Secondary Markets
2023 was arguably the year in which GP-led secondaries came of age. No longer just a way to privately manage the poorest performing assets in a portfolio, they are quickly becoming (if not already) a well-accepted tool in the kit of GPs and a legitimate alternative to a sale to a third party in a slow M&A market. But GP-leds are, as an investment proposition, a subset of the broader secondaries market. In this Closer Look, we go back to basics on the alternative ways in which liquidity can be provided to LPs.
With humble beginnings in the 1980s, this previously niche investment strategy has grown into a sophisticated, well-established and high-profile part of the alternatives market involving substantial portfolios of fund interests with fast evolving deal structures, utilisation of W&I insurance, and innovative use of fund financing.
What Drives Secondaries Transactions?
The driving force for a secondary transaction will differ depending on the players involved, and context generally dictates the type of secondary transaction pursued. While not exhaustive, the motivations and benefits for the various parties can be summarised as follows:
Selling Limited Partners (“LPs”):
- achieve early liquidity and lock-in returns;
- manage portfolios and general partner (“GP“) relationships more proactively; and
- adapt investment strategy due to regulatory or strategic changes.
Buyers/Incoming LPs:
- provide access to funds/GP relationships not previously available (i.e. at primary fundraising stage);
- minimise blind pool risk, mitigate the j-curve effect, and achieve better visibility on portfolio performance; and
- accelerate portfolio build and immediate exposure to a well-diversified portfolio.
GPs:
- proactively manage investor base;
- optimise portfolio capitalisation and availability of funding to well-performing assets, extend portfolio duration, realign interests and portfolio risk management;
- provide liquidity option to fund’s original investors;
- secure additional time to hold fund’s assets; and
- re-alignment of interests of the new and remaining investors with those of the GP through some resetting of the fund’s T&Cs.
How are Secondary Transactions Structured?
A secondary transaction will be classified as an ‘LP-led’ or a ‘GP-led’ transaction, which relates to the party instigating the transaction.
LP-led
These transactions involve the LP co-ordinating the sale of fund interests to a buyer. The buyer will acquire the interests and become a replacement LP in respect of the relevant fund. The replacement LP assumes the original LPs obligations to pay outstanding commitments to the underlying fund(s). Remaining LPs will have no involvement in the transaction save for instances where they enjoy a right of first refusal.
GP-led
A GP-led involves a transaction co-ordinated by the GP to provide liquidity to LPs or follow-on investment to the portfolio, other than through traditional means i.e. the drawdown of capital from limited partners or return of capital following asset disposals or refinancing. The most prevalent GP-led secondary transactions are:
- Continuation funds: the GP establishes a new special purpose continuation fund vehicle (the “CV“), capitalised by a secondary investor, to acquire certain assets in a portfolio from the existing fund. It can be structured as the CV acquiring a single asset, a selection of assets, a full portfolio of assets, or a strip percentage of the portfolio. Given its potential relevance to PE deal executives who may be considering these transactions as part of an exit strategy, a spotlight on CV transactions is set out below.
- Tender offers: the GP sources a secondary buyer to acquire all or some of the interests in a fund from LPs at an agreed price, and all LPs are given the option to take liquidity or remain exposed to the fund. The buyer’s offer may be subject to a minimum take up by LPs.
- Annex funds: the GP establishes a new vehicle, capitalised by a secondary investor, to provide capital to a portfolio that is held by an existing fund where fund level borrowing in the existing fund is challenging and/or investor commitments in the existing fund have been fully drawn.
- Preferred equity: the GP facilitates a preferred equity lender to provide capital to a portfolio held by an existing fund, and in exchange, the preferred equity lender takes a priority return from the portfolio (which can be facilitated either through a dynamic economic waterfall or structurally, with the interposition of a special purpose vehicle between the fund and the portfolio).
- NAV facilities: the GP facilitates a lender to provide fund level borrowing which is secured against the value of the underlying portfolio.
- Hybrid: the GP facilitates a lender to provide fund level borrowing (akin to both subscription lines and NAV leverage) which is secured against both the value of the underlying portfolio and certain uncalled LP commitments.
Spotlight on CV Transactions
Structure of a CV Transaction
Whilst CV transactions are inherently flexible in nature, they are typically structured as one of the following:
- A Full Portfolio Sale: whereby the CV acquires the entire portfolio of the existing fund.
- A Strip Sale: whereby the CV acquires a percentage of the existing fund’s investment in selected underlying assets.
- A Single or Multi-Asset Sale: whereby the CV acquires a single or selected asset(s) of the existing fund.
Investors in the existing fund (the “Existing LPs“) will be given the option to “cash-out” and exit their exposure at a market-tested price or reinvest their proceeds into the CV to maintain exposure to the underlying asset with further potential upside. If Existing LPs elect to re-invest into the CV (the “Reinvesting LPs“), they will become LPs in the CV, managed by the existing GP, alongside the secondary buyer.
A typical GP-led Secondaries acquisition structure
What are the Similarities to a Traditional M&A Process?
As GP-led transactions are highly bespoke in nature, the transaction chronology will vary on a deal-by-deal basis, but as a guide, the following reflects a standard process:
Typical process:
Preparation: the GP appoints advisers (including a corporate finance adviser (the “Intermediary“) who will provide structuring, pricing and process advice), prepares a data room, has preliminary discussions with and give presentations to key Existing LPs and the fund’s limited partner advisory committee (“LPAC“).
Phase 1: potential bidders enter into confidentiality agreements and are given access to the data room containing “phase 1” due diligence materials on the assets being sold. At the end of the “phase 1” period, potential bidders will be invited to submit indicative offers.
Phase 2: a select number of bidders are given access to “phase 2” due diligence materials and after their review, will be asked to submit binding offers. Assuming the price meets the GP’s expectations, the GP will select a preferred bidder.
Document Negotiation: the key transaction documents, namely: the framework agreement, the equity commitment letter, SPA, the election pack, limited partnership agreement relating to the CV, and subscription agreements relating to the CV will first be negotiated by the lead investor in the CV. Syndicatees in the CV will typically follow the commercial position agreed by the lead investor (subject to the usual discussions around side letter terms).
LPAC: The GP will almost certainly need to seek a conflict waiver from the LPAC to the transaction due to the potential and/or actual conflicts of interest associated with a CV transaction, including the inherent conflict that senior executives at the GP will likely be incentivised by carried interest on both sides of the transaction.
LP Election: The GP circulates the election memorandum to LPs in the Existing Fund, setting out the commercial rationale for the deal, the key terms and structure of the transaction, the amendments to the governing documents and the proposed timeline, together with all conflicts of interest and how they will be managed. It will also include an election form setting out the offer to either “cash-out” and take liquidity, re-invest or both.
LP Election Deadline: LPs return the election form, and if applicable, their application forms to be admitted to the CV. Following expiry of the election period, the GP will assess the appetite of LPs to invest in the CV and determine the amounts being invested by the various parties in the CV which may include any scale-backs.
SPA Conditions: The SPA becomes unconditional when the conditions are satisfied (e.g. regulatory clearances).
CV Closing: The CV is closed and the secondary buyer and Reinvesting LPs are admitted as members of the CV.
SPA Closing: SPA closing takes place and the assets transfer from the Existing Fund to the CV.
Key considerations and quirks of a CV transaction:
Drawdown: The CV draws down funds from its investors.
Pricing: to help generate alignment amongst the multiple stakeholders involved and cut through potential and/or actual conflicts which are inherent on GP-led transactions, the price is typically set through the involvement of an Intermediary who markets the transaction and solicits bids from a pool of secondary investors – generating market-tested pricing. This pricing may also be guided by the sale of a minority equity stake in the underlying assets to a third party investor.
Legal Due Diligence: CV transactions are generally considered “diligence-lite” when compared to a traditional M&A transaction. This is the result of: (a) the GP having held the underlying assets for some time and undertaken a more rigorous legal due diligence process on the original acquisition by the fund; and (b) the secondary buyer community typically assessing investment opportunities not only on the nature and risk / return profile of the asset but also the track record of the GP. The approach to diligence will though differ depending on structure and nature of the asset, how concentrated the transaction is and the advisers involved.
Fund-level Documentation: as key aspects of the transaction may be structured above the fund which owns the underlying asset, the style of documentation will likely differ to typical M&A documentation as certain fund-specific considerations will need to be taken into account.
Conflicts of Interest: Recently updated ILPA guidance on CV transactions and conflict management make clear that the LPAC should be consulted on an early, regular and fulsome basis. ILPA has further made clear that the LPAC is there to: (a) provide a sounding board for the GP; (b) approve the conflicts; and (c) provide guidance to the GP so as to support a transparent and fair process.
LP Election: in making an election, the Existing LPs may need to internally re-underwrite the deal and/or seek approval of its own investment committee. As such, and in line with the most recent ILPA guidance, Existing LPs must be afforded sufficient time to make roll or sell decisions. The standard approach is to give Existing LPs no less than 30 calendar days or 20 business days to make such decision.
Allocations: if the deal is only partially underwritten by a secondary buyer, the CV will require a walk-away right if, after other third-party LPs and Existing LPs have been invited to subscribe, there are insufficient aggregate commitments to meet the purchase price for the underlying assets. On the other hand, if the CV is over-subscribed, the GP will be entitled to “scale back” the Reinvesting LPs’ commitments. A secondary buyer may stipulate that its consent is needed for its commitments to be scaled back below a minimum commitment amount.
SPA Conditions: like a traditional M&A transaction, a CV transaction may trigger certain other consents or notification requirements e.g. in connection with competition/anti-trust regimes, foreign direct investment regulations, national security clearances, regulatory bodies, financing or material customer/supplier contractual arrangements at portfolio company level.
Is W&I Available?
Whilst the use of W&I insurance on secondary transactions is still emerging, it is becoming an increasingly common feature of secondaries transactions as a risk allocation and mitigation tool.
Who is insured?
The structure of W&I insurance for secondaries transactions is driven by specific deal structure:
| Type | Insured |
|---|---|
| GP-led | • GP • New Investors (with “Lead Investor” serving as the named insured) |
| LP-led | New Investors |
Benefits of W&I:
There are many benefits associated with utilising W&I insurance in secondary transactions, including:
- streamlined transaction negotiations as sellers can often cap liability for warranty breaches;
- offers more accurate, robust valuations for investors thereby maximising transaction value;
- facilitates the post-closing wind-up of selling funds (subject to other liabilities) and proceeds from such sale can be released more swiftly; and
- minimises any requirement for and likelihood of escrow/retention/guarantees; and reduces post-closing disputes between GPs and LPs given claims made under the policy and recourse is against underwriters.
Underwriting and Due Diligence
Similar to a standard M&A/W&I process, insurers will typically expect fulsome due diligence which covers the scope of the warranties being given. However, due to the nuances of a secondary deal and less strenuous due diligence typically associated with secondaries, there is an increasing trend for underwriters to adapt the standard buyout underwriting approach in order to more appropriately reflect the diligence on secondaries transactions. Consequently, the underwriting of secondaries for the purposes of W&I insurance policies can be streamlined in many cases.
Key considerations on W&I
Actual Knowledge
In a GP-led, the GP will have significant actual knowledge of the matters underlying the warranties. As standard with W&I insurance, issues which the insured has actual knowledge of are excluded from cover. Given that the GP and the new LPs are often insured under one W&I insurance policy, it is crucial that the GP’s knowledge does not prejudice the LPs’ ability to recover loss under the policy. Consequently, knowledge of the GP and LPs is specifically deemed to be several and not joint.
Excluded Obligations
Secondaries transactions generally result in the seller transferring to incoming investors all obligations and liabilities of the seller post-completion. The sale and purchase agreement will accordingly preclude the new investor from having to take on specified excluded obligations. W&I insurance policies may be designed to cover excluded obligation indemnities, providing comfort to sellers and new investors.
Portfolio Company Representations
Warranties given in a secondaries transaction are fundamental in nature. Generally, to the extent any warranties are given in respect of operations of portfolio assets, they are usually qualified by the knowledge of the GP or certain executives at the relevant company.
