Although the GP market has boomed over the past couple of years, it’s not about to replace secondary transactions led by investors.
GP- and LP-led transactions are two distinctly-structured liquidity vehicles for investors in the secondary market where both stakes in long-term funds and private companies change hands. “In a market like today’s, each individual institution is going to use portfolio management for their own specific needs,” Cari Lodge, managing director at Commonfund Capital, told Institutional Investor. “There’s a lot more flexibility to reallocate your portfolio through LP-transactions, especially if it’s across multiple positions, versus waiting for a GP-led transaction.” This is primarily due to the fact that in an LP-led transaction, the seller (the LP) controls the timing; in a GP-led transaction, the GP handles the timeline. It’s less efficient.
Here’s how it works: A private equity firm starts with a pool of capital collected from investors. These funds — typically closed-end funds — are managed by general partners (GPs) and bind the LPs to the investment for over 10 years, with no options for exiting or liquidating.
According to a UBS white paper, these types of funds use a “commitment model” that requires investors to provide capital periodically when the GP makes an investment decision. These capital calls help GPs manage their investment decisions over the long-term, but LPs who may need to leave the fund before their contract expires are left with only one option: sell their interests on the private equity secondaries market.
Historically, a sale like this would happen in the form of an LP-led secondary transaction. In this transaction type, a secondary buyer replaces an LP in an existing fund and gains exposure to any assets in that fund. These types of transactions are the traditional path to liquidity in the secondaries market. An LP initiates the transaction and often participates in the search for a buyer. When a LP wants easy access to cash before the expiration date of their investment contract, they can initiate one of these secondary transactions, selling the fund’s assets to another owner. Meanwhile, the GP helps facilitate the transaction but is otherwise hands-off.
“It’s a traditional funds transfer position that is the bread and butter of the industry and has been for years,” said Jared Barlow, partner at Kline Hill Partners, an investment firm focused on small deals in the private equity secondary market, in an interview with Institutional Investor. In the first half of 2022, overall secondary transaction volume increased to $57 billion, a $9 billion increase from the first half of 2021, according to data included in the Commonfund article. Over half of that volume ($33 billion) was generated from LP-led transactions.
Until 2020, secondary market transactions were dominated by LP-led deals. But with the onset of the Covid-19 pandemic and the subsequent market volatility, investors wanted more options for liquidity. By the end of 2020, GP-led transactions accounted for over half ($35 billion) of the year’s total secondary transactions. And the trend continued into 2021, with GP-led transactions outpacing those led by LPs by $4 billion. “The GP market is certainly the darling of the moment,” Joe Marks, senior managing director and head of secondaries at Capital Dynamics, a private equity firm, told II.
But Jared Barlow warned against drawing conclusions from those numbers. “One [transaction] isn’t cannibalizing the other,” he said.
In an LP-led transaction, a buyer and a seller agree on the terms of the transaction — the assets for sale and the valuation date. The GP then approves the transfer, the buyer pays the purchase price to the seller, and the seller transfers the LP’s interest to the buyer.
A GP-led transaction looks quite different and resembles more of a “custom solution” for the GP, Barlow said. In these transactions, GPs are the ones initiating and creating the liquidity in some portion of their portfolio. While there are many types of GP-led transactions, the process typically calls for a private equity firm — or GP — to lift a portfolio company or other investments out of one fund, pay out investors, and then create a new one.
GP-led secondary transactions generally have lower fees and start at lower carried interest rates with higher carried interest hurdles, a situation that Marks called a “double benefit.” These deals are also generally underwritten to high multiples, which means they have higher multiple potential.
GP-led solutions also allow managers to hold onto their best assets – which Marks called their “trophy assets” — while providing their clients with liquidity when they need it. “[GPs] have realized that this is a great way to hold on to their winners longer, give liquidity to people who want to get off the bus, and continue to generate economics, versus giving it away to your competitor. That’s not fun,” Marks added.
But in some areas, Marks said, GP-led secondaries transactions fall short, and he warned that GP-led secondaries lack some of the fundamental characteristics that secondaries are supposed to deliver.
For one thing, GP-led secondaries often don’t offer much of a discount for the buyer. This is a product of how this type of transaction is structured. Marks gave an example: A manager is holding a company valued at $500 million and the buyer asks for a 3 percent discount. The manager agrees to the discount, selling the company to the buyer for $485 million.
“The value of that investment is going to be 485, not 500,” Marks said. “[That discount] might be there in terms of not paying what the manager says it’s worth, but you don’t get the markup cushion.” In traditional LP-led transactions in the secondary market, LPs have enjoyed that discount. In GP-led deals, most transactions are reported at-cost.
GP-led deals also don’t offer the same level of diversification that LP-led deals do. In fact, GP-led deals are highly concentrated — some contain only a single asset — which is the opposite of a diversified investment. This means that these types of transactions come with higher risks and higher rewards.
While GP-led deals have their benefits and have enjoyed increased popularity in recent years, Marks said he believes that the market for them will normalize. Barlow, meanwhile, said he expects GP-led deals to continue going strong into the near future, but he added that volumes for the rest of 2022 could be dampened by a shortage of buy-side capital. LP-led deals, he said, are “not to be forgotten.”