Boosted by the exponential growth of the primary private equity market in recent years, the secondaries segment has grown and matured and may strongly appeal to investors, notably via the trend of GP-led transactions. Once again, Luxembourg has a key role to play due to its favourable position within the EU and may offer investors significant and attractive tools.
While investments in the primary market are directly made in newly formed private equity funds, in the secondary market, investors acquire existing limited partners’ interests and/or assets (available in existing funds before their maturity date) that are sold for liquidity purposes or for a better exit.
Secondary funds, the ideal solution for search of liquidity
The major reason behind secondary funds’ appeal is the search for liquidity. From a limited partner perspective, secondary funds can be seen as an effective management tool because their specific situation and investment strategies can vary over time and thus create a liquidity need which could easily be fulfilled by selling their interests into funds. From a general partner perspective, secondary funds can also be seen as a management tool for transforming illiquid assets (like a private equity portfolio company) into liquid assets. However, both general and limited partners may also have an opportunistic approach and monitor the market to sell their participations and assets at the highest possible value based on their expected revised valuation.
Irrespective of the standpoint players are focusing on, secondary funds have been trending as they offer diversified private equity exposure (with an accelerated pace) and give access to known and well-performing assets. They also allow investment for a shorter duration compared to the usual private equity funds, help mitigate or eliminate the J-curve (discount at entry and avoidance of near-term underperformance of younger vintage funds) and offer attractive returns and early cash back.
Before the COVID-19 sanitary crisis, two types of deals with different end goals were made depending on the party at the origin of the transaction. On the one hand, limited partners led transactions to sell their investments into funds, either to generate some liquidity or for portfolio diversification purposes by redeploying their capital via other strategies. On the other hand, general partners led transactions that usually had a twofold strategy (i) organising liquidity in their funds under management by engaging buyers and then informing the limited partners of opportunities to sell their interests or (ii) single asset transactions whereby a fund would sell an asset into a continuation vehicle capitalised by secondary buyers.
In the context of the sanitary crisis in 2020 and the resulting fund valuations decline, the sharp decrease in the number of limited partner-led transactions made sense as the limited partners selling their interests were waiting for the fund valuations to return to their former levels before selling their participations. Consequently, secondary funds focused on buying back limited partners’ interests had dramatically less activity in 2020.
Growing potential in GP-led transactions
On the opposite side, general partner-led transactions flourished in 2020 and continue to flourish in 2021 as, from a general partner standpoint, it was not and is not a propitious time to have an interesting exit price for an asset. The trend has therefore been for the general partner to set up a continuation (or sidecar) fund to lodge their top-performing asset(s) and to be able to extend the asset(s)’ holding duration and secure more growth capital. The general partners can then leave a choice to their existing limited partners to either sell their interest at a premium to appraised value or stay in the continuation fund. In secondaries, GPs are no longer “passive spectators” but instead become more and more the leaders of the transactions. The tremendous increase in the size and complexity of the GP-led market gave priority to LPs with the required network, experience and resources. This well-established network of primary business relationships is now becoming the key to access high-quality transactions and insights.
These types of transaction are currently very attractive as the discount on the asset is around 15% on a fund valuation; that is lower than before the sanitary crisis according to Unigestion, a major European asset manager, in February 2021.
Given that the fund valuations are now in the process of recovering to reach their former level (i.e. prior to the sanitary crisis), a resurgence in limited partner-led deals can be seen even though the general partner-led deals still seem to be favoured by the market.
Luxembourg as a preferred financing centre for the structuring of the secondary segment
In Europe, continuation vehicles are generally formed as multi-asset continuation funds for diversification purposes, contrary to the US where single-asset vehicles predominate. Given Luxembourg’s strategic situation at the crossroads of Europe and its established financial expertise, Luxembourg is becoming an increasingly competitive location for initiators to structure and set up their secondary funds and notably their continuation vehicles.
The rapid development of Luxembourg’s alternative investment fund servicing infrastructure, combined with the steadily evolving legal structuring toolbox, has enabled Luxembourg to become the leading EU centre for domiciling alternative investment fund managers, alternative investment funds and their acquisition vehicles in the same jurisdiction. In Luxembourg, there is a complete fund structuring toolbox to respond to each investment manager’s specific needs.
Whatever the initiator’s priorities in terms of structuring secondary funds, the wide range of Luxembourg vehicles available should satisfy initiators’ and investors’ needs by accommodating (semi-) open-ended and closed-ended strategies with different levels of regulation, from the classic non-regulated special purpose vehicles, special limited partnerships and reserved alternative investment funds (RAIFs), to the regulated specialised investments (SIFs) and sociétés d’investissement en capital à risque (SICARs). As Luxembourg is a member of the European Union, the marketing of a secondary fund qualifying as an alternative investment fund (AIF) can be accomplished without difficulty within the European Union because of the alternative investment funds directive (AIFMD) marketing passport.
As an alternative to non-regulated special purpose vehicles, secondary funds formed as continuation vehicles could also be organised as special purpose acquisition companies (or SPACs) which, if needed, could be structured to be eligible for the alternative investment fund status under the AIFMD. A SPAC could be a solution for a single asset deal and/or for an entire portfolio depending on general partner liquidity needs.
Once again, Luxembourg knows how to play the game admirably well and appears to be one of the favoured financing hubs with respect to secondaries segment structuring. Thanks to its political stability, its corporate flexibility and its efficient and sophisticated investment fund toolbox, as well as the fact that it is an established and well-known GPs and LPs financial centre for primary deals, it has become a key centre for GPs and LPs to build their secondary vehicles.
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