The GP-led secondaries market has buoyed to new heights in recent years, driven by muted M&A and IPO activity and the resulting dearth of distributions. Amid a dry spell of cash distributions, these transactions have provided much-needed hydration to liquidity-starved portfolios while allowing GPs to continue compounding value in their trophy assets. While the seasonality of high interest rates coupled with a cold exit and fundraising environment has undoubtedly provided a strong tailwind for GP-led secondary growth, there has been a notable ‘acceptance’ regarding their versatility and validity as a tool in allocators’ and investors’ toolboxes.
These transactions allow GPs to retain assets to maximize untapped value while remaining mindful of liquidity in their flagship vehicles. LPs can also glean various advantages from secondaries, such as access to attractive private markets, J-curve mitigation, and the opportunity to access liquidity or double down when they have a strong conviction on a particular asset. Many of these benefits retain appeal in ‘all weathers,’ with these transactions likely to sustain momentum even when market conditions improve. However, a continued uptick in secondaries activity, particularly in GP-led deals, will affect participants across the private market ecosystem. LPs, buyout firms, and secondaries investors will all have to adjust to evolving dynamics.
Secondary buyers have shown a stark preference for middle-market continuation funds, which composed the vast majority of single-asset deals closed in 2023. Similar to traditional buyouts, middle-market companies can provide a greater opportunity set and greater versatility in exit options compared to larger continuation funds that can be more reliant on public markets and often have less variety of exit types. The smaller check sizes of these deals also make it easier for secondaries investors to manage their ownership limitations.
As demand for mid-market continuation funds increases and overall acceptance grows, middle-market PE firms emerge as significant beneficiaries. Traditionally, mid-market PE firms often had to sell their top-performing assets to larger counterparts to achieve material distributions to paid-in capital (DPI) and support fundraising efforts. Subsequently, they witnessed these assets triple in value as a result of the groundwork they laid for future growth under the arm of larger buyout shops. Continuation funds offer a means to realize the gains they’ve traditionally had to pass off. Why would a GP sell an asset to another firm when they could achieve the same returns by realizing the value themselves?
Widespread adoption of continuation vehicles by mid-market firms could fundamentally alter the sponsor-to-sponsor market, which has already been impacted by challenges arising from higher interest rates. With larger buyout shops blocked from accessing opportunities they’ve traditionally sourced via the middle market through traditional M&A, partnering on a continuation fund may be the only path to still gaining exposure to those returns. If this trend were to gain momentum, multi-strategy private equity firms may start to develop dedicated secondaries programs and strategies to hedge against this impact.
However, mid-market PE firms still face several barriers to fully embracing continuation vehicles. While the benefits are clear, the path to execution can be long and winding, involving a wide array of constituents and significant data aggregation. For resource-constrained mid-market firms, the complex nature of seeing a continuation fund across the finish line poses a notable obstacle to accessing these opportunities.
Are single-asset continuation vehicles just co-investments with fees attached? It’s a question on the minds of some LPs — many of whom are trying to figure out how these opportunities stack up against one another. On paper, the difference is clear. Co-investments provide LPs the opportunity to get a sizeable piece of new assets added to a GP’s portfolio, while secondaries involve companies that GPs have spent significant time laying the foundations for growth, often investing a significant amount of their own capital into the new vehicle. The dynamics and alignment are intrinsically very different.
However, from a portfolio construction and strategy viewpoint, the overlap of objectives and outcomes is worth considering. Both vehicles reward LPs for high concentration, with co-investments bypassing fees and carry and single-asset vehicles providing returns on a risk-adjusted basis. For LPs, the question arises regarding the placement of secondaries in their portfolio alongside a co-investment strategy. If allocators start to compare these opportunities, assessing returns on a net basis will play a salient role. With co-investments, LPs must be comfortable with some level of unknowns. Continuation funds, with their positive selection bias, will likely offer appealing risk-adjusted returns. As a result, secondaries funds could potentially encroach on capital traditionally earmarked for co-investments.
As GP-leds become more prevalent in secondaries strategies, the move towards concentrated transactions will affect both secondaries investors and LPs. For secondaries investors, concentration limits in the Limited Partner Agreement (LPA) come into play. However, many secondaries investors are quickly adapting to the burgeoning opportunities presented by these vehicles by bringing check sizes down to enhance diversification, negotiating more flexible investment mandates with their LPs, and raising solely focused GP-led funds. This said, a marginal preference for multi-asset continuation funds continues to characterize the market, with these deals gaining a further share of total continuation fund activity in 2023.
From an LP perspective, classifying secondary funds’ role in a portfolio where GP-leds are part of the strategy can be difficult. These funds often stray from the traditional composition that LPs typically associate with the secondary asset class, lacking the same level of diversification found in purely LP strategies. Consequently, LPs could grapple with decisions regarding allocations and portfolio construction, pondering whether secondary commitments should be classified under buyout or treated as separate entities.
Although private equity doesn’t exhibit the same level of ‘power law’ dynamics as venture capital, where a few (and sometimes just one) assets largely influence returns, transferring prized assets out of a flagship fund vehicle on a meaningful scale does surface questions on how it could impact the returns of those funds.
Private equity returns are already under a microscope, with many investors skeptical of the asset class’s ability to achieve the same returns in a high interest rate environment without access to attractive debt financing. Over the past year, the push to intensify value creation efforts has been a frequently echoed sentiment, and the dynamics continuation funds create underscore this significance — GPs will need to double down on value creation efforts in a flagship fund’s remaining assets.
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