To Be Continued: The Case for GP-Led Secondary Funds | DeMarche (2022)

A Changing Landscape

Many of us recall a time before DVRs in which television shows used “to be continued” as a technique to encourage future viewership by linking two episodes together. In many cases, the cliffhanger would not be resolved for an entire week. Fortunately those days are largely behind us. We can binge watch an entire season of our favorite show over a rainy weekend! Conversely, private equity secondary investing has reached a point where “to be continued” is more and more common. The common thread is that it wasn’t always possible to know what lies ahead, although we often suspected that Batman and Robin would likely survive to fight crime in Gotham City another day. In the case of private equity funds that are to be continued, the sponsoring general partner (GP) also believes that they know how the fund’s story will have a positive ending as well.

The market for secondary private equity interests continues to evolve. While the secondary market emerged in the late 1990s as a venue for limited partners (LPs) to transact fund interests, the latest decade has brought hyper-growth of commitments to “secondary funds” that are specifically designed to target these opportunities. This trend continued into 2019 as six of the 20 largest private equity funds raised that year were secondary funds. Further, dry powder in the secondary market today is $180 billion, continuing a secular trend dating back to at least 2012, as evidenced by the graphic in Figure 1.

To Be Continued: The Case for GP-Led Secondary Funds | DeMarche (1) Figure 1

Investors Discover Secondaries

Initially, secondary markets were pretty homogeneous and more or less a direct derivative of the primary market for private equity. Historically, secondary investors sought diversified exposure to private companies by purchasing LP fund positions (or sometimes an entire portfolio of LP fund positions), usually at a discount to Net Asset Value (NAV). The ability to “look through” a portfolio was considered highly desirable, especially for those investors seeking less “blind pool” risk. However, as Michael Woolhouse of TPG Capital has noted, large secondary funds that might contain several hundred underlying companies represent more of a macro investment, thus lessening the importance of underwriting individual companies.

(Video) LP-Led and GP-Led Private Equity Secondaries

Following the Great Financial Crisis (GFC), managers typically competed in the secondary market by positioning their offerings as benefitting from differentiated deal flow or proprietary due diligence and underwriting capabilities. Leverage was relatively rare, and GP-led and single asset transactions were not typically on the agenda. Fast forward to today and the market for secondary investment opportunities has developed into an increasingly complex ecosystem with different investment strategies focused on fundamentally different economic exposures. This paper will focus on GP-led secondary investing and, more specifically, so-called “continuation funds,” which have at times been unfairly accused of being the sole purview of sponsoring GPs that, often for self-serving reasons, did not want to call it quits just yet.

As private equity allocations have continued to increase, as evidenced in Figure 2, plan sponsors often turned to private equity secondaries as an effective J-Curve mitigant as committed capital was typically put to work quickly. Attractive IRRs often followed as successful secondary funds generated significant cash returns, having purchased LP interests that were often in the harvesting phase. In addition, new entrants to the asset class could attain immediate exposure to investments across prior vintages, strategies, and industries.

To Be Continued: The Case for GP-Led Secondary Funds | DeMarche (2) Figure 2

Holding Periods Are Increasing

In general, PE firms often sell their best performers early, thus looking in gains (and attractive IRRs) for investors, while at the same time providing liquidity (these early "wins" are also often celebrated in subsequent capital raises). However, it has become evident that a major structural limitation of the typical PE fund model is that after 10 years the trajectory of one or more portfolio companies could still be very promising, even after a strong return had often been locked in for the fund. According to a recent report issued by Morgan Stanley, prior to the Global Financial Crisis, approximately 40% of private equity portfolio companies were sold within three years of acquisition.

(Video) Continuation vehicle in private equity

From 2009–2018, however, the average holding period has increased by 32%. As a consequence, the median time it takes for a private equity fund to liquidate fully is now longer than 13 years, while the average term for a PE vehicle remains at 10 years. GP-led secondaries are ideally positioned to address this duration mismatch.

Initially, secondary strategies were often associated with broken or “zombie” funds with misaligned (future) economics and were characterized as existing to maintain fee generation for the GP. At times, legitimate criticism was leveled against the sponsoring GP as it became apparent that the existing fund/strategy was not going to generate competitive results (and associated carried interest for the GP). As a result, subsequent funds would not be coming to market, or would likely be much smaller. Therefore, holding onto some tail-end assets and collecting management fees (while hoping for a miracle) became a path forward for some GPs while they plotted their next move. However, as LPs have become more sophisticated (often backed by strong advisory boards, not to mention the Institutional Limited Partners Association’s (ILPA) guidance), a different picture has started to emerge. Specifically, a paradigm change has occurred in which secondary offerings are now part of a much more robust tool set for plan sponsors versus a last-ditch provider of liquidity.

GP-led to the Rescue!

Today, certain secondary investors focus on tail-end fund solutions, whereas others seek to invest in more recent vintages that are still deploying capital. To navigate today’s complex secondary market, investors need to answer a single but key question: What risk-return profile and secondary investment strategies are appropriate for my portfolio? To answer this question, it is important to look at the different types of underlying secondary transactions and investment strategies. Generally, transactions range from (i) highly diversified portfolio deals that can be levered to (ii) very concentrated single asset deals. In highly diversified portfolio deals, idiosyncratic risk is relatively low and higher returns are often achieved by employing additional leverage. These types of transactions essentially provide levered beta exposure to PE as an asset class. On the other end of the spectrum are single asset transactions with higher idiosyncratic risk. This type of approach, at times, provides initially high IRRs that can burn off as discounts are realized. The potential to generate high return multiples is, however, often limited given the high level of diversification and mature nature of the underlying investments. Secondary strategies that provide this exposure are typically more focused on IRR and less focused on return multiples. Returns for these portfolios are often driven by capturing inefficiencies at the smaller end of the market or by exposure to a successful individual deal.

Before the advent of GP-led secondaries, GPs were often faced with primarily two, arguably sub-optimal, paths—either sell to another entity and forego future potential value appreciation or try and extend duration for all LPs and reduce the liquidity available to LPs who may lack patience. Compounding this decision are recent macro events like the global pandemic, which often served to throw off the best laid plans. Enter the single-asset continuation fund.

(Video) CD&R and Belron Deal (Example from our Video Newsletter)

What is a Continuation Fund?

A single-asset continuation fund is actually a Special Purpose Vehicle (SPV) in which the secondary buyer provides liquidity to the sponsoring GP, looking for either additional capital or a longer runway for value realization. The establishment of the SPV allows GPs to continue to manage a particular holding for a longer period of time while also providing follow-on capital as needed. Second, the SPV offers existing LPs the option to cash out or to remain invested for a longer duration. Investors that roll their interest into the newly created (and concentrated) strategy should reasonably expect to benefit from the GP’s deep knowledge of a specific asset and exposure to the assets with the greatest remaining return potential within the GP’s portfolio. On the other hand, an LP may be wary of holding such a concentrated position and prefer a more diversified approach with their capital. Also key is understanding that existing investors who opt to roll into the continuation fund receive a corresponding economic interest in the new fund, so no new tax liability is incurred. Perhaps more importantly, any earned carried interest from the previous fund typically becomes an LP interest in the continuation fund, thus improving alignment of interest.

According to Evercore in 2020, 27% of LPs elected to roll their investment into the continuation fund. However, it’s very possible that the pandemic may have skewed that number.

To increase the likelihood of a successful outcome, the general partner must set, and the limited partner(s) must understand, how potential conflicts will be identified and addressed. Specifically, ILPA recommends that limited partners should receive detailed disclosures on the terms of the new entity created by the restructuring, particularly around any differentiation in terms for new or rolling LPs. Limited Partner Advisory Committee (LPAC) members should be provided enough information to assess whether the GP-led process was appropriate to ensure that a fair price was obtained. A fairness opinion from an independent financial advisor may be helpful in this context. Additionally, the general partner should provide to the LPAC a description of the solicitation process and overview of bids received. Limited partners should review existing fund documents, including side letters, especially in cases where they may be aware of the opportunity to update the side letter in cases where they may be rolling into a new fund (and new agreement).

Conclusion

Like some of our favorite old TV shows, DeMarche believes that continuation funds are likely going to be a permanent part of the private equity investment landscape, as evidenced by GP-led secondary volume eclipsing 50% of the total opportunity set according to Evercore’s 2020 Year End survey data (Figure 3).

(Video) Private Equity Secondaries

To Be Continued: The Case for GP-Led Secondary Funds | DeMarche (3) Figure 3

As such, DeMarche expects GP-led secondary funds to be an important part of the solution set used by institutional investors in reaching their target allocation for private equity.

SourcesA. L. (2021, March 1). GP-led Secondaries Enter New Waters. Private Funds CFO. https://www.privatefundscfo.com/gp-led-secondaries-enter-new-waters/.

FAQs

What is a GP led secondary transaction? ›

The sale of a specified selection or percentage (sometimes referred to as a “strip”) of direct interests in assets held by a fund, typically to an SPV managed by the same GP at a valuation determined by secondary buyers.

What is a LP led secondary? ›

LP-led transactions are one-off transactions led by one limited partner in a fund looking to sell one or more limited partnership interests at some point during the life of the fund. Pitchbook 2021 Private Fund Strategy Report. Jefferies Global Secondary Market Review, January 2022.

What is a GP commitment in a fund? ›

General partner contribution to a private equity fund. The GP commitment to a fund aligns every member's interest as both LP and GP have capital at stake when making an investment. GP commitments range, but are typically 1% to 2% of a fund's size.

What is a continuation fund? ›

Continuation funds involve an entity – whether a co-investment fund, another private fund or one of the other existing limited partners (LPs) – seeking to buy out existing LPs as the fund approaches its natural conclusion.

What is a secondary transaction? ›

In a secondary transaction, one investor buys the ownership rights and assumes any remaining commitments, such as capital calls, of the initial investor. Secondary deals can be structured in several ways, depending on the specific circumstances and stakeholders involved.

What is a strip sale in secondaries? ›

Strip Sale The sale of a fixed percentage of the underlying companies in a fund by the GP to a new vehicle financed by a secondary buyer and managed by the GP.

What is GP vs LP? ›

A private equity firm is called a general partner (GP) and its investors that commit capital are called limited partners (LPs). Limited partners generally consist of pension funds, institutional accounts and wealthy individuals.

What are secondary transactions in private equity? ›

This secondary private equity market is considered the buying and selling of unrealized investor commitments to another private equity fund. Limited partners receive liquidity in this way as their interest is transferred to the secondary buyer.

What is a single asset secondary? ›

Single-asset secondaries, the latest GP-led wrinkle, are the sale of a sole investment, usually a company. The best offer access to a portfolio gem, typically from an aging fund where incumbent investors want liquidity.

How much does a GP contribute to a fund? ›

LPs typically expect GPs to contribute 1-5% of the fund's total size using their own money. If the GPs are raising a large fund, they may not have that kind of cash to pay their commitment up front.

What is GP clawback? ›

This is a common term of the private equity agreement. To the extent that the general partner receives more than its fair share of profits, as determined by the carried interest, the general partner clawback holds the individual partners responsible for paying back the limited partners what they are owed.

What is a GP line of credit? ›

GP financing provides a line of credit to an individual fund's general partner (or equivalent) to assist with the general partner's capital contribution requirements into such fund.

What are secondary funds? ›

Secondary funds are vehicles investing in a range of private equity funds on the secondary market. Through these funds, investors are exposed to a highly-diversified portfolio of indirect investments in hundreds of companies.

How does a continuation vehicle work? ›

Continuation vehicles are investment funds created in order to acquire a single portfolio company investment, or multiple portfolio investments, of a predecessor fund.

What does Hamilton Lane do? ›

Hamilton Lane Incorporated provides private markets investment solutions. The Company conceives, structures, build outs, manages, and monitors portfolios of private markets funds and direct investments. Hamilton Lane operates worldwide.

How do secondaries funds work? ›

Earlier Returns of Capital

Unlike primary funds, secondary funds buy interests in funds that have mostly completed their investment periods, containing portfolio companies that are already generating cash flow.

What is a secondary buyer? ›

A secondary buyer purchases an interest in an existing fund from a current investor and makes a new commitment to the new fund being raised by the GP. These transactions are often initiated by private-equity firms during the fundraising process.

How is price decided in a secondary market? ›

Secondary Market Pricing

Primary market prices are often set beforehand, while prices in the secondary market are determined by the basic forces of supply and demand. If the majority of investors believe a stock will increase in value and rush to buy it, the stock's price will typically rise.

What is strip sale? ›

Strip Sale: A form of fund restructuring which involves the partial sale of a fund's investment (strip) in all/some underlying assets to provide LPs with liquidity.

What are stapled secondaries? ›

A stapled secondary sees the new buyer purchase fund interests from current investors, while also making a commitment to the new fund of the same general partner. The liquidity offered to the existing investors may then free up amounts for them to invest in the new fund as well.

Does GP get preferred return? ›

With an ongoing GP-catch up, the LPs still receive their preferred return first. However, before the remaining profits are split 70/30, the GP receives a promoted catch-up distribution. This distribution is equivalent to a 70/30 split.

Who makes more money the GP or the LP? ›

Simply said, the LPs put up the money and for that they get 80% of the gains on the investment. The GPs are doing the work, as in making the investments, and they get 20% of the gains.

How many LPs can a fund have? ›

How Many LPs Do I Need for my Fund? The ideal number of limited partners is between 25 and 35, but some funds launch successfully with many fewer depending on ticket and fund size.

What is a secondary offering private? ›

A secondary offering is a sale of securities by someone who purchased the security in a primary offering to a subsequent purchaser. That is, a private investor sells their shares to another private investor.

What is a secondary investment opportunity? ›

What is a secondary investment? A secondary investment occurs when a buyer, like HarbourVest, purchases existing private assets. The seller may want to reduce exposure to a specific stage or region or obtain near-term liquidity on what was intended to be a long-term investment.

What is a secondary fundraising? ›

A secondary offering occurs when an investor sells their shares to the public on the secondary market after an initial public offering (IPO). Proceeds from an investor's secondary offering go directly into an investor's pockets rather than to the company.

What is a single asset vehicle? ›

Single-Asset Co-Investment Vehicle means a Co-Investment Vehicle that directly or indirectly owns one Investment.

Does the GP pay management fees? ›

The GP will enter into a management agreement (or investment advisory agreement) with the management company. Under this agreement the fund pays the management company fees to employ the investment team, evaluate opportunities, manage the portfolio, and manage all day-to-day operations.

How much does a general partner make in private equity? ›

At the low end, such as at a brand-new fund with a few hundred million under management, a Partner might earn in the $500K to $1 million range for base salary + year-end bonus. As fund sizes approach several billion under management, Partners move closer to an average of $1-2 million in base salary + bonus.

What does GP mean in private equity? ›

First, the private equity fund's partners are known as general partners. Under the structure of each fund, GPs are given the right to manage the private equity fund and to pick which investments they will include in their portfolios.

What is sponsor clawback? ›

A clawback is a contractual requirement that presupposes that funds previously assigned to an employee must be returned to an employer or sponsor, sometimes with a fine.

What is a limited partner giveback? ›

In some cases, the limited partners' obligations to contribute capital to the partnership as an LP Giveback is limited to fund the indemnity obligations of the partnership, whilst in other cases, the obligations are broader and the limited partners are required to fund any liability of the partnership, including ...

What is a management fee offset? ›

The extent to which monitoring, transaction, and other portfolio company related expenses, paid to the General Partner are offset against management fees.

How does fund financing work? ›

Fund financing – fund financing ranges from subscription line financing (also called capital call or equity bridge financing: loans made by a bank to a fund, secured against investors' committed capital) to hybrid (ie asset and investors' commitment-backed facilities) and NAV financing (ie asset-backed facilities), ...

What is a fund subscription? ›

Subscription refers to the process of investors signing up and committing to invest in a financial instrument, before the actual closing of the purchase.

What does fund finance do? ›

Recognised for both technical excellence and outstanding commerciality, our market leading funds finance practice advises banks, hedge fund managers, private equity funds, real estate funds and investment fund managers.

What is a GP vs LP? ›

A private equity firm is called a general partner (GP) and its investors that commit capital are called limited partners (LPs). Limited partners generally consist of pension funds, institutional accounts and wealthy individuals.

What are stapled secondaries? ›

A stapled secondary sees the new buyer purchase fund interests from current investors, while also making a commitment to the new fund of the same general partner. The liquidity offered to the existing investors may then free up amounts for them to invest in the new fund as well.

What is a strip sale in private equity? ›

Strip Sale: A form of fund restructuring which involves the partial sale of a fund's investment (strip) in all/some underlying assets to provide LPs with liquidity.

What does Hamilton Lane do? ›

Hamilton Lane Incorporated provides private markets investment solutions. The Company conceives, structures, build outs, manages, and monitors portfolios of private markets funds and direct investments. Hamilton Lane operates worldwide.

Does GP get preferred return? ›

With an ongoing GP-catch up, the LPs still receive their preferred return first. However, before the remaining profits are split 70/30, the GP receives a promoted catch-up distribution. This distribution is equivalent to a 70/30 split.

Who makes more money the GP or the LP? ›

Simply said, the LPs put up the money and for that they get 80% of the gains on the investment. The GPs are doing the work, as in making the investments, and they get 20% of the gains.

How many LPs can a fund have? ›

How Many LPs Do I Need for my Fund? The ideal number of limited partners is between 25 and 35, but some funds launch successfully with many fewer depending on ticket and fund size.

How do secondary funds work? ›

Unlike primary funds, secondary funds buy interests in funds that have mostly completed their investment periods, containing portfolio companies that are already generating cash flow.

What is a single asset secondary deal? ›

Single-asset secondaries, the latest GP-led wrinkle, are the sale of a sole investment, usually a company. The best offer access to a portfolio gem, typically from an aging fund where incumbent investors want liquidity.

What is a secondary buyer? ›

A secondary buyer purchases an interest in an existing fund from a current investor and makes a new commitment to the new fund being raised by the GP. These transactions are often initiated by private-equity firms during the fundraising process.

What is a single asset transaction? ›

Single-asset funds pool capital from multiple investors to invest in a single security, transaction, or acquisition. As managers continue to explore offerings beyond traditional strategies and fund structures, they may elect to pursue opportunities through vehicles designed to acquire a single asset.

What do you mean by sweet equity? ›

Sweet equity is a type of financial instrument that represents any form of non-monetary equity that the owners or employees of a business contribute to the venture. Sweet equity can come in the form of options, rights, warrants, restricted stocks and RSUs or other forms of equity.

What is a recycling provision in private-equity? ›

Most venture capital funds have a “recycling” provision that allows them to sell some percentage of their investments and reinvest those funds back into new investments instead of distributing that capital to their limited partners.

Is Hamilton Lane a good place to work? ›

Is Hamilton Lane Advisors a good company to work for? Hamilton Lane Advisors has an overall rating of 3.8 out of 5, based on over 87 reviews left anonymously by employees. 74% of employees would recommend working at Hamilton Lane Advisors to a friend and 87% have a positive outlook for the business.

Is Hamilton Lane private equity? ›

About Hamilton Lane

Dedicated exclusively to private markets investing for 30 years, the firm currently employs more than 520 professionals operating in offices throughout North America, Europe, Asia Pacific and the Middle East.

How many people work at Hamilton Lane? ›

Compare HLNE With Other Stocks
Hamilton Lane Annual Number of Employees
2020400
2019370
2018340
2017290
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