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Mid-market GP-led secondaries heat up

As GP-led dealflow continues to outstrip available capital, there has been a flight to quality and a flight to the mid-market, say Tim Toska of Alter Domus and Brian Mooney of Portfolio Advisors


How would you describe GP-led dealflow right now?

Tim Toska: Conversations with our clients around GP-led secondaries are becoming increasingly common. Sponsors are identifying high-performing companies where significant value-creation potential remains and are putting them in continuation vehicles. These deals have become a valid fourth option when it comes to exiting businesses.

Brian Mooney: Almost every major private equity firm has completed at least one continuation fund and many have completed several. We observe that firms that have yet to do so are working on one right now or considering their first. However, there is a massive supply/demand imbalance. While the demand side (buyside capital) is growing, it is not keeping pace with supply, particularly given that so many LPs are suffering from the denominator effect. That is impacting fundraising in all asset classes including secondaries.

As a result, GP-led deal volume is down on last year, but those transactions that are taking place involve the highest quality sponsors and the highest quality assets. I would also add that there has been a marked shift towards the mid-market. Very large single-asset or concentrated portfolio deals, meanwhile, are proving more challenging

What impact are those supply/demand dynamics having on pricing?

BM: Only 25 percent of all GP-led deals were priced at a discount to NAV in the first half of 2021. By the first half of 2022, that had increased to 50 percent, and I think that is still true today. We are also seeing more transactions with some kind of structuring involved in the purchase price. It could be a simple deferral or in some cases a portion of the purchase price is based on a contingency such as hitting a certain level of EBITDA at a given date.

How should sponsors prepare their assets and processes to maximize the chance of a GP-led deal completing?

TT: Transparency is paramount, and I think the GP-led secondaries market has benefited from enhanced transparency more broadly in the wake of the pandemic. Historically, there was criticism levelled against the asset class with regards to a lack of readily available information and stale information.

During the pandemic investors began to demand frequent data points and communication around specific companies, which forced managers to put the necessary infrastructure in place to deliver on that. That means that when a GP raises the prospect of a continuation vehicle with a particular asset today, the LP base is already well versed on how that company is faring and why a continuation vehicle might make sense.

BM: Sponsors today are communicating with their investors early and are focused on transparency, both with buyers and the existing LP base. In terms of preparing companies, it is all about finding the ideal candidate and having the right motivations.

What are secondaries buyers looking for in a GP-led deal in terms of alignment?

BM: At an absolute minimum, a GP needs to roll at least half of its capital. For us, as a buyer, the GP must be a net buyer or else the transaction is of no interest to us. We tend to become really interested, however, if the GP is proposing to roll all its capital, meaning the original investment plus carry crystalised through the sale to the continuation vehicle. A GP-led transaction becomes even more interesting if the GP wants to write an additional cheque, which could mean a commitment from its new flagship fund.

Meanwhile, economic terms tend to be more favorable, with lower management fees and tiered carry, which serves to further enhance alignment.

What role can technology and data analytics play in supporting a GP-led process?

TT: With a GP-led process, as with so many areas of private equity, it is vital for sponsors to have a single source of truth in-house. Get your data systems in place and then you can overlay that with market insight to help identify the perfect candidate for a continuation vehicle. Investors are also relying on data analytics to evaluate manager performance. But I would add that data analytics is fundamentally about taking the robot out of the person. It takes away all the laborious legwork and enables teams to bring a new and more valuable set of skills to the table.

BM: Underwriting a continuation vehicle is a very intensive process. You need to underwrite the sector and the company, but you also need to underwrite the sponsor. You need to evaluate how that sponsor has added value to that business and whether that is consistent with the strategy being proposed for the continuation fund. All of that involves pattern recognition and, if you have the data and analytical tools to gain that insight, you can better assess the risk/return profile of the deal.

What other areas of private equity do you see as ripe for tech disruption in the future?

TT: I see the real value of technology as supporting due diligence at the front end of a transaction. I also believe that automation can help streamline processes, making data requests that might previously have taken days almost instantaneous. Meanwhile, the more standardised that data becomes, the more easily it can be integrated into investors’ systems as well.

BM: I think data analytics will play an increasingly important role in LP secondaries, where you are often building portfolios with hundreds of fund interests and thousands of underlying companies. Technology can help make that market much more efficient and support our ability, as buyers, to submit offers more quickly, while also informing our portfolio construction around underlying risk and return drivers.

I agree with Tim that technology in this asset class is about taking the robot out of the person. This is still a people business. As investors, we are betting on the teams that we believe are the smartest and best at what they do.

This article was originally published in PEI’s US Mid-Market Report.

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Tim Toska

North America

Global Sector Head, Private Equity

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