Maximizing Value and Aligning Incentives In The Ever-evolving Secondaries Market
The huge amount of capital that has flooded the secondaries market over the past few years has had a direct impact on the options available to the high quality fund managers of tail-end fund portfolios. Many private equity fund managers significantly slowed their investment pace during the Global Financial Crisis. The slower investment pace for fund managers has forced them to explore creative options for these legacy funds (even where new funds have been subsequently raised). The options available are more solution oriented today and include not only the traditional secondary buyer base but many leading primary LPs that would like to buy into these tail end portfolios as a way of building a relationship with the manager.
For traditional secondary buyers, the capital raised over the past few years has outstripped the transactions requiring this capital, thus secondary buyers are broadening their approach to the market in search of opportunities. For primary LPs, their mandates have expanded and a secondary transaction is viewed as a means to building a primary relationship – and vice versa. Buyers have increasingly looked outside the box for creative new structures that allow them to put capital to work, but that will generate the same attractive returns that they seek from traditional secondary purchases. This has been very welcome news to GPs who continue to manage legacy assets that have real value and in some instances have incremental capital needs to actualize that value (in the form of add-ons or tuck-ins), but have exhausted their investment periods (and extensions). Secondary buyers have been approaching many of these groups to discuss recapitalizing older vintage funds and the structures often provide a path to success for all parties. Many high quality firms have recognized the secondary market as a viable option that allows them more time to build value in the portfolio and reset the timeline associated with doing so. Many of these transactions now feature a co-investment component or incremental capital investment that allows the GP to perform tuck-in acquisitions for these companies because the secondary buyers are interested in providing managers with the ability to manage to the upside as opposed to winding down their portfolios and thereby losing real value. Existing LPs have been increasingly supportive of these options because of the ability to generate future value, but in cases where they can achieve short-term liquidity there is even greater interest.
An innovative structure that has recently gotten traction in the secondary market is the asset strip sale. In this type of transaction a secondary buyer acquires a minority interest directly in the legacy assets. The proceeds from this sale would go towards providing the fatigued existing LPs with some much needed liquidity without the GP having to cede control of the companies or prematurely exit them. The secondary buyer can then contribute their minority interests of these portfolio company assets (asset strip) into an SPV that has structured economics for the GP thereby incentivizing the team to continue accreting value for these assets. In addition, some secondary buyers will also be able to provide some primary capital for a successor fund if the fund manager is seeking a new committed fund vehicle to support their go-forward investing efforts.
Each secondary transaction has its own particular set of circumstances that buyers need to solve for, but the capital base and incentives that exist for solving these issues is strong, and so we anticipate many more of these transactions getting done in the months that follow. It is paramount in this market that buyers have a keen appreciation of how alignment and motivation works within these fund partnerships and how to maximize value for all parties involved including the existing investors who have a separate, but equally important set of sensitivities and priorities.
Next on 60 Seconds with Sixpoint: Is Permanent Capital the Holy Grail of Private Equity?