Travers Smith's Alternative Insights: The growing importance of GP-led secondaries

A regular briefing for the alternative asset management industry.

Dealmakers who were stuck in their home office last year may not be surprised to know that, in 2020, Europe saw the second highest level of capital deployed by private equity and venture capital funds ever. Although 12% down on 2019, €88 billion was invested in over 8,000 European companies in 2020, according to figures published by Invest Europe last week. This remarkable resilience was matched by funds raised, which topped €100 billion for the third successive year – meaning that the combined total for the last three years is 15% more than was raised in the three years immediately before the financial crisis.

Primary funds are, of course, the linchpin of the private funds industry. However, they are supported by a well-established, and still growing, community of finance providers, who are constantly innovating to develop products suitable for a growing investor base. Among them, and a crucial part of a mature asset class, are secondary funds – and they also showed resilience during the pandemic. According to a report published by Campbell Lutyens, global transaction volumes dropped sharply in the first half of 2020, but the market staged a pretty strong recovery in the second half, ending at a respectable $60 billion. Even more encouragingly, fundraising dropped by only 6% on 2019 levels – and there is now significant dry powder for deals in 2021. Aware of the scale of the opportunity, many large asset managers have been busy establishing secondary business lines.

Perhaps the most striking finding from the Campbell Lutyens report was that, for the first time, GP-led secondaries accounted for the majority of secondary transactions last year. In part, this was because LP-led deals suffered the brunt of the downturn – with less than 25% of such deals achieving better than a 5% discount to NAV. That part of the market will return to full health, and investor appetite remains strong: in December a survey by Coller Capital found that over half of LPs expected to access the secondary market – either as buyers or sellers – in the next two years.

But the dominance of 'GP-leds' in 2020 follows several years of strong growth for such transactions. They are generally implemented by GPs to generate additional follow-on capacity for a portfolio (or, increasingly, a single asset) and allow an extended hold period to maximise exit value. GP-leds have generally been supported by LPs because they typically offer investors the opportunity to take liquidity at a market tested price ahead of a more conventional exit or, if they prefer, to maintain exposure to assets that still have upside potential.

Investors are also aware that GP-led secondaries must be handled very carefully. The Institutional Limited Partners Association (ILPA) published Guidance in 2019 and particularly focused on the inevitable conflicts of interest that arise. Expert advice is therefore key to a successful transaction and, at our recent webinar on these deals, we explained that a robust price discovery exercise and the early involvement of the Limited Partner Advisory Committee (LPAC) are crucial. We also discussed why the deal structure, with a focus on the interests of all stakeholders, needs to be carefully considered at the outset.

Importantly, the regulatory issues must be considered as early as possible. There is some complexity in working out how to market, and, potentially, manage the continuation fund (the vehicle into which continuing investors will re-invest), and a UK manager may find that more difficult after Brexit than before. The analysis is often different to that which applies when structuring a new blind pool fund vehicle, and so can trap the unwary.

Similarly, US tax issues can cause unexpected headaches, even for funds that themselves hold no US assets – especially following recent changes to the US rules on "Effectively Connected Income" (ECI). Under these rules, non-US persons must pay US tax when they transfer an interest in a partnership and realise a gain if that partnership would normally throw off some ECI. The draconian enforcement mechanism requires the buyer to withhold at a rate of 10% – careful due diligence and an audit trail are vital if this withholding is to be avoided.

...for the first time, GP-led secondaries accounted for the majority of secondary transactions last year.....

Tax issues arising when carried interest is triggered by the deal also need close attention, especially where the recipients are re-investing all or part of their carried interest proceeds in the continuation fund. One issue for UK tax-payers is that the term of the continuation fund is typically only three or four years, so it is important to establish whether the anticipated hold period of the assets qualifies the newly issued carried interest as sufficiently long term to justify capital gains tax treatment.

In our webinar we noted that, in a private equity context, generating buy-in from the management team of the underlying portfolio companies is a crucial component of the structuring. Clearly, the secondary underwriter will expect a level of involvement from management in diligence, but it is not unusual for management to receive little or no liquidity, with their equity incentives being triggered on ultimate exit. Management usually have an interest in getting the deal done – the promise of follow on capital and a continuing relationship with the same private equity firm will often be enough to keep them onside – but a deal can be hard to do without their active co-operation.

There is an inherent tension between offering investors the right to maintain their pre-transaction exposure to the assets (the so-called status quo option) and raising follow-on capital to inject into the portfolio. Innovation in non-dilutive capital structures and sources has eased the process and it is now usual to consider NAV facilities and preferred equity solutions as part of the transaction structuring.

Further innovation – and growth – can certainly be expected in this important part of the market as GPs seek to tap the secondary market to buy time and generate capital for their trophy assets. LPs and GPs will both benefit – but running and structuring a deal is complex, and requires multi-disciplinary legal, tax and regulatory input from the outset.

Find out more information on our recent webinar and our experience in secondary transactions.