Many limited partners — myself included — have expressed skepticism of general-partner-led secondaries. Among the top concerns: potential conflicts of interest, perverse incentives, and adverse selection bias.
But perhaps these concerns are unfounded.
First, some numbers: Private equity secondary volume last year remained pretty robust, as approximately $100 billion of transaction volume traded hands. According to research from Jefferies, roughly half of this was LP-originated activity, as institutional investors like CalPERs sought to access liquidity from secondary markets.
Some of this was because many LPs found themselves overweight to PE and cash-flow negative in their private markets portfolio. Another portion of this volume was from institutions that simply had a change of management or philosophy.
Or, sometimes after many years of committing to the asset class, large institutions come to realize they have hundreds — potentially thousands — of funds and not enough resources to actually monitor and manage all the line items. If they can’t hire more people, sometimes it makes sense to do a portfolio cleanup sale.
Of course, if half of secondary volume was driven by LPs, that means the other half was GP-led transactions.
GP-led processes, often also called continuation funds or continuation vehicles, occur when a private equity sponsor has a company or a handful of companies remaining in a fund that is approaching the end of its life. Rather than sell the company to an arm’s-length investor, like another private equity fund or a strategic corporate acquirer, continuation funds are special-purpose vehicles set up by the GP, often with participation from an external investor, to purchase assets from an old fund and move them to the new vehicle.
A private equity firm that moves an asset or several assets from one fund to another has broad discretion over what price the “transaction” occurs at. The GP might have an incentive to set pricing low, making the deal attractive to new money. Such transactions often have a primary commitment to the next fund launch included as a prerequisite for participating in the continuation vehicle — a so-called stapled deal.
Worse, GPs can often crystallize their carry in one fund without providing any net liquidity to their clients. It may be better than being trapped in a zombie fund — but all else being equal, it’s preferable to generate liquidity for your investors via a true independent transaction with a third-party investor, where maximizing the price is the objective for all partners in the fund.
Speaking of zombie funds, there’s also the concern around adverse selection bias. LPs are often worried that the assets left unsold during the back end of a fund’s life are poorer-quality businesses. Perhaps they aren’t performing well, or maybe they aren’t attracting buyer interest, but investors often suspect that if they were great assets, they would have no problem selling.
This is probably why 90 percent of LPs are electing for liquidity in GP-led continuation vehicles, according to Lazard.
Yet new performance data for continuation vehicles suggests that maybe we’ve all been wrong about GP-led secondaries.
Alternative investment advisory and research firm Upwelling Capital Group estimates that there have been about $220 billion worth of GP-led secondary transactions since 2016. Upwelling argues that these vehicles have outperformed their respective main funds as well as vintage-year top-quartile funds.
Using data from Hamilton Lane, Upwelling showed that from 2018 to 2020, continuation vehicles generated multiples of capital that were well north of the top-quartile funds in all three recent vintages.
This outperformance holds up when continuation vehicles’ returns are compared with the performance of their underlying funds. On this basis, single-asset transactions outperform their main funds by 1.6 turns of invested capital, and multi-asset funds beat their corresponding flagship funds by 0.5x. Such impressive returns certainly don’t seem to be indicative of adverse selection effects.
Private equity GPs have typically argued for positive selection bias, saying that the companies they have yet to sell have far more room to run and they’d be leaving money on the table by selling now. They insist that they know the business much better after owning it for several years and have an operating playbook to continue growing and improving the company. They believe they can make more money by continuing to hold than by buying a new company.
The early data shows that there may be some truth to this argument — and that my initial skepticism about GP-led secondaries may have been unfounded. The fact that single-asset deals have done even better than multi-asset extension vehicles does seem to support GP claims that they are focusing on great assets — and it would appear the more focused, the better.
If GP-led secondaries can continue to deliver on their promise of access to strong-performing companies with private equity firms that investors already know and trust, such vehicles will likely see broader adoption among the LP community.
Christopher M. Schelling is the founder and chief investment officer of 512 Alternatives, a boutique consulting firm dedicated to helping wealth managers, family offices, and small institutions understand and access alternative investments.
