GP Led Secondaries: What's next?

GP Led Secondaries: What's next?

Anu Rajakumar: It's been a challenging environment for private equity investors as reduced exit activity, diminished distributions, and a generally tougher fundraising environment have constrained liquidity among private equity sponsors and their limited partners. Hence, the rise of the private equity secondary market. In a common secondary transaction, a sponsor sells specific portfolio assets to a secondary fund, in turn, providing liquidity for primary fund LPs while generating potentially attractive long-term returns for secondary investors.

Why are they getting traction in today's private equity ecosystem? How can investors navigate the complexities of GP-led transactions, assess pricing distortions, and identify opportunities while managing risks? My name is Anu Rajakumar. To answer those questions and more, I'm pleased to welcome back to the show Philipp Patschkowski, Managing Director of Neuberger Berman's Private Equity Secondaries Team. Philipp, welcome back to Disruptive Forces.

Philipp Patschkowski: Great to be back.

Anu Rajakumar: Philipp, to kick things off, explain what are secondaries and what role do they play in the private equity ecosystem?

Philipp Patschkowski: When you think about private equity, it is an inherently illiquid asset class. Let me explain what I mean by that. To do that, let me explain also a few terms that I'm going to use in today's episode. In private equity, we have limited partners, or the LPs, that commit capital to private equity funds. Those are managed by general partners, or the GPs, the private equity firms.

The limited partners have the option to sell their private equity funds into the secondary market to create additional liquidity from their private equity portfolios. Also, what we're seeing is that the general partners have the ability to sell select underlying investment companies into so-called continuation funds, which are capitalized by secondary buyers to create liquidity that they then can distribute up to their investors.

Anu Rajakumar: Great. How would you fit that into the broader private equity landscape? What is appealing about secondaries compared to other areas of private equity?

Philipp Patschkowski: Private equity secondaries are generally believed to be lower risk. That's shorter duration, lower valuations, reduced leverage, and reduced execution risk, and the underlying portfolios.

Anu Rajakumar: Terrific. Now we've really seen the secondary market in private equity take off in recent years. Philipp, what would you say is behind this growth? Are there any particular market trends or pressures that are driving more sponsors and investors to consider these types of deals?

Philipp Patschkowski: The secondary market has been very prominent in the financial press over the last few years. It does give the impression that the secondary market is cyclical, but it is not. There are a number of long-term trends that are driving the growth in the secondary market. Number one is, of course, the growth of the overall asset class, which has been shown tremendous growth over the last one and a half decades. The secondary market, as a deviation of that, has been benefiting from that growth of the addressable market. Number two is that LPs, so the investors, have become a lot more active in selling their private equity positions through the secondary market to manage their portfolios.

That percentage is still below 2%. It's hovering around 1.5% to 1.75%. If that goes up to 2%, 2.5%, there's a tremendous growth opportunity for the secondary market. The third long-term trend is the emergence of the GP-led market, which in 2011 barely existed and now represents about half of the overall secondary market.

Anu Rajakumar: All right. Philipp, does that mean that there's not a temporal pressure in the market right now? How do you think about the opportunity set here?

Philipp Patschkowski: There is, of course, an accelerator as well on top of that long-term growth trend. That's really driven by the lack of distributions that we're seeing in private equity at the moment. When we look at the percentage of the distributions as a percentage of the NAV at the beginning of the period in 2024 and 2023, it's been hovering around 12%, 13%. That's less than half of the 10-year average and the lowest value since the global financial crisis of 2008 and '09.

What that means is that investors don't generate the liquidity that they need to generate to fund the capital calls from their underlying private equity portfolios. It's putting a lot of pressure on the LPs to generate additional liquidity. The answer to that is the secondary market.

Anu Rajakumar: Now, if exit activity does indeed pick up again and we go back to more normalized distributions, what happens to secondaries in that situation?

Philipp Patschkowski: I think it will continue to grow. I think one element that is interesting is that a lot of people think, "Oh, when distributions come back, everything is fine again and the whole portfolios turn cashflow positive again." I think that's probably true, but also I think in an environment where exit activity normalizes, investment activity will also normalize, and as a result, the impact on the net cash flows the LPs experience will be much more muted.

In other words, the positive effect of the distributions will be much less felt by LPs than currently anticipated. That then, of course, continues to create opportunities in the secondary market above the mean trend.

Anu Rajakumar: Sure. Absolutely. Actually, with that in mind, let's talk about pricing for a moment. How have you seen valuations and deal pricing in the secondary market evolve over the last few years?

Philipp Patschkowski: Pricing on the secondary market has been fluctuating, I should say quite, quite a bit. At the moment, we're looking at average high bids of mid-single digits, might go to just over 5%. That is an attractive value in the context of the last decade. If you look at the average, it's been hovering. It's certainly around that level. At the same time, if you go back to the late 2022, early 2023, those discounts have been more 10% to 20% for similar portfolios, so a lot more attractive than it was today. What we're also seeing is that you need to dissect a little bit why the pricing has gone up relative to NAV. I think it's interesting there are a few trends here. Number one is that the pricing for diversified portfolios is really driving the majority of that uplift in our view, but also, sellers are looking at much younger funds they're currently selling in the market.

Funds that have much more leeway for future value creation and, as a result, can demand higher pricing as well. Also, then as a third theme, LPs are taking a more sophisticated or different approach, I should say, to creating liquidity. They may offer a portfolio of a billion dollars of NAV with the goal of only generating $400 million of liquidity. They will then go through all the bids that they receive on that portfolio to optimize the pricing relative to their own goals, which typically is the narrowing of the headline discount.

Anu Rajakumar: Let me ask you about that first one that you mentioned. You said there are more diversified portfolios, the pricing is really driving the uplift. Can you just explain what do you mean by that?

Philipp Patschkowski: It appears that at the moment, there is a premium for larger diversified LP portfolios in the market. It appears to be driven by a number of buyers that are active in this space. The diversification allows for the use of transaction-level leverage, which can then be used to pay a higher pricing, but certainly also is changing very much the risk and the cashflow profile of these investments.

Anu Rajakumar: Okay, thank you. That's interesting. Staying on the topic of pricing, I'm actually now curious as a follow-up, what's your outlook on pricing trends going forward, and how should investors be thinking about value in this environment?

Philipp Patschkowski: To think about that question, I think it's important to also touch on the fundraising and the secondary market overall. What we've seen is that the fundraising has been lagging behind the growth of the transaction volume. When you divide the dry powder so the capital available for new investments by the transaction volume of the prior year, that's a multiple that's been going down. At the moment, it stands at around 1.4 times.

That compares to historical levels, which are more hovering around the two times of dry powder to transaction volume. The market is undercapitalized. What that means is that there is an attractive opportunity set here for buyers, and I think for buyers that are having a targeted approach to isolating interesting assets from broader portfolios and avoiding a little bit the more competitive environment that I just referenced before. That's on the LP side. I think on the GP-led side that undercapitalization is even more acute because the majority of the dry powder is currently allocated or earmarked for the LP market. That means the factor of dry powder to transaction volume on the LP side is much lower. We are seeing that in most of the transactions we're doing that there seems to be a very attractive investment environment at the moment.

Anu Rajakumar: Well, that's actually a great segue to my next question, which is about GP-led deals like continuation funds. They've garnered a lot of attention lately. Two-part question for you, Philipp. First, just explain what a GP-led transaction is or how a continuation fund works. Then, second part of my question is going to be about what's holding back this part of the market from even further growth?

Philipp Patschkowski: To address your first question, what it is, so in a continuation fund transaction, a GP sells one or more portfolio companies into a new vehicle that they set up and continue to manage going forward. That allows the GP to participate in that future evolution of the asset. Existing investors in the fund have the option to either take the cash from the purchase price or to roll their commitment into the new fund and participate in the future evolution of that asset. These transactions are capitalized by secondary investors.

Currently, they are representing just shy of 15% of all the distributions that are coming out of private equity funds

Anu Rajakumar: How does that stack up to historical levels?

Philipp Patschkowski: This is the highest number it's been, and to be fair, it's also on a relatively low number of distributions overall, but when we go back to 2019, that number was maybe 2%. Maybe it was a little bit higher, a little bit low, but it's been really on a rising theme here, which, I guess, addresses then the second part of your question, so what is holding back the additional growth? I think it's been growing a lot. What has held it back for more growth is a lack of capital, both financial capital and human capital.

A lot of teams are being currently founded, but it's difficult for investors to allocate capital to what is still a very new subsegment of private equity and especially if a lot of those teams are still very new and don't have a proven track record.

Anu Rajakumar: Sure thing. Well, and that take me to the next question, which is about risks, which I think is something maybe you can address here. Thinking about what you just said, a relatively newer market, but in general, what should investors be mindful of when they are looking at the secondary market, including GP-led deals, and how does that risk and rewards stack up compared to more traditional drawdown-style private equity funds?

Philipp Patschkowski: I think the secondaries are a lower risk entry into what is a high risk asset class, private equity. The benefit of secondary investing, both on the LP side and also on the GP-led side, is the benefit of hindsight, which means that when secondary investors are looking at the portfolios they acquire, whether on through the LP transactions or through the GP-led transactions, they will have a trajectory the GP is on with these assets. What is one of the hidden secrets of private equity is that most transactions that don't go well do so within the first 18 to 24 months of ownership. That's a big level of operational risk that can be eliminated on the secondary side. In addition to that, of course, businesses typically have had the time to grow earnings and de-lever their capital structure, so meaning lower capital structure risk, but also because they're more mature assets that might be closer to an exit, which would mean shorter duration and quicker de-risking of the investments.

Anu Rajakumar: Now, bringing this all back to the context of an uncertain and somewhat volatile macro environment, do you think that it actually creates more opportunities in the secondary space? In other words, how can disciplined investors turn today's challenges, like motivated sellers and shifting valuations, into potentially attractive investments?

Philipp Patschkowski: Historically, the times of volatility have always been a catalyst for additional activity in the secondary market, with a bit of a lag behind it, mainly because they led to lower exit activities as well. Now we're seeing sort of a perfect storm, as it were, on that side of the equation. My perspective, I'm actually very positive about the future need for secondary investors to provide liquidity into the private equity asset class as a whole.

Anu Rajakumar: Terrific. Philipp, thank you very much for all of those comments today. Lots of great content that we've generated from this episode. I can't let you go without a quick bonus question. I would love to know, what is a food or a dish that you always go for seconds on?

Philipp Patschkowski: That is a good question. I like to cook at home, and the one thing that I like to cook also for my three children is pancakes.

Anu Rajakumar: Okay, not American style, though, I imagine. A crepe?

Philipp Patschkowski: European crepe style, and that is one dish that I also enjoy very much myself.

Anu Rajakumar: Do you have any favorite fillings that you particularly enjoy to eat?

Philipp Patschkowski: They come in all sorts of fillings, depending on the weather outside.

[laughter]

Anu Rajakumar: I was going to say, sweet or savory?

Philipp Patschkowski: Mainly sweet.

Anu Rajakumar: Very, very good. Philipp, thank you for sharing that and for your insights on the world of private equity secondaries. [background music] Today, you talked about the evolution of GP-led transactions, the changing pricing dynamics. You talked about the future growth, and if exit activity does indeed pick up, all of these shaping a market that's not just a temporary solution, but really a core part of private equity's future. Thank you very much for being on the show and for sharing this with us today.

Philipp Patschkowski: Thank you for having me. For information, we have a white paper that we publish on our webpage, where a lot of these thoughts are elaborated and lots of depth as well.

Anu Rajakumar: For those who are interested in that paper, it's called Navigating Secondary Growth: Opportunities Beyond The Horizon. Philipp, thank you again for being here.

Philipp Patschkowski: No. It was great to be here. Thank you.

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