ESG Hot Topics: Insights into cultivating ESG in the secondary markets and best practices!
Albin Axelsson
I'm supercharging ESG transparency and regulatory adherence by offering end-to-end ESG compliance solutions for the alternatives
Greetings, fellow ESG and sustainability enthusiasts! ??
Welcome to the eighth blog post. Today, we will go through how private equity secondary markets relate to ESG and the SFDR - since all Fund Managers (GPs) with their Limited Partners (LPs) need to classify their funds according to 6, 8, and 9 of the SFDR in a European context. The private equity secondary market has been displaying quite significant resilience in various market cycles, and since we are currently living in quite turbulent economic times, it has gained strong momentum lately and captured the attention of investors and fund managers alike. ??
Private market investors are increasingly drawn to the PE secondary market as an appealing alternative asset class. These secondary transactions, involving the sale of interests in funds or assets under the same management, gain prominence, especially during M&A downturns. Once a niche strategy, secondary now ranks as the second most popular PE strategy, with over $100 billion in deals in both 2021 and 2022 and a staggering $37.2 billion raised in 1H 2023.
Historically, the view of the secondary market in PE has been that Fund Managers couldn't do very much and that they had limited influence in the ESG arena since secondary investors are removed from the level of the assets. They do not manage the assets themselves directly; the transaction activity is rather on the fund level than on the asset level since the fund, and their investments have already been made and established; therefore, the term 'secondary market'.
This is quite similar to indirect investing through funds of funds. In this scenario, the focus shifts to the manager and their ESG performance rather than on the underlying assets. Many talk about integrating ESG into the investment process, but what does it actually mean to do so in reality? At A Triple C Consulting, we work closely with deal teams from the get-go, focusing on risk areas, cross-referencing with third-party data, and drawing strength from our institutional memory and experience, having assessed either similar funds or companies. This holistic approach allows us to better inform the investment committees when presenting our recommendations in our client's investment memorandum.
The ESG assessment we perform includes the following steps in the secondary market:
Assessments are usually based on the ILPA ESG framework, considering the maturity of GPs' ESG policies. The results are presented to the investment committee, and decisions to invest with GPs are carefully discussed with clients.
The purpose of this is to focus on screening for potential ESG issues in underlying portfolio companies, as funds are often fully invested when considered for secondary transactions. We advise our clients to prioritize identifying material governance factors and gaining confidence in the manager's and companies' ability to address them appropriately.
Overall, we aim to achieve the following by partnering up with Fund Managers in the secondary market:
Our approach includes:
Now, let's dive into the secondary markets and their complexities but also present opportunities from an ESG perspective. ??
Anticipating the Future of the Secondary Market - an overview of the market
In the current landscape of market volatility, premium-priced liquidity, and PE exit headwinds, secondary investments have gained further momentum, constituting 18% of total Q1 2023 PE fundraising—a remarkable 800% increase year over year. Driving growth in secondary transactions are large multi-strategy private equity firms, specialized secondary funds, and impact-focused funds targeting specific assets on the secondary market.
Compared to the secondary market in public equities, the private capital secondary market remains relatively small, constituting around 1.4% of private equity's total net asset value, even in the face of historically high market volumes.
What once started as a niche strategy in the early 1990s has rapidly expanded, becoming a mainstream feature of the private capital world. In the short term, the market may become highly attractive if the macroeconomic environment continues to deteriorate, fostering investor nervousness. Concerns such as the war in Ukraine, a high inflationary environment, and central bank interest rate hikes are exerting pressure on a financial system accustomed to the low-interest environment of recent years.
The World Bank's January 2023 Global Economic Prospects Report warns, "Global growth has slowed to the extent that the global economy is perilously close to falling into recession." In such a scenario, significant consequences for LPs and GPs may loom large.
Expectations and Projections for Secondary Volume:
Secondary volumes are projected to reach $110 billion in 2023, with a long-term estimate for the market to soar to $500 billion by 2030. Several factors drive investors to participate in the secondary market, with most LPs leveraging it to rebalance their private equity portfolios and enhance liquidity.
The secondary market provides LPs with an appealing means to bolster their private equity portfolios, offering early exit opportunities, asset liquidation, and portfolio rebalancing. These avenues present diversification, liquidity, risk mitigation, and pricing advantages. However, LPs must conduct thorough due diligence, meticulously assessing factors like liquidity needs, investment objectives, diversification, and return expectations before venturing into the secondary market.
As the private equity secondary market continues to evolve, LPs can harness its flexibility and strategic opportunities to navigate the intricate landscape of private equity alternative investment funds. While encompassing various transaction types, careful evaluation of key considerations is paramount for LPs to efficiently navigate the market and fully exploit opportunities presented by GP-led or LP-led secondary transactions.
Unraveling Secondary Market Trends:
A secondary transaction involves the sale of assets before reaching the end of their expected investment cycle. These transactions, initiated either by a GP (GP-led) or an LP (LP-led), come with various structuring options influenced by stakeholders' interests, investor preferences, legal and regulatory environments, and market conditions.
In a GP-led transaction, a GP decides to sell fund assets before their end cycle to new investors or another investment fund, aiming to raise additional capital and optimize asset returns. The "continuation vehicle" emerges as the most popular structure, transferring assets to a new fund, where existing investors can either cash out or invest in the new fund. Managing conflicts of interest at both the existing and continuation vehicle levels is crucial for securing LP support for this type of transaction.
On the other hand, an LP-led transaction occurs when an LP decides to sell its interests in one or several private equity funds before their scheduled end to other investors. These bilateral transactions, subject to GP consent outlined in the fund's documentation, see the LP buyer(s) assuming all rights and obligations held by the selling LP, including its undrawn commitments.
Initially driven by the need to exit underperforming positions, LP-led transactions have evolved into a compliance tool, particularly for certain types of LPs facing new regulations. For instance, banks investing significantly in the private equity market must maintain reserves as a percentage of their capital to cover potential losses. Secondarys offer banks an opportunity to decrease exposure to private equity and comply with regulatory requirements.
Beyond providing an additional exit route, LP-led deals showcase the limitations of private equity funds, fostering the growth of LP-led transactions and uncovering new opportunities for investors to explore.
Understanding GP-led Secondary Transactions
In the realm of GP-led secondary transactions, the GPs take the lead in initiating the deal. The motivations for such transactions are diverse, providing a combination of liquidity to LPs and the ability to extend the holding period for both the manager and investors.
For LPs, engaging in a GP-led process offers opportunities to de-risk their portfolio, expedite liquidity, and accommodate strategic shifts in their investment strategies. The versatility of GP-led transactions proves instrumental in navigating various factors affecting private equity portfolios.
Driving Forces Behind the GP-led Market:
GP-led transactions empower sponsors to actively manage their portfolios, driven by motives such as extending asset duration, securing additional capital, and proactively generating liquidity for LPs. Sponsors strategically utilize GP-leds to retain ownership of their most promising assets, with single-asset continuation funds emerging as an alternative to traditional exit paths like M&A or IPO.
From the LP perspective, GP-led processes enable them to tailor their approach, de-risk their portfolios, accelerate liquidity, and align with specific industries, assets, and geographies—especially valuable in challenging macroeconomic environments.
Balancing Benefits and Risks of GP-led Secondary:
An enticing aspect of the GP-led market is the Positive Selection Bias. GPs, intimately acquainted with their portfolio companies, prefer to manage high-performing assets, resulting in a continuation-vehicle market skewed towards the most attractive assets under successful funds and reputable managers.
Another significant benefit is the Limited Blind Pool Risk. GP-led transactions limit the blind pool risk associated with traditional private equity investing, offering secondary buyers an opportunity for in-depth due diligence and a lower-risk entry into assets familiar to the GP.
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However, GP-led secondary come with their share of risks, including asset concentration and fair valuation. Careful consideration of each transaction's merits, especially within the broader portfolio context, becomes crucial for investors.
The Nexus Between ESG and GP-led Secondary:
In an era where ESG considerations influence global corporate agendas, the qualities of GP-led deals provide levers to address ESG concerns during due diligence. These transactions offer a transparent process, enabling a comprehensive review of the GP's underlying assets. With heightened scrutiny, buyers and investors can identify and remedy ESG-related risks.
Continued Opportunities in LP-led Transactions:
LPs are increasingly drawn to the secondary market for several compelling reasons. The primary benefit is liquidity, offering a means to exit a fund early and mitigate risks associated with specific funds or vintage years. This flexibility proves valuable during economic downturns or when LPs aim to rebalance their portfolios.
Secondary transactions often occur at discounted prices compared to the initial purchase, presenting an attractive opportunity for LP buyers to acquire private equity assets at potentially lower costs. The active involvement of GPs in LP-led transactions fosters positive synergy, building closer relationships between GPs and LPs.
Challenges and Opportunities of ESG Integration in Secondary:
Firms with secondary investment strategies may face challenges in analyzing and managing ESG risks compared to conventional PE buyout transactions. However, secondary investors enjoy advantages in evaluating ESG risks and leveraging existing assessments and KPI data.
While challenges exist, continuation transactions offer longer hold periods, facilitating strategic planning for ESG management practices. Secondary investors, spanning diverse GPs, can play a pivotal role in advancing ESG best practices throughout the PE market.
As the secondary market grows, investors can influence ESG values, incentivizing broader adoption and potentially gaining seats on portfolio company boards, enhancing their leverage for stringent ESG policies.
Adopting ESG Best Practices Across Transaction Stages:
ESG best practices for secondary investors draw inspiration from traditional LP and GP ESG management principles. In LP-led fund-level transactions, investors can leverage existing ESG initiatives developed by LPs to influence investment managers. On the other hand, investors in GP-led asset-level secondary transactions can adopt the foundational aspects of PE manager ESG programs.
Tailoring ESG practices to each stage of a transaction is crucial. During the investment stage, investors in fund-level LP stakes can request information on GP ESG practices, perform formal evaluations, and share observed ESG diligence and portfolio management best practices across different funds to enhance programmatic maturity.
For investors in GP-led deals, a more robust ESG risk assessment is essential. They can review original investment materials, conduct a lighter touch ESG diligence directly screening assets for red flags, and request historical and future ESG Key Performance Indicators (KPIs). Identifying ESG concerns prompts engagement with GPs to understand their risk mitigation strategies.
Engagement and Collaboration for ESG Maturity:
If ESG diligence reveals immature governance and management of ESG issues, secondary investors can engage with GPs post-transaction. Tools like ESG-related side letters, resource sharing, and setting thresholds for ESG performance metrics become instrumental. As committed LPs, secondary investors monitor GP governance and asset performance on ESG metrics through AGMs and other LP-facing materials.
While secondary investors may not directly influence asset-level ESG management practices without a board seat, collaboration with GPs is key. Supporting GPs in enhancing ESG programs, policy creation, and operationalizing ESG management practices contributes to overall ESG maturity.
A Triple C Consulting's Role in ESG Integration
Investors pursuing secondary strategies often face limitations in analyzing and managing ESG risks compared to traditional PE buyout transactions. Acquiring fund-level stakes in LP-led transactions may restrict their influence over management, impacting their ability to manage ESG risks effectively. Furthermore, the sheer volume of assets acquired through fund-level LP stakes can raise the threshold for materiality of ESG risks and increase the probability of encountering assets with significant ESG risk exposure.
On the flip side, GP-led secondarys present a different challenge. The concentrated dependency on the performance of a limited number of assets heightens ESG risk exposure levels. Investors in continuation funds also grapple with limited access to management and non-financial information, requiring a more streamlined approach to ESG analysis.
Opportunities for ESG Integration in Secondary ??:
Despite the challenges, secondary investors possess a unique advantage – the ability to evaluate ESG risks based on existing assessments and Key Performance Indicator (KPI) data. Unlike primary investors, secondary investors can screen portfolios for ESG risks and benefit from multiple layers of due diligence. Continuation transactions, with their longer hold periods, offer the chance for strategic planning, enabling the development and operationalization of ESG management practices.
Moreover, secondary investors, by acquiring stakes across various GPs, play a pivotal role in promoting ESG best practices throughout the private equity market. As the secondary market expands, investors can influence asset and fund managers to align with their ESG values, fostering broader adoption of sustainable practices. In GP-led secondary, investors may even gain seats on a portfolio company's board, providing leverage to push for more stringent ESG policies.
ESG Best Practices in Secondary ??:
To foster ESG best practices, investors should tailor their approach to each stage of a transaction. During the investment stage, those involved in fund-level LP stakes should request information on GP ESG practices and perform evaluations of GP ESG management programs. Sharing ESG diligence and portfolio management best practices across different funds can enhance programmatic maturity.
For single or multi-asset GP-led deals, a more robust ESG risk assessment is crucial. Direct screening of assets with a focus on red flags, along with requesting historical and future ESG KPIs, helps identify areas of concern. If issues arise, reaching out to the GP for clarification and understanding their risk mitigation strategies is essential.
Once committed to a manager, secondary investors transition into the role of LPs, monitoring GP governance and asset performance through AGMs and other LP-facing materials. Though direct influence on asset-level ESG management may be limited, secondary investors can engage with GPs through ESG-related side letters, resource sharing, and setting thresholds for ESG performance metrics.
Supporting ESG in Secondary Markets ??:
In addition to these best practices, secondary investors can further contribute to ESG in the secondary markets by actively supporting initiatives such as GHG emissions tracking and reduction programs. By encouraging GPs to invest in longer-term, value-additive ESG opportunities, they can contribute to the overall sustainability of the private equity landscape.
In conclusion, ESG integration in secondary markets presents challenges, but with a proactive and strategic approach, investors can turn these challenges into opportunities. A Triple C consulting stands ready to guide investors through the complexities of ESG in secondary, ensuring a sustainable and responsible investment journey. ????
Feel free to reach out to us if you need an ESG advisor or help with ESG data collection to support your existing ESG workflows and compliance efforts. At A Triple C Consulting, we have ESG legal expertise (Magic Circle Law firm based in Luxembourg), ESG data platform (Seneca ESG), and ESG climate and carbon accounting capabilities. A true end-to-end service offering at your disposal. ?? ?? ??
Best regards,
Albin Axelsson
Founder & CEO of A Triple C Consulting
Note: The content provided in this newsletter is for informational purposes only and should not be construed as financial or legal advice.