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Once upon a time, in the jargon of private equity, a “secondary” would have meant one master of the universe selling to another. Now, it could easily refer to a buyout fund flogging assets to itself.
In the twilight years of the pre-crisis credit boom, the growth of secondary buyouts prompted concerns about dwindling investment opportunities, ailing returns and valuations detached from the strictures of public markets.
As another cycle falters — one where ultra-low interest rates facilitated debt-fuelled deals and sucked money into ever-larger funds — the emergence of so-called GP-led secondaries where a group effectively sells to itself raises similar questions. It is presented as a win-win for private equity shops, known as general partners, and their investors. It won’t be.
This debate, typically, is muddled by a variety of terms that are used to refer to various different deal structures. But the general idea is that passing assets, either singly or in a portfolio, from one fund to another within the same group is just another tool in the toolkit, alongside selling to a strategic buyer, another buyout firm or pursuing a listing.
Investors in the original fund, known as limited partners, are given the option to cash out or to roll into the new fund. Third-party money, sometimes from investors like sovereign wealth funds or other private equity groups but often from the “secondaries” market where LP stakes can be traded, is brought in to fill the gap (and set a price).
The theory is that investors get more flexibility. Funds get to capture the remaining upside in what are usually presented as prize assets, rather than handing it over to someone else.
For a start, it is a bit rich for the sector to promote the “optionality” this gives its customers. Buyout funds have historically been sniffy about investors selling stakes in the secondaries market, which they have now co-opted for their own ends. As sell-to-yourself deals have surged, these GP-led transactions now account for over half the market, according to Jefferies.
Investors, meanwhile, signed up for a find, fix, flog model that turns assets round within the life of a 10-year fund. True, some single-asset deals may involve gems that merit treasuring. But on a basic level, these deals reflect that something has gone wrong, or at the very least not delivered in the promised timeframe.
There will be more of them. Market convulsions make attractive exits harder to find. These deals, say industry figures, are best used where there is another leg of the growth plan, or a need for fresh funds, to make the most of a good asset. In reality, some concede, the quality of assets and the rigour of deal governance varies considerably.
Pricing is the obvious issue. Concerns about the cosy juicing of private valuations led Amundi’s chief investment officer to comment that parts of the industry look like a pyramid scheme. But original investors could equally lose out where an asset is transferred at a lower price than its full market value.
The US regulator’s proposal to require an independent fairness opinion is inadequate. But its consultation has pierced the industry omertà, exposing divisions. The sector lobby group in its response bemoaned “burdensome requirements” reducing returns. The body representing investors commented that “the most meaningful shift in market practice would be to address the conflicts of interest . . . more broadly.”
One issue is asymmetry of information and experience: deal-savvy private equity groups can be asking thinly staffed investment offices unaccustomed to these types of transactions to make unreasonably quick decisions on the basis of limited information.
Another is the recutting of terms. Logically, that should benefit existing investors. Instead, it can introduce “super-carry” or other changes to the advantage of the buyout fund. These are bespoke, negotiated deals. But terms are often proposed by new investors bidding to take part: as more money has chased after deals, “GPs have taken advantage of what has been a very competitive market”, says one adviser.
Private equity’s time horizons were already straining at the confines of the 10-year fund, a vehicle designed for the recycling of capital and extraction of profits. The explosion of sell-to-yourself deals should mean pressure to diversify investment structures to better suit what’s now being delivered. Meanwhile, others should contemplate what another lever for keeping assets in private hands for longer could mean for public markets and those like pension funds that still predominantly invest in them. This self-sale innovation poses questions for everyone.
helen.thomas@ft.com
Twitter: @helentbiz
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