Very limited partners — including me — have expressed skepticism about general partner-led sophomores. Among the main concerns: potential conflicts of interest, perverse incentives and adverse selection bias.
But perhaps these concerns are unfounded.
First, some numbers: Private equity secondary volume last year remained fairly steady, as approximately $100 billion of transaction volume was traded. According to research by Jefferies, roughly half of that is activity originating from LPs such as institutional investors such as CalPERs seeks access to liquidity from secondary markets.
Part of that is due to the many plates found themselves overweight until PE and negative cash flow in their private markets portfolio. Another part of this volume was from institutions that simply had a change in management or philosophy.
Or, sometimes after many years of commitment to the asset class, large institutions realize that they have hundreds—potentially thousands—of funds and insufficient resources to actually monitor and manage all the positions. If they can’t hire more people, sometimes it makes sense to do a sale to clear the wallet.
Of course, if half of the secondary volume is LP driven, that means the other half were GP led transactions.
GP-led processes, often also called continuation funds or continuation vehicles, occur when a private sponsor has a company or several companies remaining in a fund that is nearing the end of its life. Instead of selling the company to an independent investor, such as another private equity fund or a strategic corporate acquirer, continuation funds are special purpose vehicles created by GPs, often with the participation of an outside investor, to buy assets from an old fund and move them in the new vehicle.
A private equity firm that moves an asset or multiple assets from one fund to another has wide discretion as to the price at which the “transaction” takes place. The GP may have an incentive to set low prices, making the deal attractive to new money. Such transactions often have an underlying commitment to the next fund launch included as a prerequisite for participation in the continuation instrument – a so-called bracket transaction.
Worse, GPs can often crystallize their carry into a single fund without providing any net liquidity to their clients. It may be better than being trapped in a zombie fund – but all other things being equal, it is preferable to generate liquidity for your investors through a true arm’s length deal with a third party investor, where price maximization is the objective for all partners in fund.
Speaking of zombie funds, there is also concern about adverse selection. LPs often worry that assets left unsold at the end of a fund’s life are lower-quality businesses. Maybe they’re not performing well, or maybe they’re not attracting buyer interest, but investors often suspect that if they were great assets, they wouldn’t have a problem selling.
This is probably why 90 percent of long-term partners choose liquidity in GP-led continuing vehicles, according to Lazard.
Still, new performance figures for the continued vehicles suggest we may have been all wrong about GP-led aftermarkets.
Alternative investment consulting and research firm Upwelling Capital Group grades that there have been around $220 billion in GP-led secondary transactions since 2016. Upwelling claims that these vehicles outperform their respective underlying funds as well as top quartile vintage funds.
Using data from Hamilton Lane, Upwelling showed that from 2018 to 2020. continuation vehicles generated multiples that were well north of top-quartile funds in all three recent vintages.
This superiority persists when comparing the returns of extended funds with the performance of their underlying funds. On this basis, single-asset transactions outperformed their core funds by 1.6 times the turnover of invested capital, and multi-asset funds outperformed their respective leading funds by 0.5 times. Such impressive returns certainly do not appear to be indicative of adverse selection effects.
Private equity professionals typically argue in favor of positive selection bias, saying that companies that have yet to sell have much more room to manage and would be leaving money on the table if they sold now. They insist they know the business much better after owning it for several years and have the operating book to continue to grow and improve the company. They believe they can make more money by continuing to hold than by buying a new company.
Early data suggests that there may be some truth to this argument – and that my initial skepticism about GP-led secondaries may have been unfounded. The fact that single-asset deals have done even better than multi-asset expansion vehicles seems to support GP’s claims that they are focusing on great assets – and it seems the more focused the better.
If GP-led secondaries can continue to deliver on their promise of access to high-performing companies with private equity firms that investors already know and trust, such funds are likely to gain wider acceptance among the private equity community. LP.
Christopher M. Schelling is the Founder and Chief Investment Officer of 512 Alternatives, a boutique advisory firm dedicated to helping wealth managers, family offices and small institutions understand and access alternative investments.