The value of co-investment and secondaries, and why GPs are growing more selective

The disruption of the Covid-19 crisis initially prompted fears of a financial meltdown on par with the Global Financial Crisis (GFC). As the first wave of lockdowns began, private equity investors anticipated liquidity shortages, challenges with putting capital to work and possibly distressed, deep value opportunities.

However, 2020 concluded with strong investment returns and the highest volume of new private equity transactions in years. Pricing has been rich and liquidity, so far, abundant. The private equity market seems to be headed for a strong, expansionary period. But uncertainty remains.

These dynamics are fostering significant evolution in the co-investments and secondaries markets. We outline the ways in which the co-investment and secondaries markets are changing, why GPs are growing increasingly selective and discuss the characteristics that could favour the most sophisticated LPs. 

Covid-19 is not a repeat of the GFC

First of all, the current market environment is markedly different from the aftermath of the GFC.

• Increased availability of capital: Unlike the GFC, the Covid-19 crisis has not triggered systemic liquidity shortages. Strong government and central bank responses ensured that economies did not collapse and that the financial system could remain solvent. The private equity industry also continues to have strong support from lenders, which have also grown in sophistication.
• Increased sophistication of GPs and LPs: The private equity market has more than doubled in size since 2009 and the secondaries market has tripled. This growth has vastly increased competition for assets prompting a greater degree of specialisation and sophistication for GPs and LPs alike.
• “Flight to quality”: With profound uncertainty remaining, investors continue to flock towards high quality assets. This has led to a notable polarisation of investment opportunities. Businesses with robust fundamentals are in high demand and those impacted by demand disruption continue to experience reduced investor appetite.

Co-investment and secondaries are highly valuable to LPs  

The increased focus on quality investments, as well as the economic and portfolio construction benefits of co-investments and secondaries, has led to increased LP interest in these two types of investments.

Focus on high quality assets

Co-investments and secondaries help investors to target high quality assets.

With co-investments, LPs can flexibly target the most attractive sectors, geographies and business models at any given point in time. Secondaries, in particular GP-led transactions, give incoming investors the ability to invest alongside GPs in a select group of companies in their fund portfolio. GP-led solutions are structured to ensure full alignment between the investors and GP, incentivising GPs to select their best portfolio companies.

Attractive terms and earlier liquidity

The economic and portfolio construction benefits of co-investments and secondaries remain fully relevant. Co-investments can give LPs access to the private equity market with significantly reduced economics (fee and carry). However, this is not true for all co-investments. As we will discuss later, LPs need to have strong relationships and provide value-add to secure these economic benefits. 

Secondaries can give LPs exposure to the private equity market with shorter holding periods and varying cash flow profiles – transactions ranging from preferred equity to full fund GP-led transactions.

GPs - more selective, more proactive

GPs focus on most valuable partners for co-investments

We have seen the co-investment market evolve towards a greater share of transactions being co-underwritten by co-investors rather than broad post-close syndications. Co-underwriting is the process of assessing and executing a co-investment in parallel with the GP, in contrast to a post-close sell-down (syndication). Co-underwriting gives GPs certainty of funding and minimises the risk of having to overcommit their funds to close transactions, especially at a time when it is prudent to preserve liquidity across the portfolio.

GPs focus on their closest and most reliable LP co-investors – those with enough sophistication and resources to meet transaction timelines and contribute valuable insights during the due diligence process. Deep pockets are also a plus, because that reduces the need to introduce multiple co-underwriting partners.

For sophisticated LP co-investors who can meet those requirements, co-underwriting offers them priority involvement with deals, and often the ability to secure larger overall allocations at attractive terms, as mentioned above.

We go into detail about the qualities that can make LPs more attractive to GPs later.

GPs take control of the secondaries market post Covid-19

The secondaries market has experienced strong growth over the last few years, much of which has been due to the rise in GP-led transactions. This trend is likely to continue. Today’s market is very different from ten years ago, not only in terms of size, but more importantly in terms of sophistication and transaction type.

Until recently the secondaries market was dominated by traditional LP transactions in which GPs were passive spectators, (beyond requiring GP approval to a transfer). The pandemic has further pushed the advance of GP-led transactions, while reducing the volume for LP portfolio transactions. As can be seen in the following graph, market statistics show that 2020 actually saw GP-led transaction volume eclipse LP transactions, with more than $35 billion of GP-led transactions.

Global secondary transaction volume by year

Source: Credit Suisse PFG Capital Solutions Update (December 2020), Lazard (2021)

The rising involvement of GPs in secondaries has been accelerated by the pandemic, which has pushed many GPs to use innovative secondary solutions in their portfolios. In the first half of 2020, with capital markets closed,  GPs focused on supporting their portfolios through the initial shutdowns with preferred equity structures and NAV facilities (credit facilities backed by the portfolio).

In the second half of the year many GPs turned their attention to the companies in their portfolios with good upside potential, but also in need of additional time and, to a lesser extent, capital to grow. These funds are now seeking longer holding periods in the form of secondary continuation vehicles.

Importantly, today’s secondary investors are only willing to underwrite transactions that involve companies that have performed well through the pandemic and where the near-term value creation is clear. This flight to quality has also led to increased asset concentration in the secondaries market, whereas in the past secondary investors sought diversification above asset quality.

How can LPs best position themselves to access to deals?

Strong LP interest for co-investments and GP-led secondaries has increased competition for these assets. LPs with strong GP relationships, resources and reliability of execution are at an advantage over other LPs. Alignment of interests remains a key element for success.

Broad networks of high quality partners

A broad and strong primary investment capability is the starting point of successful co-investment and secondary programs. Without those relationships, LPs are left with limited access to the highest quality transactions and limited insights and information to assess them. LPs who have built those relationships in early fund generations are typically best positioned.

Reliability and resources

GPs and advisors opt to work with their most responsive and reliable LPs. LPs need to have expertise and resources to underwrite specific assets in a short period of time. This requires in-house knowledge of specific industries and business models as well as a sophisticated finance, legal and tax infrastructure. For GP-led secondaries, having the experience and knowledge required to take a lead role in shaping transactions is key.

Deep pockets of capital dedicated to the strategy are also beneficial. For co-investments, especially in co-underwriting situations, the ability to underwrite the full amount required by the GP is valuable because there is no need to introduce more parties into a process. For GP-led secondaries deep pockets allow LPs to underwrite the full transaction and take a lead role.

Increasingly LPs look to provide additional value to GPs and companies. This includes introductions to clients, suppliers or joint venture partners, or providing financing or liquidity solutions. Warehousing of transactions when a GP’s fund is not yet in place and bridge financings ahead of refinancings are growing.

Full alignment of interests

Full alignment of interest with the GP is equally important for both co-investment and secondary transactions. For co-investments it is imperative to invest at the same terms and valuation as the GP. For secondaries, it is important that the GPs roll a meaningful part of their carried interest into the new structure. Just as important as economic alignment, long-term partnership with GPs also provides strong assurance that GPs will treat co-investors and secondary investors fairly.

Key take-aways

The Covid-19 crisis is fostering evolution in the co-investment and secondaries markets, which benefits the most sophisticated LPs. GPs are looking to their most proven and long-term LPs to co-underwrite a higher share of co-investments. In the process the lines between co- and direct investments are blurring. In secondaries, GPs have gone from being passive spectators to lead drivers of transactions. The rise in size and complexity of the GP-led market favors LPs with the required experience and resources. A strong network of primary relationships becomes increasingly important for access to high quality transactions and insights.

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