Secondary restructurings: Opportunistic delays

When NewQuest Capital Partners and Committed Advisors backed a new fund for Singapore's Basil Partners as a way of institutionalizing the GP's platform and extending its exposure to key portfolio companies, it said much about the future of secondary transactions in Asia. Perhaps chief among these takeaways was the idea that as investors look to solve increasingly complex timing and strategic needs among stakeholders, a mere win-win will no longer be enough.

The deal saw NewQuest and Committed commit $175 million to a fund that acquired an existing Basil portfolio of six Indian and Southeast Asian IT companies, juggling the concerns of more than 30 counterparties, some of which had stakes in multiple businesses. The idea was to consolidate a disparate set of shareholders into one controlling interest, the Basil fund, while extending the GP's stewardship of a group of growing companies that needed more runway.

The difficulties presented by the deal, both conceptually and in its mechanics, suggest that it is destined to be something of a one-off. But as a hybrid of an annex fund and a staple – it featured primary and secondary capital components – the transaction is bound to be replicated in some way, shape or form across a range of situations where investors are hungry for new liquidity solutions.

Confidence in innovation is most effectively realized through success, however, and creative deal-making is no exception. Acceptance of the Basil template could therefore be inferred by internal projections that most of the portfolio companies will outperform this year, and that after only a matter of weeks, a number of bolt-on plans have been advanced. If this traction continues, opportunities in markets with long gestation timeframes could take secondaries in a more growth-oriented direction.

"Going through multiple cycles with different investors backing growing companies is not a new phenomenon in Asia. What the secondary market is doing now is essentially saying it's not necessarily that the GP has to sell to another GP," explains Amit Gupta, a partner at NewQuest. "A lot more LPs are comfortable backing GPs that have some sort of sector expertise with portfolio companies that need another 3-5 years to maximize value. The end of fund life will always be a key reason for secondaries, but there are other motivations."

Secondaries investors concur that the market dynamics are changing, based in part on a desire among GPs to opportunistically extend their exposure to quality assets beyond typical private equity horizons. There are myriad reasons for extending a hold, including slowness in market development and various economic or personal shocks to a particular company. Now, capturing further portfolio upside in strongly performing businesses has joined this list of incentives.

Naturally, firms that specialize in fund restructurings are enabling the trend, but they remain cautious about conflicts of interest among GPs and risks around poor liquidity. In theory, managers seeing few quality investment options are increasingly compelled to look inward and grow the assets that they already know well. At the same time, they are duty-bound to realize returns on these companies for LPs, but often struggle to achieve optimal outcomes, typically because of erratic IPO cycles.

Driving factors

In order for more growth-oriented secondaries to be transacted in Asia, this backdrop will have to be enhanced by a number of factors, including heightened engagement between secondary investors and the portfolio companies in question. Meanwhile, LPs will have to become more comfortable with delayed returns, quality assets will need to remain scarce, entrepreneurs will have to want to stay private, and exit options will have to remain depressed.

For the moment, these ingredients are only coming together in certain markets and sectors, notably Indian venture capital and Southeast Asia's midcap enterprise space. As a case in point, a stapled secondary earlier this year involving Southern Capital Group was said to been conceived in part as a way to help the GP extend its exposure to some promising portfolio companies in various Southeast Asian consumer, healthcare, and education segments.  

Growth-oriented secondaries could also see traction in technology, especially as geopolitical uncertainties complicate perceptions about valuations and rattle traditional exit channels. Zhan Yang, a principal at secondaries specialist Coller Capital, says that concerns about the global economy are translating into some interesting deal dynamics, especially with regard to highly valued tech companies that have seen meaningful valuation adjustments in recent months.

"As a secondary investor, expectation for the price of these assets is one of the most important things for us," Yang says. "Because of this market movement, sellers are writing down their expectations, or if they used to be confident supporters of the companies, they're now starting to say they want to reduce their exposure to get some liquidity."

TR Capital, which primarily targets direct secondaries and fund restructurings, could also be seen as taking advantage of falling capital markets in China, although not in the tech space. The firm recently completed a restructuring of Cassia Investment's second fund whereby it acquired a food company and clothing maker and integrated them into a newly incorporated entity.

However, in situations where the GP continues to manage the assets, seemingly similar opportunities may be more classifiable as traditional stress-related secondaries than growth plays. Paul Robine, CEO and founding partner of TR, notes that as macro cycles slow down, GP requests for extensions will be increasingly characterized by troubled situations rather than opportunistic ones, putting increased urgency on the need to renegotiate terms.

"If a GP engages himself to have a fund of eight years, he should stick to it," Robine says. "If he does not and asks for an extension, it means that he has not fulfilled his contractual obligation and you need to think twice before accepting. That's why it will only work if all parties establish clear milestones and terms are changed."

In transactions that involve high-growth underlying companies, investors will also need to check on alignment with the relevant founders, especially regarding their expectations around the GP's exit timeline. More often than not, portfolio companies are unfazed by the replacement of an LP, appreciating the chance to maintain continuity in a relationship with a trusted GP. But according to some secondary players, including NewQuest's Gupta, it is sometimes necessary to sit down with the CEO or even the whole board to make sure all parties are in sync.

For TR's Robine, this situation has put pressure on secondary investors to ramp up their operational capacity by hiring staff with technology and consulting backgrounds. "The future leaders of the secondary space are the ones that will not only be able to acquire a portfolio at a good price, but equally importantly, will be able to convince entrepreneurs that the substituting existing shareholders is going to bring value to their companies," he says. "That's a fundamental change that's happening in the Asian secondary market now. It's not about being a passive financial investor anymore."

Residual skepticism

A number of other factors could converge to keep growth-style secondaries in check, not least of which is the fact that the overall secondaries market in Asia has yet to attain the required critical mass. According to Setter Capital, Asia Pacific represented only 10.8% of total secondary market volume globally at $6.4 billion last year. This compared to about $30 billion for North America and $16 billion for Western Europe.

At the same time, there is an industry consensus that extending the life of one or more assets through a secondary deal is only an ethical maneuver in end-of-fund-life situations. Secondaries have to offer a solution, either to a shortage of time or a lack of capital. If the motivations seem too opportunistic – and the suspicion is the GP is only looking to create value for itself – negotiations will dissolve. As a result, a GP targeting a secondary transaction as a means of realizing upside beyond previously agreed horizons is likely to encounter significant counterparty friction.

"It's beside the point whether a portfolio company is on a good trajectory or not because if a GP is extending the life of an investment simply because they think there's more growth, presumably they could sell that growth story to somebody else," says Jason Sambanju, who launched Asia-focused secondaries specialist Foundation Private Equity last year.

"If they're doing it opportunistically, they should be able to capture that value through a sale of the asset, so I think it would be fair for an LP to question whether the GP is acting in the best interests of the fund. Of course, this changes when you're talking about selling a portfolio en bloc because then it's a question of whether you can sell a growth story around a pool of assets of probably mixed quality."

Outlooks for secondaries as a means of extending GP holds could also be informed by the development of other phenomena leveraging demand for long-life assets. Evergreen funds, for example, which offer investors perpetual, cross-cycle exposures, remain a tough sell globally and especially so in Asia.  

Jordan Silber, a partner at Cooley, says his firm has seen increasing interest in these models among Asian GPs and even helped covert several 10-year funds into evergreens. But he sees significant headwinds to further adoption in issues familiar to the secondary market such as overwhelming deal structure complexity and skepticism among LPs with relatively short-term strategic interests.

"In our view, these funds are not well suited for everyone and require a set of just the right circumstances to work well," Silber says. "It is accordingly not uncommon for a top-tier manager to have to abandon its plans to shift to an evergreen structure due to the mere fact of top performance is simply not enough in all cases to support a successful outcome of moving to this structure."

Evergreen angle

The evergreen philosophy has translated into growth-oriented secondary activity in at least one instance, however, when HarbourVest Partners led a $420 million transaction last month that enabled Capital Today China Group to roll an investment from its first fund into a new single-asset vehicle. Capital Today, which has recently formalized its evergreen-style approach, had already held Yifeng Pharmacy for 12 years, including a two-year extension, but the company was still seen as a strong growth prospect in light of various demographic and regulatory drivers.

The new HarbourVest-sponsored fund will have a standard PE timeframe and continue to be managed by Capital Today. HarbourVest had an opportunity to do the deal as a full fund restructuring but was only interested in Yifeng. The company, which went public in 2015 and is valued at almost $3 billion, has established itself as one of the largest retail pharmacy chains in China.

The details of the deal offer some hints as to how secondary-enabled growth plays may work in the future, especially in resolving inherent conflicts of interest. This essentially entailed maintaining a high level of transparency and information sharing with all parties via discussions with LP advisory committees and the use of separate advisors to determine pricing. Importantly, existing LPs were given a chance to reinvest.

"We have seen a lot of very concentrated secondaries where there's been a single company that's accounted for three-quarters of the aggregate exposure or more, but almost none of them are getting done," says Tim Flower, a managing director at HarbourVest. "So, it's good for the market that this got done. It's an interesting new opportunity and I'm sure it will be the first of several because GPs are struggling to find new high-quality assets to invest in. But it's not going to be 25% of the market because they're very difficult to execute and some LPs are quite justifiably skeptical."

The view that growth-oriented secondaries will remain a niche within a niche leaves little hope that a large amount of precedent will accumulate and thereby offer guidance to investors struggling to do the right thing on a case-by-case basis. As such, valuing exits and defining alignment in these deals will remain a theoretical exercise at best, perhaps as much art as science, and as much about finding the right tone as finding the right price. 

"If GPs are using the secondary market to keep more upside for themselves, we're going to run up against more of the questions that have historically been raised around fund restructurings about conflicts of interest," says Foundation's Sambanju. "GPs have to be very careful not to get into that mindset because fulfilling a partnership agreement is not just in the actual terms – it's in the spirit of the contract too."

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

• Topics
• GPs
• LPs
• Secondaries
• Portfolio management
• Asia
• NewQuest Capital Partners
• Coller Capital
• TR Capital
• Foundation Private Equity
• HarbourVest Partners