets of these restructuring plays. Mostly, this is because the industry has been trying to interpret a deal in the dark. 

The consortium, which also included GIC Private, gained exposure to a relatively mature portfolio in return for committing fresh capital to a first close of Southern’s fourth Southeast Asia vehicle. Historically dismissed as a do-or-die fundraising and liquidity solution for troubled firms, secondary staples are increasingly seen as strategic plays – thanks largely to a number of recent transactions by brand-name GPs. 

To some, the $450 million Southern deal demonstrates that even lesser known GPs with relatively niche strategies can make staples a viable part of their playbooks. To others, who suggest Southern was acting more out of necessity than choice, the transaction has fueled persistently mixed feelings about these structures. It remains to be seen whether there are enough high-quality franchises in Asia that want to embrace the complexities of a staple, and whether those that do can inspire confidence in investors.

“We’ve gotten quite a few calls from GPs keen to understand how and why staple deals are done, so although I would not expect a flood, I think you will see more of these deals,” says Tim Flower, a managing director at HarbourVest Partners. “On the other side of it, this is probably the most benign fundraising environment we’ve had in some time, which might exacerbate concerns around why GPs would need to do a staple. The bifurcation has become very stark – it’s easier than ever for the best firms to raise money, but still quite challenging for the rest.” 

Demand drivers

Increased demand for staples in this context is seen as a function of the natural maturity of the global private equity market. LPs have embraced secondary liquidity as a portfolio management device and are increasingly engaged in selling their positions prior to the ultimate liquidation of a fund that is no longer considered core to their strategy. Recognizing this trend, managers have seen an opportunity to exchange non-continuing investors for investors that support their current fundraising efforts.

“In order to make these transactions attractive to LPs, the manager is incentivized to drive competitive pricing which we often see generates premium pricing for such interests in the secondary market,” says Immanuel Rubin, a partner at Campbell Lutyens. “We believe this development is particularly relevant for Asia, where we see LPs entering the market but also a number of LPs investing less in the region.”

Growth in the amount of secondary capital looking for new ways to be deployed has also been an important driver in recent years. According to Preqin, secondaries-focused dry powder increased fairly steadily from $23 billion globally in 2008 to $53 billion in 2015, when fundraising began to surge. Secondaries capital looking for deals reached $74 billion in 2016 and $89 billion last year. As of March this year, it had already hit $88 billion.   

Some of the highest profile deals to come out of this trend have included a $1 billion staple – facilitated by Campbell Lutyens’ Rubin –  that teamed up Lexington Partners with BC Partners, and a $3 billion transaction involving Coller Capital and Nordic Capital last year that was said to be the largest-ever GP restructuring. 

The Lexington-BC deal is widely regarded as the strongest validation of the staple as a legitimate tool for GPs that are seeking case-specific liquidity options for existing LPs and fundraising at the same time. Lexington submitted a tender offer to LPs in BC’s ninth fund and made a primary commitment to the GP’s next vehicle equivalent to half the investment it made in the secondary tranche. 

The Coller-Nordic deal has likewise helped popularize the notion of the deliberate fund restructure but has also kept skepticism firmly in the equation. This is due to uncertainty about whether or not it included a separate commitment to Nordic’s ninth fund, which was in the market at the time with a $4 billion target. 

Mingchen Xia, a Hong Kong based managing director at Hamilton Lane, has tracked stapled secondary transactions by GPs ranging from global heavyweights to family-run funds. He notes that although demand for strategic options to generate early liquidity and help fundraising is indeed driving deal flow, most of the momentum for staples is a result of increased levels of secondary capital chasing opportunities.

“Secondary buyers need different kinds of deal flow beyond just LP interest transfers, because LP interest transactions are relatively easy to do and therefore tend to become more competitive and expensive,” says Xia. “In more complicated transactions, like staples, there will be less competition and investors may see more attractive deals.”

Seeking alignment

The complexity of staples stems from the combination of primary and secondary components in a situation that aims to deliver a three-way win. This invariably results in more delicate negotiations between GPs, existing LPs and incoming secondary buyers. The process is arguably the most straightforward among existing LPs, for whom the only significant term is the price of their position. But for GPs and secondary buyers, the variables multiply. 

The key challenge is that GPs need to maximize the new fundraise while also making the deal attractive to buyers that want to avoid blind pool risk. The issue essentially boils down to agreeing a ratio between the amount paid for the existing LP position and that committed to the new fund. Although the two-to-one formula used in the Lexington-BC deal is seen as a broadly accepted standard, there is significant room for back-and-forth between stakeholders, especially given the difficulty among buyers in getting comfortable about GP motivations. 

The clear motivation for a GP in a staple is to raise primary capital, but there are nuances that separate the playbooks of managers pursuing the deal for strategic reasons and those looking for a last-ditch lifeline. GP quality is consequently the most critical due diligence consideration for buyers in such deals. Size, strategy, and reputation are all factors, but there are few rules of thumb beyond the need to combine a systematic deal-screening approach with gut instincts around spotting potential dead-ends.    

“The key for secondary buyers is that they really have to be able to tell the GPs that are trending in the right direction from the ones that are struggling in raising their funds and hence resorting to a staple,” explains Lucian Wu, a managing director at HQ Capital. “Staples are an opportunity where you can find GPs that are trending up toward the top quartile after having made some mistakes in prior funds, but buyers really have to know how to weed out those situations from the staples that they should not be doing.”

The process of sizing up a GP and nailing down its motivations can be made more difficult by the myriad of reasonable rationales behind a fundraising hiccup, including extenuating macro pressures or an unforeseeable shake-up in the management team. As a result, secondary buyers in staple deals are encouraged to improve their access to information by bolstering their negotiating position as a possible partner. 

“In a staple transaction, there is more of a requirement for a secondary buyer to add value,” Wu adds. “In situations where you’re factoring in a primary commitment, you have to provide a bit of tailwind, because if you’re bringing in expertise and relationships that the GP values, you’ll have more leverage.” 

Honest brokers

Although many industry participants contend that the added complexity of staples only marginally increases their execution risk relative to other multiparty GP-led restructures, anecdotes about fizzled transactions appear to outnumber success stories. Reasons for failures usually revolve around disputes about primary-secondary contribution ratios, the quality of the GP, and dissatisfaction among existing LPs.

The latter of these causes was evident in 2014 when Australia-based Ironbridge Capital had to drop the staple component of a proposed secondary transaction. Some LPs interested in rolling over their positions into a new fund protested a condition that required they also contribute a fresh primary commitment. In the wake of the breakdown, HarbourVest was able to secure a standard secondary sale.

Like many secondary players, HarbourVest sees GP quality as the most important factor in filtering potential staple deals, but the firm approaches the issue in tight coordination with its primary investment team. This is considered the most reliable way to get the needed experience-based insights on the managers in question and support related diligence findings. 

“These are very tough deals to do unless you have a big primary platform because that’s what allows you to get access to the right people, track the assets quarter to quarter, and get comfortable around motivation,” says HarbourVest’s Flower. “General partners may also be more interested in communicating with a primary team because the relationship could be long term, whereas arguably, all they might want from a secondary-only player is the most money possible for the fund they’re raising today.”

Jason Sambanju, who launched Asia-focused secondaries specialist Foundation Private Equity last year, reinforces this view by noting that GPs should always remain sensitive to the potential conflicts of interest in staple deals. He sees an open and honest dialogue with existing LPs as the best starting point for managers that have decided to entertain such an option.

“GPs, and their advisors, need to have a realistic set of expectations of what a stapled transaction can deliver, especially at the outset,” Sambanju says. “The GP-LP relationship is a long game and it would seem to me that focusing on an incoming LP's likely commitment to multiple future funds – rather than just the fund being raised at that moment – should be the priority.”

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Secondaries
• Secondaries
• Fundraising
• Asia
• HarbourVest Partners
• AlpInvest Partners N.V.
• HQ Capital
• Foundation Private Equity