Private Equity GP-Led Secondary Transactions – Are They Here to Stay?

Introduction and Background 

For many years, private equity has been challenged with providing a liquidity mechanism for its large limited partner (LP) investor base. Historically, the primary way an LP could convert its investment to cash before the expiration of a fund’s contractual term would be if the LP itself initiated a transaction and at times participated in finding a prospective buyer. In these LP-led transactions, the general partner (GP) of the fund would often facilitate matters and, unless circumstances warranted, sign off on the transaction with modest involvement in the process. Such LP-led transactions were commonplace and still constitute the largest segment of the secondary market. However, GPs themselves are now more active in these transactions, using their common right under a fund’s limited partnership agreement (LPA) to manage information flow and approve who can be admitted to the partnership.

As LP-led transactions have continued year-after-year unabated and grown in sophistication, a large, noticeable trend has emerged in recent years – the rise of GP-led secondary market transactions.

Drivers of GP-LED Transactions

As private equity has matured as an asset class, its status and reputation as a purely illiquid investment has evolved and become much more nuanced. The traditional ten-year fund term is often not enough time to fully implement a GP’s value creation plan; portfolio companies are complex organizations that don’t always develop and increase in value strictly in accordance with a fund’s contractual timetable. As a result, market conditions have given rise to the increased prevalence of GP-led secondary transactions. Such transactions provide an opportunity for a GP to further execute on its value creation plan, often with the ability to invest new capital into portfolio companies provided by a new secondary market investor. From the LPs’ perspective, the secondary market provides them with a tool that allows for greater precision in overall portfolio management.

Growing Secondary Fund Formation 

The increasing demand for private equity liquidity solutions is clearly evidenced by fundraising statistics, especially in recent years. Funds dedicated to a secondary market strategy are being launched at a rapid pace. According to Private Equity International (PEI), secondary fundraising (private equity, real estate, infrastructure and credit) in 2020 nearly tripled compared to the year before, with $95.6 billion raised in 2020 vs. $33.1 billion raised in 2019. Secondary funds raised in 2020 accounted for approximately 15% of the total. With the continued interest in GP-led transactions, this trend is expected to continue. In addition, secondary market investors are also large institutional investors themselves who can often add insight and advice to the GP leading a current transaction.

Structuring and Executing Secondary Transactions 

GP-led secondary transactions typically take the form of either LP tender offers or fund restructurings. In an LP tender offer, a secondary buyer acquires certain LP interests in an existing fund. In a fund restructuring, a newly created investment partnership (a “continuation fund”) acquires defined assets from the predecessor fund. In many respects, fund restructurings are sales of assets whereby the same party (the GP) is on both sides of the same transaction. New capital (the secondary fund) anchors the continuation fund’s LP base and generally provides LPs in the selling fund the ability to cash-out or rollover their LP interest into the new fund. Significant tax benefits can potentially be obtained by the rolling LPs; deep involvement from legal, tax, and other advisors is expected and well-advised.

Best Practices for GP-LED Transactions 

GP-led transactions are clearly quite complex and typically require time, patience and the ability to resolve multiple objectives that are sometimes not in alignment. Best practices and recommendations provided by the Institutional Limited Partners Association (ILPA) for fund restructurings have been useful to both protect LP interests in these transactions and to guide GPs in running a process where all parties are satisfied with the outcome. Certain of ILPA’s best practices and recommendations include:

• GPs should share the transaction rationale with the limited partnership advisory committee (LPAC) and in some cases a broader set of LPs as early as possible in the process.
• An LPAC’s defined role is contained in a fund’s LPA and generally involves the review and resolution of conflicts throughout a fund’s life; the LPAC can provide guidance to the GP throughout a fund restructuring process.
• In presenting a comprehensive rationale for the restructuring, the GP should provide information on the quality and outlook for the fund’s remaining investments, among other information.
• Before the terms of a deal are presented to limited partners as an election, any conflicts related to the transaction should be identified, mitigated where possible, and approved by the LPAC.
• LPAC members should be provided enough information to assess whether the GP-led process was appropriate to ensure that a fair price was obtained.
• LPs should be afforded sufficient time to thoroughly evaluate the GP proposal and return their respective election forms.

The GP should engage an experienced advisor to solicit bids for the portfolio of assets, and the LPAC should review the GP’s selection.

Conclusion

A close look at the drivers of GP-led transactions clearly shows a fundamental shift in the very nature of the private equity asset class and leads to the conclusion that GP-led secondary transactions are here to stay. GPs and LPs alike will increasingly search for liquidity and establish recurring programs to achieve such goals. In future years, more and larger pools of secondary funds are expected to be formed – see Ares Capital Management’s recent acquisition of secondaries specialist Landmark Partners as clear evidence that this is likely to occur. Also, according to PEI, BC Partners, EQT and Blackstone are recent examples of firms that have either used continuation vehicles or transferred assets into successor funds. The resulting vast amount of capital will be under significant pressure to be deployed, leading to it being commonplace for GPs with long-dated funds containing valuable assets being approached with offers of liquidity. This trend may ultimately change the long-standard ten-year term of a private equity fund and allow for liquidity at various points along the trajectory a fund’s life cycle.

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