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- [00:01]
Madeline Farman
Do true status quo options for LPs exist in the secondary's market today? What's the state of play for leverage use and GP LED transactions? Welcome to Spotlight and our ongoing mini series where Secondaries Investor dives into interesting developments in the secondaries market I'm Madeline Farman, a senior reporter with Secondaries Investor, and today I'm joined by my colleague Adam Lay, senior editor with pei. We sat down to run through some of the key takeaways that came out of Private Equity International's GP led secondary special published on PrivateEquity International.com in March. Here's our conversation. So Adam, we and our colleagues were hard at work at the beginning of the year writing UP Private Equity International's GP led secondaries report for 2023, which aimed to demystify some of the key questions GPs and LPs may have around these processes. But us being in the weeds of the secondaries market, we also threw in some deep dives as well, as there were some really interesting points made in the report that I just thought warranted some further interrogation. Unfortunately, the list that I drummed up was kind of a laundry list of different bits and pieces. So you had the fun job of whittling down to three.
- [01:15]
Adam Lay
And a fun job it was. And for any listeners out there, I mean we're talking about the March GP Led Secondaries report on pei. So I guess readers can go to the PEI website and click on the top links to to GP Led Secondaries and read all the great content there of which which there is a ton of content. And you're right, we did have to whittle it down to three. And the three that we've decided to go with are use of leverage in GP LED deals. That's the first one. The second is status quo options. So, so really what are these and and what does it mean in practice? And the third one being the rise of non traditional capital and primary players coming on on the buy side of the secondaries market. Is that right?
- [01:53]
Madeline Farman
It is indeed. It is indeed. So I thought today we might as well start off with status quo options. P.E.I. writer Amy Carroll spoke with lawyers as well as a managing director at HarbourVest. You can find the full story on secondariesinvestor.com as well as privateequityinternational.com for those who want to get into the weeds. But maybe I'll sort of just give a top line here of what that story went into. So the concept of a true status quo option is misleading because GPS need More time and money are complications around carry. For example, there are quirks around where a vehicle is in its lifespan at the time these deals are done and or buyers are seeking minimum exposure in a deal which thereby limits what LPs can actually invest into a continuation fund vehicle.
- [02:40]
Adam Lay
And so you have been having some pretty interesting conversations with some of the market's leading kind of voices, haven't you?
- [02:47]
Madeline Farman
Yes. So Michael Hacker, managing director and head of portfolio finance at Carlisle's Alpinvest, really painted the backdrop around the history of where the language status quo has come from and what's changed and why. So he explained to me that these transactions have gone from fund recaps where essentially it was easier to tell LPs that you weren't going to change their economic deal to today's continuation funds which are company oriented transactions with new capital. Here's a snippet from our conversation where he walks through one of the biggest points Alpinvest has to wrestle with in these transactions. How to treat new capital going into these transactions today which are company oriented.
- [03:25]
Michael Hacker
A lot of LPs really understand this because they're co investors in specific deals and they'll understand that you can't just sit on the sidelines while new money is going into a business and expect that it's not going to affect your economics or your ownership in the business. And so we often have to deal with dilution and how does that happen and are we asking LPs to put new money into the deal or not? And even right there you're going to have some LPs who will want to participate, some LPs who won't. And so coming up with one size that fits all situations I think is very difficult. Now when you talk about the economics as well, you know, what are we doing with this company, we're obviously taking it out of the larger fund. And so we need to figure out an economic package that's actually fair for everyone involved. And so the idea that you would just leave the existing waterfall in place I think is very difficult. So what we're trying to do is find something that again fits within the spirit of the status quo and what we're trying to accomplish. But this very sort of legalistic. Is it exactly what the LPs had before? I think it's quite difficult to actually accomplish that. So what we're focused on in these transactions is making sure that there isn't a big step up in management fees, for example, for LPs that carried interest is going to be Oftentimes tiered based on the performance of the asset, as opposed to sort of another free bite at the apple for the gp. And so what you'll see is these terms, they've gotten progressively more LP friendly in general. And so as we've solved some of those issues that you saw in the early fund recaps, that gps were looking for another bite at carry after they had sort of missed out on the waterfall. You know, you're seeing less of those kind of terms, much more LP friendly terms in general. And I think as we've accomplished that, this focus on do I have to be exactly in the same spot that I was before has become a little bit less important as long as the idea is that the LPs are not going to be paying a lot more economics for the same experience they would have had otherwise.
- [05:21]
Madeline Farman
So sounds as though the headline label status quo option may need a rethink.
- [05:26]
Adam Lay
I mean, as far as I understand, and it seems like it was Mike Echo who was talking, talking about this, but I mean, the only real way to completely unchange anything in a deal for an LP who's an investor in a fund is just not to do anything at all. Right. And so what they're trying to do with these status quo options is to replicate as best as they can, not only the, the details of, but the spirit of the terms in the original fund in a new transaction. And obviously that's, that might be sort of 98% possible to do, but there's no way that they can really keep 100% of the terms. Right. So that's what we mean by status quo option, isn't it?
- [06:04]
Madeline Farman
Yes, I think it is. That point around this is a piece of wording that has worked in the past. Before these transactions, you know, were sort of jewel in the crown asset type transactions. And now status quo option seems to mean, you know, what is the best economic deal for all players involved, LPs as well, who want to reap some more of the rewards, you know, those new investors coming in, the GP itself, you know, wanting to have additional time and effort with a really good company and moving it forward. So when we say status co option these days it's more like a, I don't know, like the fairest amount for all parties to make sure that everyone is completely aligned in the economics moving forward.
- [06:51]
Adam Lay
It's interesting when I'm just thinking out loud about status quo options because I've heard from LPs that, you know, even a status quo option can be seen by some LPs as a form of underwriting a new transaction. Even if all the 98% of the kind of economic terms are remaining the same for them, they're going to still have to put it through their investment committee. It's seen as, you know, a new deployment of capital, even though for all intents and purposes it's kind of replicating their existing investment. Though it's not a kind of reinvesting more capital in the continuation fund. And therefore for them, a lot of them, it's easier to sell than even take the status quo option because either due to time constraints or capital constraints, they're not able to, you know, re underwrite this transaction even if it is a status quo. So they just sell because that's the kind of default. So moving on to the next big topic. So leverage in GP LED transactions, particularly in GP LED deals, this seems to be something that's sort of popping up its head a little bit more. I have to be perfectly honest, I don't have a strong sense of to what extent what all GP LED deals use leverage and the different types. I haven't actually seen some, some data around there. There have been a lot of commentators in the market who've been talking about the use, but I haven't seen anybody sort of point to any sort of data or figures about to what extent it's really being used. If any listeners out there have any data, please do get in touch with us and let us know. But one piece that did appear in our GP led Secondaries report was written by Investec. This was a sponsored piece and authored by Stuart Ingledoo and, and Sharon Tandy. And they essentially wrote that, you know, despite rising rates and kind of volatility that's going on in the wider global markets, GPS are remaining thoughtful about the use of leverage. The uses they cite deal leverage partially to fund the purchase price, also used kind of post continuation fund close to support growth and another use is also for deferring capital calls. So I guess this means on the unfunded part of the continuation fund. Stewart writes that, you know, amid the kind of challenging backdrop, we may see fund facilities at a fund level on continuation vehicles. So I guess that's something to keep our eyes on. And then in terms of terms they write that they are seeing lower loan to values. So I guess sort of pre pandemic, you know, anywhere like a 70% loan to value could have been industry norm. I'm guessing that they're seeing those coming down to kind of 50% or something like that. And then in terms of views from LPs they do note that LPs who traditionally have, haven't really been very sort of pro using these leverage facilities in continuation vehicles are starting to accept them, especially on a kind of one year deferral mechanism because the LP knows that they will be able to put their capital to work, you know, within maximum kind of 12 months where there is typically pushback. It seems to be around sort of waterfall structures and alignment, you know, surprise surprise, because LPs want to know that their GPS are using leverage for the right reasons. So lots to discuss there. Fortunately you have been speaking to Alpinvest and Goldman Sachs.
- [09:54]
Madeline Farman
Goldman Sachs, yes indeed. So let's start with Goldman Sachs here. Goldman partner and head of secondaries Harold Hope explained at a high level the firm is not opposed to using leverage in secondaries transactions broadly. But where it struggles with it more is in continuation fund transactions. Here's Harold chatting me through his views.
- [10:16]
Harold Hope
You know, many of them are much more concentrated than portfolios that we're buying in other parts of our business. So in some cases it might make sense if you really have a diversified portfolio, a diversified continuation vehicle or a tender offer or something like that across a diversified fund. But really most of what we've been doing in the continuation vehicle space has been more single asset oriented. And the idea that we would buy a single company, put it in a continuation vehicle, try and put it into a structure that allowed it to continue to execute its value creation plan and then put some additional leverage, you know, on top of it, on our equity is really not something that I think makes a lot of sense. I mean, I guess in some circumstances if the underlying company is really under levered that you know, you can, you can add some leverage to kind of bring it back to more market levels, maybe there's an opportunity there, but I really think it's just not by its nature, by the fact it's so concentrated it's maybe not the best place to apply leverage.
- [11:14]
Madeline Farman
Where a GP is looking to use leverage, this is what Goldman is looking for and the potential red flags it's looking to weed out too.
- [11:21]
Harold Hope
With the caveat that we haven't done a lot of it. I would say, you know, the things that we focus on when it is in play are really, you know, most importantly like what's the rationale for it? I do think there are some valid rationales. Like I mentioned earlier, if you have a company that's under levered and you know it's appropriate to re lever it or you have a company that maybe has, you know, a really attractive M and a strategy and you need to get some more firepower to go execute on that. I mean, there probably are some reasons why it makes sense, but you know, the best practices for us are really one, kind of understanding what the rationale is, you know, two, being really transparent with people about, you know, what the plan is and why you're doing it, and probably three, being thoughtful, you know, around the duration. I mean, one of the differences between continuation vehicles and kind of other pools of capital that private equity managers manage is that typically the continuation vehicles, you know, the carry is going to be tiered carry so that the manager does better as the asset performs better. But oftentimes those tiers might involve IRR hurdles and multiple hurdles. And so I do think there are opportunities for managers to come in and put in more short term type of subscription financing really as a way to kind of juice the early IRR and kind of mitigate some of the IRR hurdle based carry. And so we're super focused on situations like that because I think when we put these tiered carries in place, you know, with various hurdles, you know, the intention is really not that they're going to be achieved through financial engineering, but rather that they're going to be achieved through performance of the asset or assets.
- [12:57]
Adam Lay
Okay, very interesting, Matti. So you mentioned that Alpinvest takes a different view.
- [13:02]
Madeline Farman
Yes, in the sense that Mike tells me the firm has never really been a user of leverage, generally in secondaries. He told me he believes it creates some distortions in the market where there's a single asset transaction. For example, Alpinvest as a buyer is really asking itself why the additional leverage is needed. Where a company has its own capital structures in place, who is it really benefiting? Like Harold and Goldman, Alpinvest has seen GPS trying to introduce leverage to make it easier to hit their performance targets.
- [13:34]
Michael Hacker
And so what you're finding is that they're trying to add more risk to the transactions and the benefits of that risk are going to the gps, not to the investors. We've been trying to push back on this. I think if buyers want to use leverage themselves, that's certainly something that's their choice. I would say the key mechanism is to figure this out early in the transaction. What is the GP trying to accomplish? Why are they interested in using leverage? We'll flesh this out early on in the discussion and we'll set the groundworks of what's permitted and what's not permitted. Sometimes you'll see that they want to do something very short term to maybe accommodate a refinancing at the level of the company. That's a perfectly reasonable rationale for using leverage, and I think we can work around those. But if the idea is really just to say you're going to make a commitment to this transaction and we're going to leave a significant part of that unfunded, you're going to have to reserve that capital at the level of your fund, but we're not going to use your money. And then we're going to try to optimize the returns in order to hit the thresholds that you've agreed. I don't see that as something that we would buy into or we would do very often. We started seeing GPS sneak this in late into the negotiations early on. So a few years ago there were a couple of transactions that we saw where it had not been advertised up front and the GPS tried to do this at the very end of the process.
- [14:48]
Madeline Farman
Michael did say this is becoming less and less common, adding that motivations to do so are a lot less significant now as the cost of debt has gone up. But what he's interested to see is whether buyers push back as a group over the next year or two or, or whether there are individual buyers who may be less resistant to debt than others.
- [15:06]
Adam Lay
Fascinating. So I guess any buyers listening, if you have any strong thoughts about the use of leverage here, please don't hesitate to get in touch with us, even if it is in an anonymous capacity.
- [15:15]
Madeline Farman
So Adam, shall we move on to the last topic that's caught our eye in the GP LED Special Report, Non traditional and primary investors in GP LED continuation funds.
- [15:25]
Adam Lay
Yes, this is something that we've been asking people a lot about, isn't it?
- [15:29]
Madeline Farman
It, yes, indeed. So within the GP LED Special evercourse, Fred Stonell points out that there were capacity constraints in GP led deals in 2022, and it's a topic I've been writing on quite a bit recently too. He points out that an increasing number of primary investors, which he characterizes as family offices, pension funds, sovereign wealth funds and the like, are starting to deploy directly into GP led deals as syndicate investors. Furthermore, they expect to see new players in the market as traditional private equity firms establish GP focused strategies. I mean, we've already seen some large alts launch their own secondary strategies and then some are long term incumbents in this area. But it will be interesting to see how far that traditional private equity space extends.
- [16:15]
Adam Lay
And so what did Harold hope from Goldman Sachs and Mike Hacker from Alpinvest give that take.
- [16:20]
Madeline Farman
Yes. So perhaps let's start with the context from Harold on how he's seen players in this space morph over time. Over the last couple of years, he told me he's seen the universe of people interested in these transactions grow a lot.
- [16:32]
Harold Hope
And that's really, I think, due to the fact that transactions have gotten larger and they've gotten larger than what a single secondary buyer or even a consortium of secondary buyers can invest on their own. And so I think there's been a pretty active syndication market, for lack of a better way of describing it, that's been developed in family offices, pension plans, sovereign wealth funds are all part of that ecosystem. I think if you want to focus just on the last 12 months, we've seen a major change in the continuation vehicle market where generally people are reluctant to rely on the syndication component of it in order to get a deal done. And the reason is, you know, the syndication market can take a long time, it can be a little bit fickle, can be subject to some of the whims that we're seeing, you know, out there in terms of sentiment shift in the market. And so whereas, you know, a couple years ago you could do a two and a half billion dollar continuation vehicle on a single asset, you could get a couple of large secondary funds together to anchor it, you could get the GP and some rolling investors to provide you with a lot of capital as well, and you could kind of fill out the remainder with a broad syndication effort. Today, I just don't think those are the deals that are getting done. What's really happening today are the small and mid sized deals, 500, 600, $800 million continuation funds, where you can get one or two buyers and the GP and really feel comfortable that you can do a transaction without the need to syndicate it. And I think just everyone, given all the volatility that we've seen, it's just much more comfortable in those types of transactions.
- [18:10]
Madeline Farman
To build on that, Mike also says he saw a larger group of non traditional investors and secondaries last year, a couple of hedge funds that participated at the margins of the market, some private equity funds getting involved in transactions from time to time, but the vast majority of non traditional players were the LPs themselves. So family offices, certain sovereign wealth funds from time to time, and in his words, a smattering of other pension funds or other institutional investors.
- [18:38]
Michael Hacker
I think the big acknowledgment when we say that there are these non traditional players in the secondary market, whether it's the GP centered continuation fund market or other areas, it's really an acknowledgment that there is a lack of capital in those different specific parts of the secondary market, or really there's a lack of capital in the secondary market. Overall, I think one of the things that we've been estimating is this idea of dry powder and how much dry powder is there in the secondary market. There are quite a few of the advisors in the space who have been putting out their own studies. When I look at our estimates, we've seen a significant decrease in dry powder in the last few years. For the past decade, we had somewhere between one and a half and two years of overhang. That means the amount of capital waiting to invest into the secondary market was about 1.5 to 2 times as much as the annual transaction volume. And what we've seen in the last year or so is that's contracted from one and a half years to actually, by some of our estimates, it's been nine to 10 months of dry powder at different points in the last six months or so. Now, right now we're operating at about a year by our estimates of dry powder. But what's interesting is as we think about the fundraising cycle, that, you know, a lot of the big firms have come through the market in the last year or so. So the way we look at it, we actually think dry powder is going to shrink before it starts to expand again. And so that's something that I think is creating these pockets of opportunity. The dry powder that's out there is going to focus on certain specific types of transactions. And every secondary buyer is going to have their specific appetites and things that they're focusing on. And I think these non traditional players are playing in the margins between where the existing secondary buyers tend to have those areas of focus.
- [20:19]
Madeline Farman
The big question, I think, is whether these investors are around for the long term. And it seems there's some debate about that. Mike and Harold have diverging views here. Here's Michael's take.
- [20:31]
Michael Hacker
I would say this is something that we're seeing right now and there is a lot of transformation going on in the secondary market and there are certain investors who are saying, let's see how we can take advantage of those changes. And that's something that you would expect, but I think it's not something that will necessarily persist for the long term.
- [20:44]
Madeline Farman
Herald, on the other hand, thinks there is room for more non traditional players in the market. He told me on one side of Things demand for liquidity is outstripping buyer capital that's available. But on the other side of things, most secondaries buyers want to create diversified portfolios and they have limits on how much of a single company they're willing to take into their fund. That in turn means you're seeing deals that have multiple secondary buyer co leads committing large chunks of capital and these transactions are then syndicated to a broader base to get deals over the line. Here's Harold's conclusion on those factors.
- [21:19]
Harold Hope
I think this is likely to evolve over time. I do think there's still a lot of education that needs to be done among the LP community around how these transactions work and what the opportunity is and whether they're good investments. And I think over time, if they are good investments, which I do think they really are, I think the capital pools are going to develop to meet the demand, if you will.
- [21:43]
Adam Lay
Interesting. So I guess it rests on whether these non traditional investors stay the course.
- [21:47]
Madeline Farman
Yeah, I'd say so. Only time will tell, I guess.
- [21:50]
Adam Lay
So what are Mike and Harold's thoughts on traditional private equity players looking to come into the secondaries market? So I guess we're talking about the traditional direct buyout firms here, aren't we?
- [22:00]
Madeline Farman
Exactly, exactly. So where there's opportunity, as we know, private equity managers will follow because some of these transactions are so concentrated. You can see the logic on their side. Right. This looks similar to an M and a transaction that we, you know, take part in all the time. So. So why not hop on the bandwagon if this is an undercapitalised space? Harold told me he's seen some GPS looking to enter the continuation fund market. Here's his view.
- [22:26]
Harold Hope
It has been very interesting because I think there's almost a correlation between a private equity manager who does a continuation vehicle deal in their own portfolio, goes through that process and then afterwards feels like, gosh, maybe we should be in this business as well. Because I think they're seeing the under capitalization of the buy side relative to kind of the opportunity set. And especially for some of these concentrated continuation vehicles that may only be a single asset. I think the GPS believe that they're used to buying single assets and they're used to analyzing them. And some of these sectors and companies have been ones that they've looked at before, so they might have a natural way to enter the market effectively in partnership with another sponsor. So I'm not sure we've seen yet people scale up in that regard, but definitely we've seen multiple traditional private equity managers hire People with the intention of building some kind of strategy around doing continuation vehicle deals with other sponsors.
- [23:26]
Adam Lay
So they're lining up at the ready.
- [23:28]
Madeline Farman
Yes, indeed. And I know in conversations that we have, Adam, or speaking with some of our colleagues, they'll come up to us and say, oh, you know, P firm X is doing secondaries transactions or they've got a secondaries arm. Right. We're sort of thinking, do they? I mean, yeah, it's just so interesting the number of names I know in conversations that I have as well. One moment you'll have what you think is a firm understanding of those traditional private equity players, if you like, who's doing secondaries, who's not doing secondaries. And then in the same breath, you'll have a manager that you just never thought would be doing secondaries being mentioned alongside some of the incumbents. So it keeps us on our toes.
- [24:08]
Adam Lay
It does, doesn't it? I mean, it was just the end of last year that Bellevue Swiss firm launched a kind of secondaries unit. And then, I mean, just this morning we received a press release about a new firm in Asia on the secondary side, didn't we? So they really are popping up everywhere. I guess the question is whether they will be successful.
- [24:23]
Madeline Farman
Indeed. So Mike has also seen a couple of specific examples where PE firms have launched secondaries focused strategies and it's to be determined on how successful those groups are and how they approach it. But he tells me investing in GP led secondaries is a very different ball game compared with traditional buyouts.
- [24:42]
Michael Hacker
I would say the idea of an existing sort of buyout firm starting to play into the secondary market where they take a more control oriented type approach, I think that's going to create some issues and friction with the gps who are looking to raise a continuation fund. They don't necessarily want another partner in that transaction. And so I do think there will be some interesting push and pull between groups trying to build a business and what I think the market has evolved into. So the key question is going to be are the LPs, what are they interested in investing behind? Do they want to back, you know, an experienced secondary investor, you know, who has a lot of track record investing in GP centered secondaries over a long period of time or they going to want to back someone who might be experienced on the direct side, leading buyouts themselves, but is newer to this part of the market? There's space in the market for everyone to throw their hat in the ring and try to figure out different ways. I think one of the really interesting parts about the secondary market is that we're continuing to innovate, we're continuing to experiment. There are new players who are trying to figure out different ways to provide liquidity in private equity funds and I think the whole GP centered market has really been evolving, so I would certainly not want to bet against innovation and change and new players coming into the space. But that being said, I think the way that the market has been evolving doesn't necessarily lend itself to traditional control buyout funds or a new team affiliated with one of those coming into the market and displacing the existing incumbents.
- [26:12]
Madeline Farman
Thanks for tuning in. If you have any interesting tips for the podcast, drop me a line via email or LinkedIn. In the meantime, find all of your secondary's market news on secondary and to hear more episodes of Spotlight and our next breakdown of developments in the Secondaries market. Find us wherever you listen to podcasts or at any of P.E.I. group's various titles online. I'm Madeline Farman, thanks for listening.