Global stock markets rallied strongly over 2023 with the S&P 500 up 21% over the past year. Given this, and the higher returns from fixed income securities, one would expect that investors would feel relieved. However, this is not the case. Investor sentiment has remained cautious due to stubbornly high inflation levels making portfolios largely comprised of public securities generating inadequate returns, particularly for individual investors.

As investors seek alternative avenues to generate alpha, private equity investing has risen as an asset class offering opportunities to boost the return profile. However, simply investing in private equity will not automatically bring better returns; picking the right investment structure suitable for a specific business cycle is crucial. In light of current market conditions, private equity secondaries, and more specifically, GP-Led secondaries, have grown in prominence and warrant attention.

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Understanding Private Equity Secondaries

Private equity primary funds purchase stakes in privately owned companies with a view of selling them in the medium to long term at a higher price. Private equity secondary funds specialize in gaining such exposure by acquiring ownership stakes in primary funds (LP-Leds) or partially acquiring companies from other funds (General GP–Leds).

In LP-Leds, it starts with an LP needing liquidity and wishing to exit a fund earlier, so it sells its investment to an LP-led secondary fund. For GP-led secondaries, as it comes close to a fund’s termination date, a fund manager could identify companies owned that still have strong growth prospects. The GP creates a structure that allows any LP who wishes to liquidate his fund ownership to do so by selling his respective ownership in such companies to an LP-Led fund, while other LPs who are interested to continue can carry forward their interest through the structure.

One structure that has seen rapid growth is a Continuation Fund.

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How do Continuation Funds Work?

Continuation funds are created for the purpose of enabling a GP to continue managing the sold investment for a longer period. This is done in a structure that is separate from the previous fund until the additional expected growth has been achieved and the company is ultimately exited.

This new investment vehicle (the continuation fund) is set up with new secondary investors and selected companies are sold from the existing fund into the continuation fund. This could be the case for either several assets bought together or individual assets.

With this new structure in place, new investors could get exposure to successful investments that are not available for investment through the primary market and that benefit from a clear growth plan overlooked by an existing manager who may be on a faster track to exit.

Growth Drivers of GP-Led Private Equity Secondaries

The secondary market has grown sharply over recent years, up 51% since 2018 to $112bn in 2023, according to Jefferies’ Global Secondary Market Review. Within this, GP-Led volume growth has been the fastest growing segment, rising to $52bn in 2023 from $24bn five years previously. GP-Led volume is expected to continue its rapid growth in 2024 to more than $65bn.

The reasons behind the growth in secondaries have been driven by the need for greater liquidity in volatile markets, while GP-led secondaries have emerged as a high-performing and stronger returns strategy within the secondary market.

GP-led secondary returns: Morgan Stanley stated that between 2018 and 2020, continuation funds secured a top-quartile net MOIC (multiple oninvested capital) of 2.6x with a median net MOIC of 2x). This compares to buyout funds with a top-quartile net MOIC of 1.6x and median MOIC of 1.4x.

Net MOIC by Vintage Year

In addition to generating the strongest returns across private equity strategies, continuation funds also have achieved a lower principal loss ratio at just 8%, compared to 19% for buyout funds. Multi-asset continuation funds have also been proven to outperform single-asset continuation funds.

While the higher level of returns generated by GP-led secondaries is clear, doing so requires the ability to pick the right assets at the right time, which is far from easy. Managers pursuing this strategy need specialized skill sets, as they engage in direct transactions with other managers rather than acquiring bulk portfolios.

• Successful investments are only likely in GP-led transactions when strong partnerships with GPs exist. These will offer deep insights into portfolio companies’ financial performance, as they extend beyond the transaction itself.
•  Excellent resources for due diligenceare important for underwriting standards. Unlike LP secondaries, these transactions are focused on specific portfolios. Secondary investors with robust access to private markets data and industry research are likely to have more successful investments.
•   Governance can often be complex, so strong negotiation skills is key. Experience in alignment, structuring, execution and fee arrangements are also crucial, as is clear communication withthe LP advisory committee.

Especially during periods of market uncertainty, investing in GP-led secondaries have additional advantages, including greater visibility over underlying opportunities and enhanced control over portfolio management. This strategy enables managers to adapt to challenging market conditions more effectively and provide investors with a level of transparency that may be lacking in LP-led secondaries.

Why Else Consider GP-Led Secondaries?

The advantage of higher returns from investing in GP-led secondaries, and in particular, continuation funds, is not the only benefit to building exposure to this segment of private equity. When considering private equity GP-led secondaries, other benefits include:

1. Investing in the best assets: GP-led secondaries will be focused on the assets with the strongest growth prospects in a portfolio – and hence the potential for even stronger returns.
2. ‍Influence over sector exposure: As portfolio companies in GP-led funds are either concentrated on one or just a few companies, investors are likely to be able to have stronger influence over sector exposure, especially compared to LP-led funds where company exposure is much more spread.  
3. Alignment of interest with the GP: For GP-led secondaries, secondary buyers often require a sponsor to roll over the carried interest from the selling fund to the continuation fund. It is common for the sponsors to make large financial commitments into the continuation funds to show their level of commitment.
4. Performance: GP-led secondary investors tend to have greater visibility into the underlying assets compared to traditional LP deals. Buyers are also likely to have access to the sponsor. This enhanced level of transparency enables more accurate predictions about future performance.

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GP-Led secondaries: A Robust Investment Strategy

While private equity secondary funds have grown in prominence over recent years, GP-led funds have taken the stage more recently. Continuation funds are now often being used as a way to hold on to high-growth assets, with sponsors increasingly using them as a path to manage their LPs’ varying preferences.

Higher levels of flexibility and optionality for GPs and LPs from GP-led deals, along with strong options for secondary investors means that GP-led volume growth is only likely to move sharply higher, in our view.

We have shown that private equity GP-led secondaries, particularly continuation funds, offer unique advantages that can transform portfolio performance over the long term. However, investors should remember that it’s important to exercise due diligence in selecting managers with a strong track record of success – not simply within the secondary space, but also with a history of outperformance within primary fund management.

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Author

Saad Adada, CFA

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