GP-led secondary deals — where a sponsor initiates the sale of portfolio companies from a fund it manages to a new fund it also manages — were a prominent feature of the private equity landscape in 2022, encouraged by macroeconomic headwinds, rising interest rates, downward pressure on valuations, and a less-active exit market. GP-led secondary deal volume has grown significantly over recent years to reach US$68 billion in 2021, according to Evercore. However, GP-led secondary deals remain challenging to execute, with approximately one third of such deals failing to close, typically due to difficulties in establishing a market price, challenges around fund economics, and complexities in dealing with management teams and other investors.
While each deal is unique, recent successful transactions have involved GPs addressing the following three themes:
A key area of concern remains managing valuation conflicts of interest, particularly with many valuations trending down from 2021. In an illiquid asset class like private equity, GP valuations may differ from actual liquidation values, so firms must manage differences in price expectations. Transactions will typically require approval of the fund Limited Partner Advisory Committee (LPAC) and an independent valuation and/or benchmark provided by new cornerstone investor(s). Offering a status quo alternative is typically expected, with LPs given an option to maintain their existing position or rollover into the new continuation fund.
UK single asset continuation fund deals indicate investors’ preference for competitive auction processes as a means of price discovery, in which valuations are validated by third party bidder(s). In Germany, recent deals have seen co-investors validate an arm’s-length valuation. In France, we have seen lead investors make competitive offers for the assets to be moved into a continuation fund vehicle. That said, GPs still often back such valuation with a third-party fairness opinion. Regulators also remain focused on valuation, with the US Securities and Exchange Commission last year proposing yet-to-be-adopted rules prohibiting regulated advisors from completing GP-led secondary transactions without obtaining an independent fairness opinion (proposed rule 211(h)(2)-2).
While approximately half of continuation fund deals involve the transfer of a single portfolio company into a new fund, in our view, multi-asset continuation funds will become more popular as LPs seek to balance their portfolios. No longer the domain of less attractive assets, recent deals in Germany have seen GP dealmakers bring together several strong portfolio companies in complementary sectors for the purpose of a continuation fund deal, to craft a more compelling deal narrative with enhanced growth prospects in order to better appeal to LPs’ needs.
Such deals are by their nature more complex than single asset continuation fund deals, requiring the alignment of various stakeholder interests (including tax structuring and related economics) and management of multiple jurisdictions, all requiring expert legal counsel. In addition, existing financing arrangements and the need to address multiple currencies and funds flows can also present challenges, requiring careful planning.
Private equity sellers remain reluctant to provide broad warranties and extensive liability to buyers (including on continuation fund deals). However, due to new investor demands (and in contrast to exit transactions), recent GP-led secondary transactions have seen certain GPs willing to grant warranties (e.g., warranties regarding financial statements, compliance with law, and litigation) and protection for tax matters, together with a meaningful liability regime (i.e., no €1 cap). W&I insurance is therefore becoming an attractive option on continuation fund deals, particularly when the legacy fund is wound down shortly following closing. Insurers will typically focus on separate deal terms, separate external advisors, buy side due diligence (i.e., not only a transferability study), and adequate disclosure.
GP-led secondary transactions are now a well-worn alternative exit or liquidity opportunity for PE investors. Due to the number of moving parts and the extended time period to execute, careful planning is essential.