Stapled secondaries: Shades of gray

Within a week of publication, the emails began to trickle in. "Saw your Ironbridge article the other day," one read. "Not sure if you're aware, but most of the LPs have kicked up a stink and the deal has been changed so they don't have to commit new money to the new fund."

This was a story in a state of flux, and according to sources familiar with the situation, it still is. Negotiating with existing and prospective LPs on a deal that will see a series of entries, exits and rollovers, was never an easy task. And on top of that, the GP is asking for more capital.

Australian GP Ironbridge Capital has not commented on its current fundraising efforts. The proposed scenario that emerged last autumn, relayed by investors and service providers, involved LPs in Funds I and II exiting their positions or rolling over into a new vehicle that will continue to manage the assets. Those that chose to participate would also do a stapled secondary transaction, contributing capital to a blind pool that would make new investments.

Ironbridge apparently opted for a GP restructuring in order to leverage the secondary activity it was seeing in its funds and get more primary capital. However, a number of LPs objected to the notion of committing capital for new investments as a condition of participating in the rollover. It was duly removed; hence the emails suggesting AVCJ update its coverage to reflect subsequent developments.

The deal is now expected to be a secondary position only, with an anchor investor willing to cover the full $200 million available. This suggests a confidence in the GP that could give momentum to a future primary vehicle. Yet at the same time, it remains to be seen whether existing LPs hold their discomfort with the initial proposal against Ironbridge when it returns to market.

Tread carefully

Structuring a pure stapled secondary - where an investor takes an LP position in an existing fund, offering the GP who must approve the deal additional capital for a future fund as a sweetener - isa tricky balance of pricing, demand and opportunity. Unless the GP is a standout performer, LPs may well demand a number of sweeteners themselves.

"If we are a secondary investor leading the deal, we would work with the GP and advise them that in order to secure the approval of existing LPs they have to put a package together that gives the LPs a strong incentive to invest. Perhaps reducing their capital requirement is one way of doing it," says Jason Sambanju, managing director at Paul Capital. "Once you go down one path it raises all sorts of questions, which is why it is important to structure proposals properly."

While stapled secondaries and other fund restructurings are on the rise in Asia, it is not because the market is particularly conducive to them. The phenomenon is arguably more global in nature, driven by the maturing private equity industry, larger funds and more widespread LP bases, and regulatory change.

According to Cogent Partners, trading in traditional LP interests accounted for 77% of the $27.5 billion in global secondary market volume in 2013. Yet Dominik Woessner, a Shanghai-based director with Cogent, notes that GP-led transactions now account for around 25% of the firm's deal flow, up from 5-10% three years ago. The proportion of these transactions in Asia is also higher compared to the rest of the world because it is a shallow market with few investors selling traditional LP interests in funds.

This has a knock-on effect in terms of the allocation of on-the-ground resources. Most secondary specialists have staffed up in Asia in recent years and these people are expected to do more than conduct due diligence on Asian managers that crop up in global portfolio sales.

Their origination efforts must therefore be proactive. This might involve seeking out the GP with a fund that is nearing the end of its life and offering an exit route either for LPs in need of liquidity or for fund level assets the manager wants to sell in order to give LPs liquidity. There may be a successor vehicle, or there may not.

Restructuring opportunities can be fashioned from the debris, with or without the manager, but investors have to get their hands dirty. "You have guys on the ground telling everyone they are a global secondaries firm but they have to get some deals done," says Dean Collins, a partner at O'Melveny & Myers. "People have to be creative."

However, the highest profile stapled secondaries to emerge in Asia recently did not come from inexperienced managers or distressed situations.

An LP interest in a Morgan Stanley Private Equity Asia vehicle was picked up by AlpInvest Partners and LGT Capital Partners from Morgan Stanley and the two investors made a commitment to the GP's latest pan-regional fund, which is expected to close later this year. Headland Capital Partners is also heading back to market and AVCJ understands that a stake in an existing fund held by former parent HSBC is being offered to prospective investors in the new vehicle.

In both cases, the driving factor is banks needing to comply with the Volcker Rule restrictions.

"If you have an exceptional manager and an exceptional blind pool then a pure staple is possible," says one industry participant. "But it's not like anyone can go out there, sell the portfolio and raise a new fund alongside. GPs try it but it is a challenge getting a pure staple for a blind pool of capital."

Tough negotiators

Ask most secondary investors to list their preferred deal structures and an LP stake in a fully funded, fully capitalized portfolio would be at the top; a stapled secondary would rank much lower.

In Asia as elsewhere investors have been more interested in entering funds and providing capital required to service existing portfolio companies rather than entering fresh blind pools. This may involve participating in additional funding rounds for growth companies that are not yet ready for IPO or, in the case of a control investment, supporting bolt-on acquisitions.

"Where the money is invested into the same vehicle and allocated to existing assets, two things happens," says Paul Capital's Sambanju. "First, you get cross-collateralization, with the GP accumulating carried interest on the basis of assets already in the fund. Second, you know the money is only going into those assets so there is no blind pool risk."

The documentation behind a stapled secondary can be as straightforward as a one-page term sheet, a transfer agreement between two investors on the existing fund and a subscription booklet for a new fund. Complications come in negotiating terms between the various parties.

These processes may ultimately be GP-led - the exception being when LPs move to oust the manager - but how the transaction came to market in the first place is significant.

Was it the result of extensive discussions with the LP advisory committee, which includes a few funds-of-funds that make primary and secondary commitments and are looking for deal flow in the latter? Or was it prompted by a speculative inquiry from an investor that is keeping tabs on secondaries market activity? Even the presence of an intermediary like Cogent may have a bearing on the outcome.

Once an investor becomes aware of a potential transaction, the first step involves understanding the assets, capital needs and deal pipeline. A proposal is put together and presented to LPs, usually a handful of key players. If there is agreement on general terms such as pricing, deeper due diligence follows. Issues including the legal ramifications of transferring assets and the rights of co-investors in particular deals come to the fore.

This detail goes into the definitive agreement, but battles are not easily won.

"Unlike a traditional secondary where there is a buyer and a seller and you look for a win-win situation, in these restructurings you add the third party, the GP, so you have to find a win-win-win situation," says Adam Howarth, managing director and co-head of PE secondaries at Partners Group. "It's all a negotiation and there are so many levers that need to be pulled to find a solution."

Pricing is an obvious sticking point: it has to be attractive enough for the seller to sell without making the deal economically unfeasible for the buyer. Various other clauses can be layered in to temper the economics. These might include the reset of carried interest and linking future payments to specific performance hurdles; the subordination of certain investors so that new entrants can get priority in terms of cash flows and distributions; and reductions in management fees or a larger GP commitment.

The objective is to realign interests to reflect the changing dynamics of the fund and the relationships between the main actors. It comes down to who can push the envelope and how far.

While it is not unusual for secondary players to structure investments on an IRR-driven basis, O'Melveny & Myers' Collins says he is seeing these terms filter through to stapled primaries. There are, for example, triggers as to when management fees start and when draw downs can be made for the new fund, designed to achieve a combined return based on the projected performance of both vehicles.

"It is all about the secondary investor's rationale for doing the deal," Collins adds. "These might be global groups with traditional fund-of-funds businesses, but the new primary commitment comes from a secondary fund. A lot of it boils down to how a secondary purchaser sells the deal to its LPs."

Tailored solutions

The bespoke nature of deals in Asia may also be a function of the kinds of stapled secondaries that are available below the landmark transactions involving established managers.

Several industry participants reference friends-and-family deals whereby GPs offer access to a basket of earlier deal-by-deal investments to LPs that commit to their first institutional fund. These are not necessarily stapled secondaries because the existing assets may end up in the same structure as the primary capital.

The GP receives support to take its franchise to the next level and the groups or high net worth individuals who provided capital for transactions that now form the basis of the GP's track record get an exit route. However, Cogent's Woessner notes that raising a blind pool often comes at the expense of the price of the secondary and if the sellers want to maximize returns they probably wouldn't do it.

"An alternative would be to do the secondary transaction first," he says. "You create a first institutional, third-party fund, possibly including unfunded commitments for follow-on investments, in order to build up a track record with this new LP base. Then you go back to them, as well as other potential investors, after some time and raise a new, blind pool fund."

There is no formal staple binding GP and LP together, more an agreement to see how things go with the secondary and be open-minded about a subsequent primary. This approach might be preferable in less developed and volatile markets like India - the focus of much secondary structuring activity right now - where many managers have yet to convince LPs of their ability to create sustainable PE franchises.

"There are opportunities in Asia both to back well-established managers or even less well-established managers that are trying to get a PE franchise off the ground," says Doug Coulter, a partner at LGT. "As long as it's the right structure and terms there will be LPs willing to underwrite a new franchise."

Almost regardless of country, there are GPs seeking to build these relationships in a compressed timeframe. In a challenging fundraising environment, the onus is on reaching a first close and one way of getting there is to offer a secondary LP exposure to existing assets while presenting a pipeline of new deals that would be funded using the new capital this investor provides. The staple remains but the risk and uncertainty of the blind pool might be reduced.

While such opportunities may be increasing, they must be treated with caution. "Fund restructurings or stapled transactions are generally large in terms of dollar volume," says Partners Group's Howarth. "It does move the needle in terms of deal flow, but in terms of opportunity each has to be evaluated on its own merits, on the assets and on the team side."

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• Topics
• Secondaries
• Secondaries
• Fundraising
• Secondaries
• Ironbridge Capital
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• Paul Capital Partners
• LGT Capital Partners
• Partners Group