Consistent with their experience in prior market corrections, current macroeconomic and capital market conditions appear to be creating attractive investment opportunities for secondary buyers, say Philipp Patschkowski, managing director, and Ben Perl, global head of secondary private equity, at Neuberger Berman.
Over the last 18 months, we have witnessed a meaningful decline in private equity (PE) exits. This dynamic, combined with the denominator effect and elongated holding periods, is creating attractive opportunities for providers of liquidity to the private markets. GP-orchestrated “continuation funds” alleviate liquidity challenges and provide an appealing opportunity for investors to access private markets strategically and selectively.
Many PE investors remain overallocated as their private investments outperformed in recent years, while other asset classes underperformed. Exacerbating this, closed exit markets caused liquidity to dry up, and PE investors suffered an estimated $106 billion of net cash outflows in 2022 alone. Against this backdrop, the secondaries market recently marked the second-highest volume of closed transactions in history. Indeed, in 2022, marketed transactions volumes, both for LP- and GP-led transactions, were at all-time highs, according to PJT Park Hill, a secondaries advisory firm.
Over the past couple of years, capital formation in the secondary markets generally has not kept pace with the increasing supply of secondary investment opportunities, creating an attractive imbalance between supply and demand. Dry powder in the secondary market is currently less than one times annual transaction volume, a long-time low; by some estimates, the ratio for GP-led secondaries is even lower.
The recent decline in closed transactions in the GP-led market can be attributed mainly to limited available capital and occasional bid-ask spread, but not primarily related to a declining supply of opportunities or flagging demand from GPs.
While current investment dynamics are attracting new entrants to the GP-led market, success in this market requires a unique combination of skills and characteristics, including:
•Underwriting resources and structuring capabilities: Successful investors in GP-led transactions require substantial direct-underwriting resources and structuring capabilities, similar to direct buyout investors, due to the extensive due diligence needed to analyse the underlying assets, differing from analysing diversified portfolios of LP positions. New entrants to the GP-led market often need to hire staff from outside the secondary market, taking years to train.
•Ability to partner with GPs: Successful investors in GP-led transactions should partner productively with GPs ensuring access to high-performing portfolio assets and structure governance and alignment with GPs. GPs prefer partnering with experienced GP-led investors to improve certainty of closure. Furthermore, secondary teams part of larger, integrated private-market platforms with dedicated fund-of-funds, co-investment and private debt offerings are positioned to provide long-term capital solutions.
•Access to capital: Successful investors in GP-led transactions require access to sufficient capital to position themselves as lead investors to set pricing and align governance with GPs.
Targeted approach to mitigate risk
While PE’s long-term prospects and performance looks optimistic, there may be greater dispersion of ultimate returns within legacy portfolios, given the changes observed in the macroeconomy and capital markets.
Given the current economic and financial cycle, with persistent volatility and healthy secondary transaction supply, investors may benefit from a targeted approach in the secondary market rather than relying on diversification to mitigate risk. This targeted approach has potential to reduce risk by avoiding the underlying return dispersion that often comes with buying large, diversified portfolios.
GP-led transactions have the potential to isolate not only high-performing PE portfolios but go deeper and target the highest-quality investments within those portfolios. GP-led vehicles have additional structural benefits helping investors maximise returns.
Underlying GPs typically require a substantial commitment to the new continuation fund. Secondary funds can extend the investment holding period of a particular asset in a GP-led continuation fund or inject expansionary capital with which the fund can make add-on acquisitions or fund other growth initiatives in the portfolio companies. Continuation funds have the potential to generate returns that compare favourably to traditional buyout firms but with a superior risk profile. Reasons include:
•Strong alignment with the underlying GPs: In a GP-led transaction, secondary buyers seek alignment by requiring a substantial GP commitment. While each transaction is bespoke, investors often expect the GP to invest substantially all of the carry proceeds generated by the transaction back into the continuation fund, and make a meaningful new additional commitment.
•Lower execution risk: GP-led opportunities involve companies with proven management teams. Underlying GPs typically have strong track records managing the portfolio companies transferred into the continuation fund and driving growth strategies over many years. This intimate understanding of target companies and solid relationships cultivated with their management teams, helps reduce the execution risk of GP-led transactions versus new buyouts. In these transactions, underlying GPs decide to continue to own and invest in high-conviction assets, lowering long-term risk.
•Shorter duration: Because GPs are intimately familiar with managing target companies, value creation continues from the day of transaction without a 100-day plan or replacement of C-suite.
•Lower entry valuations: In typical GP-led transactions, the underlying GP maintains control of the assets, whereby investors in the continuation fund do not pay a change-of-control premium, potentially lowering the purchase price versus traditional buyouts.
•Safer capital structures: Companies in GP-led transactions typically have spent time proving their business models and deleveraging balance sheets versus traditional new buyouts.
Looking ahead, further economic and geopolitical uncertainty will bolster demand for liquidity by primary fund LPs and GPs, and ultimately continue to stoke GP-led transaction supply. In this undercapitalised and understaffed market, experienced investors in the GP-led secondary market have the potential to capitalise on these structural dislocations and generate attractive long-term returns.
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