THE Secondary Day Panel

KHP - THE Secondary Day

We would like to thank those who joined us for Kline Hill Partners’ Annual Secondary Day in mid-town Manhattan, and Evercore for hosting this year’s event again and, of course, all of our sponsors. We’re thrilled to have raised $120,000 for the organization that we sponsored this year, the Melanoma Research Alliance.

Evercore also hosted last night's women's networking event that we heard was a fantastic success!

Our panelists – who hail from PJT, Baird, and PJT and joined by the moderator from Cleary Gottlieb Steen & Hamilton – held a lively discussion about the vital role secondaries have played in today’s private equity market against the backdrop of macroeconomic uncertainty, poor alternatives liquidity, capital markets volatility, a depressed deal environment, and geopolitical developments.

Below are some snapshots of topics and trends discussed at this year’s event that drew more than 150 participants from leading buy-side institutions, sell-side advisory and secondary fund managers.?

The panel kicked off by setting some historical context of secondaries. As many of you know, the secondaries market has evolved considerably over the past couple decades and this year has been no exception. Limited partnership ("LP") deals drove the early growth of the industry picking up in the 2000's and then seeing a step function of growth after the great financial crisis. Secondaries GP-led transactions (also known of as continuation vehicle or "CV" deals) started to kick off in scale in 2015 and were initially considered to focus on “cherry-picked” assets associated with aging private equity funds and leftover, lower quality assets up until the end of 2018. A shift began in 2019 when these deals started to focus more on high quality “trophy assets” in single-company deals. The GP-led innovation and deal-making culminated in 2021 when GP-led volume surpassed limited partnership transaction volume for the first time.

Below are some highlights and a look at what made for a lively discussion among our guests (thank you!) who attended Kline Hill’s 2023 Secondary Day panel.?

What happened in 2023:

• The sponsor-based demand for GP-led secondaries among financial sponsors persisted in 2023 after having skyrocketed in 2022 when the M&A and IPO markets turned mostly dormant. Relatively large discounts for limited partnership deals in 2023 drew secondary fund attention at the expense of GP-led deals which often trade closer to par. CV volume lagged far behind LP volume in 1H 2023.

• Perhaps due to the challenging 2H 2022 and 2023 fundraise environment, sponsors began to consistently ask for staples in LP-led transactions as part of LP sale processes even after the final deal terms have been announced. There has been a very low success rate to accommodate these requests.

• As traditional exit avenues for general partners to realize liquidity – M&A and IPOs – remained moribund, smart PE sponsors sought to preserve capital and drive value creation for select portfolio companies through GP solutions that enabled them to continue owning and preserving portfolio companies or what we would prefer to say are “trophy assets” with a focus on sustained value creation.?

Let’s double click on that:

• The secondary banker panel view was that when it comes to multi-asset versus single asset transactions, the due diligence process goes substantially deeper and is much more involved in single-company deals with extensive "contract level" work going deep within many aspects of a company's performance. Many feel these single-company buyer deal teams are best filled by dedicated specialists and some firms have populated these teams with buyout professionals. They evaluate potential GP-led transactions through a lens that, interestingly, resembles much more of a traditional corporate buyout fund mindset and often bring many aspects of a buyout fund toolkit to these deals.
• By contrast, multi-asset CV deals often have higher level diligence efforts which may be more at the GP investor relations level. Sponsors' IR professionals have utilized the transactions as a tool to support fundraising in the near-term. The thinking is “maybe I can kill two birds with one stone and still get a transaction done” as one of our panelists noted.?Some of these transactions include staples as part of the CVs and also provide liquidity to LPs which can help a current fundraise effort.

• Private equity firms engaged in secondaries transactions are trying to think through what is the best strategy that they can pursue to continue driving value creation and liquidity without pursuing a traditional realization event – especially in times of a weak IPO or M&A market. These are GPs who are interested in preserving and generating value with their portfolio companies over the longer haul and see the promise in future growth opportunities.?

• If you look at an environment where capital calls have been outpacing distributions now for a number of quarters, for the first time in a number of years, in theory, any option for investors to realize liquidity would be one that would be well received.

• Secondary industry participants are expecting to see more continuation vehicle transactions come online in the coming months and into 2024.

Why’s that?:

GP-led deals are typically transacted close to par, or at least in the 90s. With LP-led deal discounts for high quality assets pushing 20% over the last twelve months, buyers have seen the LP acquisition route as a better value approach.?However, discounts for LP-led deals have shrunk as we've stepped further into 2023. As such, buyers can better pay up for CVs on a relative value basis, especially for the trophy assets. This is expected to drive increased volume in CVs over the coming quarters.

What’s been different in 2023?

• As the secondaries market has continued to evolve into a mature and sophisticated strategy in? private equity, so too have the transaction structures grown to become more complex.?

• One such transaction is to develop a structured solution that could include preferred equity, for example, or involve a credit financing component such as an NAV loan. Sponsors can use this type of credit solution to either provide liquidity to LPs or to fund portfolio company acquisitions. Similarly potential LP sellers could opt to take on low cost debt against their LP portfolio in ways they may see to be less expensive than an outright sale; these loan processes against LP portfolios though would really apply to quite large multi-hundred million dollar deals.

What’s Ahead?

• Fund documentation / limited partnership agreements: The evolution of documents is interesting and dynamic. Investors are looking to put in place protections on their co-invest, protecting against a future continuation fund and not wanting to have to step into the new terms if they have a fee free or carry free set up now in the investment. GPs are looking to add non-pro rata distributions in kind, fund expenses to cover the cost of executing CVs, and skipping LPAC or LP approval for CVs if a fairness opinion is delivered. Not all of these change requests are likely to make final docs!
• The SEC and ILPA are looking to put their stamp on GP-led processes. The SEC recently weighed in on a CV where LPs were forced to sell.
• Volume: The panels full year estimates for secondaries in 2023 was a range of $105 to $120 billion. 2024 is seen to be a very high volume year, but one where total volume will be heavily limited by available capital at secondary funds.
• 90% of LPs currently sell into GP-led processes. One panelist saw this figure shrinking to 50% over a few years as LPs become more educated and enhance their decision making processes to be able to move quickly enough.
• The growth curve for GP-led transactions in that category is going to look somewhat like the growth curve in private equity GP-led transactions over the last few years.