Anthony Minnefor
Anthony Minnefor is partner-in-charge of the New Jersey and Pennsylvania financial services audit and assurance practice at EisnerAmper.

As LP-led transactions have continued year after year unabated and have grown in sophistication, a large, noticeable trend has emerged in the last 10 to 15 years in the secondary market – the rise of GP-led secondary market transactions. Here’s what private equity firms need to know about this growing trend.

For many years, private equity has been challenged with providing a liquidity mechanism for its large limited partner (LP) investor base. Historically, the primary way an LP could convert its investment to cash before the expiration of a fund’s contractual term would be if the LP itself initiated a transaction and at times participated in finding a prospective buyer.

In these LP-led transactions, the general partner (GP) of the fund would often facilitate matters and, unless circumstances warranted, would sign off on the transaction with modest involvement in the process. Such LP-led transactions were commonplace and constituted the largest portion of the private equity secondary market. In recent years, LP-led transactions still constitute the largest segment; GPs themselves are now more active in these transactions, using their common right under a fund’s limited partnership agreement (LPA) to manage information flow and approve who can be admitted to the partnership.

As LP-led transactions have continued year after year unabated and have grown in sophistication, a large, noticeable trend has emerged in the last 10 to 15 years in the secondary market – the rise of GP-led secondary market transactions.

Drivers of GP-Led Transaction Trends
As private equity has matured as an asset class, its status and reputation as a purely illiquid investment has evolved and become much more nuanced. The traditional 10-year fund term is often not enough time to fully implement a GP’s value creation plan; portfolio companies are complex organizations that don’t always develop and increase in value strictly in accordance with a fund’s contractual timetable.

As a result, in years 8 through 10 of a typical fund’s contractual life, tension is sometimes present between the GP’s desire to further grow and add value to its remaining portfolio companies and the LPs’ desire to achieve liquidity and reallocate their capital. This tension and other market conditions have therefore given rise to the increased prevalence GP-led secondary transactions. Such transactions provide an opportunity for GPs to further execute on their value creation plan, often with the ability to invest new capital into portfolio companies provided by a new secondary market investor. From the LPs’ perspective, the secondary market provides them with a tool that allows for greater precision in overall portfolio management.

Growing Secondary Fund Formation
Fundraising statistics provide clear evidence of the increasing demand for private equity solutions, especially in recent years. Funds dedicated to a secondary market strategy are being launched at a rapid pace and are now a sizable segment of each year’s total fundraising pie.

According to Private Equity International (PEI), secondary fundraising (private equity, real estate, infrastructure and credit) in 2020 nearly tripled compared to the year before, with $95.6 billion raised in 2020 vs. $33.1 billion raised in 2019. Secondary funds raised in 2020 accounted for approximately 15 percent of the total, and with the continued interest in GP-led transactions, this trend is expected to continue. In addition, secondary market investors are also large institutional investors themselves who can often add insight and advice to the GP leading a current transaction; they may also be a potential source of new and large amounts of capital to a GP’s successor funds.

Structuring and Execution
GP-led secondary transactions typically take the form of either an LP tender offer or a fund restructuring. In an LP tender offer, a secondary buyer acquires certain LP interests in an existing fund. In a fund restructuring, a newly created investment partnership acquires defined assets from the predecessor fund. In many respects, fund restructurings are sales of assets whereby the same party (the GP) is on both sides of the same transaction. New capital (the secondary fund) anchors the buying fund’s LP base and generally provides LPs in the selling fund the ability to cash out or rollover their LP interest into the new fund. Significant tax benefits can potentially be obtained by the rolling LPs; deep involvement from legal, tax and other advisors is expected and well-advised.

Best Practices
GP-led transactions are clearly quite complex and typically require time, patience and the ability to resolve multiple objectives that are sometimes not in alignment. Best practices and recommendations provided by the Institutional Limited Partners Association (ILPA) for fund restructurings have been useful both to protect LP interests in these transactions and to guide GPs in running a process where all parties are satisfied with the outcome. ILPA’s best practices and recommendations include:
• GPs should share the transaction rationale with the limited partnership advisory committee (LPAC) and in some cases a broader set of LPs as early as possible in the process to provide adequate time for consideration.
• An LPAC’s defined role is contained in a fund’s limited partnership agreement and generally involves the review and resolution of conflicts throughout a fund’s life; the LPAC can provide guidance to the GP throughout a fund restructuring process to ensure that the process is transparent, efficient and fair.
• In presenting a comprehensive rationale for the restructuring, the GP should provide information on the quality and outlook for the fund’s remaining investments among other information.
• Before the terms of a deal are presented to Limited Partners as an election, any conflicts related to the transaction, particularly where the GP may receive a benefit that does not accrue to the Limited Partners, should be identified, mitigated where possible, and approved by the LPAC.
• LPAC members should be provided enough information to assess whether the GP-led process was appropriate to ensure that a fair price was obtained; a fairness opinion from an independent financial advisor may be helpful in this context.
• Limited Partners should be afforded sufficient time—no less than 30 calendar days/20 business days—to thoroughly evaluate the GP proposal and return their respective election forms.
• The GP should engage an experienced advisor to solicit bids for the portfolio of assets.
• The LPAC should review the GP’s selection of the advisor, including the advisor’s role, scope of services and the fee arrangement.

A close look at the drivers of GP-led transactions clearly shows a fundamental shift in the very nature of the private equity asset class. GPs and LPs alike will be searching for liquidity and establishing recurring programs to achieve such goals. In future years we should expect to see more and larger pools of secondary funds being formed. This capital will be under significant pressure to be deployed, so it will become commonplace for GPs with long-dated funds containing valuable assets to be approached with liquidity offers. This trend may ultimately change the long-standard 10-year term of a private equity fund and allow for liquidity at various points along the trajectory a fund’s life cycle.