LP-led Secondaries: Trends, opportunities and key considerations

Initially the secondaries market was considered as a niche in the private equity market. In recent years, secondary transactions have been increasingly seen by limited partners (LPs) and general partners (GPs) as an alternative to the traditional primary market and are now a mainstream pillar of the private equity landscape. While the secondary transactions market encompasses various type of transactions, it’s crucial for LPs to carefully evaluate key considerations to navigate this market efficiently and fully exploit the opportunities presented by LP-led secondary transactions.

 

Secondary market trends

A secondary transaction refers to a scenario in which assets are sold before reaching the end of their expected investment cycle. These transactions may be initiated either by a GP (GP-led) or an LP (LP-led). The specific structuring options depend on various factors, including stakeholders’ interests, investor preferences, legal and regulatory environment, and market conditions.

Through a GP-led transaction, a GP makes the decision to sell assets of a fund before its end cycle to new investors or to another investment fund, with the aim of raising additional capital and/or optimizing asset returns. A GP may strategically opt to sell underperforming assets in advance to enhance the overall performance of the fund. Among the various GP-led transaction structures, the “continuation vehicle” is the most popular. In this setup, assets are transferred to a new fund, and existing investors typically have the option to cash out or invest in the new fund. Given that the same GP usually manages the new vehicles, the management of conflicts of interest at the level of both the existing and continuation vehicle, as well as their respective investors, is crucial to secure the support of LPs for this type of transaction.

Through an LP-led transaction, an LP makes the decision to sell its interests in one or several private equity funds before its/their scheduled end to other investors. These transactions are typically bilateral (subject to the GP prior consent generally provided for in the fund’s documentation) with the LP-buyer(s) taking over all the rights and obligations previously held by the selling LP, including its undrawn commitment(s).

Initially, LP-led transactions were driven primarily by the need to exit an underperforming position before the underlying investments matured. More recently, secondaries emerged as a new compliance tool in response to new regulations for certain types of LPs. By way of example, banks which are major investors in the private equity market are now required to maintain a certain level of reserves as a percentage of their capital to cover potential losses from private equity investments. Secondaries have offered an opportunity to the banks to decrease their exposure to private equity and comply with these regulatory requirements.

LP-led deals offer more than an additional exit route. The inherent limitations of private equity funds fuel the growth of LP-led transactions and reveal other opportunities to be explored by investors.

 

Opportunities in LP-led transactions

There are several compelling reasons why LPs are drawn to the secondary market. Liquidity is one of the primary benefits. Exiting a fund early through secondaries can help LPs mitigate the risk associated with a particular fund or vintage year and provide immediate cash flow when needed. This flexibility can be particularly valuable during economic downturns or when LPs want to rebalance their portfolios.

With the extension of the term of private equity investment funds (which are mainly close-ended and by nature illiquid) and the need for major LPs to diversify their investments by lowering their over exposure to private equity and increasing liquidity, LPs see the secondary market as a market of opportunity, emerging as a remedy to the underlying constraints of private equity investments.

Secondary transactions are usually made at a discounted price toward the initial purchase price. This presents an attractive opportunity for LP-buyers to purchase private equity assets at a potentially lower cost, especially for investors with a smaller ticket, who can access portfolios that they would not have been able to access at the time of the original issue.

The enthusiasm for LP-led secondaries is also facilitated by the active involvement of the GPs in LP-led transactions, which have created a positive synergy for the growth of this market segment and became an opportunity to build closer relationships between GPs and LPs. GPs play a crucial role in LP-led transactions both in terms of approval, facilitation, safeguarding the investment fund and protecting investors’ interests. The extent of GP involvement in an LP-led transaction varies based on fund constitution documents and the transaction’s circumstances. Often, obtaining the GP prior consent is necessary to transfer the interests to the LP buyer. Depending on the fund’s documentation, a GP may have a veto right and can withhold approval, particularly if it determines the LP buyer to be ineligible according to fund criteria or if a conflict of interest arises.

Although LP-led transactions offer numerous benefits, LPs engaging in those transactions must weigh up the following key factors to avoid potential pitfalls.

 

Key considerations

Due diligence: Thorough and comprehensive due diligence is imperative when evaluating an LP-led secondary opportunity. LP-buyers must scrutinize the quality and performance of the portfolio companies, the fund's terms and structure, and the reputation and track record of the counterparty to establish trustworthiness and reliability. This due diligence process should encompass a thorough review of the fund documents and the negotiation of transactional documents to protect the buyer's interests and clarify obligations. Throughout due diligence, buyers must ensure access to all relevant information relating to the investment fund and its assets to make well-informed decisions. LPs must also ensure that secondary transactions adhere to relevant laws, regulations, fund documents, and tax implications. Special focus should be given when reviewing the fund documents to ensure compliance with eligibility requirements and transfer restrictions, while also understanding their implications.

GP role: GPs may play a significant role in facilitating the transaction by providing essential information and documents related to the fund’s performance, legal matters, and other pertinent details to both the selling LP and the buyer. Selling LPs should carefully review the confidentiality clause in the fund documents and secure a waiver from the GP before sharing any confidential information with the buyer. GPs may levy fees and expenses associated with the transfer process, which can encompass legal fees, administrative costs, and potential transfer fees. Additionally, GPs might explore the possibility of purchasing the LP interest themselves if they perceive it as a valuable opportunity. Generally, GPs are committed to ensure that secondary transactions do not negatively affect the fund’s overall performance and stability.

Financial terms: LPs should consider the current market conditions and trends in the private equity secondary market, as these factors can influence pricing. Analyzing pricing dynamics and discounts in the secondary market is crucial to ensure the acquisition of assets at a fair market value, and in some cases, seeking assistance from external valuation experts may be necessary.

Moreover, the tax treatment of secondary transactions can vary considerably. LPs should seek advice from tax advisors to get a comprehensive understanding of the potential tax implications of the transaction, including aspects like potential capital gains, losses, and options for tax-efficient structuring.

Investment objectives: LP buyers should ensure that their secondary investments align with their liquidity requirements and overall portfolio liquidity profile. Engaging in the secondary market without a strategic approach may lead to losses. Buyer LPs should also focus on crafting an exit strategy for their secondary market investments, which includes considering potential options for further transactions or eventual liquidation. Legal advisors specialized in secondary transactions can provide guidance on navigating the intricate legal aspects of such transactions.

 

Conclusion

The private equity secondaries market has evolved considerably since its inception and has proven resilient over various market cycles. It offers LPs an attractive way to enhance their private equity portfolios, by allowing them to make an early exit, liquidate assets or rebalance their portfolios. These opportunities provide diversification, liquidity, risk mitigation, and pricing advantages. But LPs must conduct thorough due diligence and carefully assess factors like their liquidity needs, their investment objectives, diversification and return expectations, before entering the secondary market. As the private equity secondary market continues to evolve, LPs can use its flexibility and strategic opportunities to navigate the complex landscape of private equity alternative investment funds.