Over the last five years, many private equity market participants have become acquainted with a “GP-led secondary” transaction – i.e., a transaction where a private equity sponsor proposes to transfer all or a portion of the assets managed by an existing fund into a new “continuation” fund that will be managed by the same private equity sponsor. In such a transaction, the equity capital generally comes from a combination of “secondary” capital providers that are putting new money into the deal (to cash out limited partners that wish to get liquidity and often for follow-on capital for the benefit of the continuation fund), existing limited partners that wish to “roll” their existing fund interests into the continuation fund and the sponsor itself who may “roll” all or some of its carried interest generated by the transaction and, sometimes, commit incremental capital to the continuation fund.
While this type of transaction was once associated with troubled funds that were “long in the tooth” and couldn’t find suitable exits for their portfolio companies, this is no longer the case. Many of the world’s largest and most preeminent sponsors have recognized the win-win-win opportunity that these transactions can provide to (1) a fund’s existing limited partners who can choose either liquidity or to remain invested on the same or better terms as their existing investment (albeit generally with a longer fund term), (2) the sponsor who can manage assets longer to create more value and have an opportunity to earn incremental management fees and promote from new and existing investors and (3) the secondary capital provider who can diligence and underwrite the assets in which it wishes to be invested and create bespoke alignment with a sponsor. These benefits – coupled with the significant amounts of buy-side capital available to support the strategy – have resulted in GP-led transactions going mainstream.
With the maturation of the GP-led market, participants have come to appreciate that the deal technology used to consummate a GP-led transaction can also be applied to a single portfolio company and, as such, there has been a meaningful uptick in GP-led “single asset” deals in the last couple of years. In the wake of COVID-19’s disruption to what otherwise may have been well-laid portfolio company exit plans, we expect volume in the single asset GP-led secondary market – particularly for high-quality assets – to grow and be seen as another viable option in the exit toolkit alongside (and perhaps concurrent with) a third-party sale, IPO or, more recently, a business combination with a SPAC.
A GP-led single asset transaction requires careful consideration of the following items:
- Sponsor Conflicts: It is well understood that GP-led transactions pose a number of conflicts of interest for the sponsor who is on “both sides” of the deal – on the one hand, as a fiduciary to the Fund selling the asset(s) and, on the other hand, as a participant alongside the buyer group and as the manager of the continuation fund where carried interest will get re-set. The market has aligned around certain best practices to mitigate this conflict, which include: a banker-intermediated auction process to solicit bids; robust disclosure of financial and operational info about the target company, as well as clear disclosure of transaction terms (including conflicts); limited partners being given a choice of liquidity or rolling their interests generally on the same terms (or better terms that may be offered to the secondary capital provider); approval of the fund’s LPAC and/or limited partners; and a fairness opinion from an independent investment bank. The foregoing technology is often used in both multi-asset and single-asset deals but, in our experience, limited partners often take a harder look at the sponsor’s rationale in a single asset process and, as such, sponsors should proactively communicate with limited partners as to why a single-asset deal is the right exit path as compared to other, more traditional liquidity events. Sponsor motivation and transaction rationale are critical elements in assessing a GP-led secondary transaction. While multi-asset deals are motivated by many reasons (e.g., seeking to extend the investment period or life of a fund, seeking additional investment capital), in single-asset deals the sponsor is usually motivated by the belief that the portfolio company has additional upside potential but is not ready to be sold because it needs more time (and potentially more capital) to maximize value.
- Valuation: In the U.S., in a typical third-party sale of a private equity portfolio company, the target company’s enterprise value is negotiated and the target is often then sold on a “cash-free, debt-free” basis with an adjustment for transaction expenses and a normalized level of working capital. In a single-asset deal, however, the target company’s valuation is often based off of a reference date of the fund’s financial statements and, depending on the asset, priced at a discount or premium to such reference date financials – there typically aren’t adjustments for cash, debt or working capital and instead, purchase price adjustments are limited to contributions from, and distributions to, limited partners in respect of the target company from the reference date through closing. Notwithstanding the distinctions between these two paradigms, as the market is evolving and maturing, sponsors are starting to utilize more creative and bespoke ways to support portfolio company valuation – one recent example included a sponsor running a process to sell a minority stake of the portfolio company to a third party investor, with such valuation then serving as the reference price for a subsequent single-asset GP-led secondary process. Single-asset deals also lend themselves nicely for contingent consideration structures which would allow limited partners electing liquidity the ability to participate in a portion of the upside and, as such, we expect to see increased use of earn-outs to help bridge valuation gaps and facilitate the win-win-win purpose of these transactions.
- Deal Execution and Portfolio Company Considerations
- Diligence: A single-asset diligence process often looks more akin to a traditional third party sale – i.e., the buyer engaging industry consultants, commissioning a quality of earnings report and taking up a significant chunk of portfolio company management time and effort – as opposed to a more diversified multi-asset GP-led process where the burden on portfolio company management may be limited to a day of Q&A (and, pre-COVID, a site visit). Sponsors and their management teams thus need to be prepared to respond to the buyer’s diligence requests and map out a plan for completing diligence and moving to document execution.
- Portfolio Company Management Team: To the management team – particularly a team just put through a robust diligence exercise – the GP-led single asset deal may feel akin to a change of control process that triggers bonus and other exit payments. A careful review of the portfolio company management equity documents is required to see if any such payments are due as a result of a GP-led single asset sale and whether management are taking any money off the table or “rolling” back in is an important consideration for buy side participants. In any event, regardless of what is required by the management equity documents, the secondary buyer is going to need to get comfortable that the portfolio company management team is appropriately incentivized to create value and thus, even where a change of control payment is not required, some sweetener or new management equity plans should be considered.
- Third Party Consents: As with a traditional third party M&A process, a secondary buyer is going to want to get its arms around what portfolio company actions are required to effect the transaction. These could include approvals from or obligations to notify antitrust/competition authorities, industry-specific regulators (e.g., FCC, FERC, state insurance regulators, etc.), lenders or equity co-investors that may have liquidity or acceleration of repayment rights in respect of such a sale. The timing and degree of difficulty will need to be well understood and the sponsor and secondary buyer will need to agree on the appropriate risk allocation in respect of obtaining any third party consents.
- Stakeholder Communication: Regardless of what third party consents are ultimately required, sponsors and their portfolio companies should agree on a communication plan (and whether such communication plan will be proactive or reactive) in order to explain the transaction to key stakeholders, many of whom may read about the deal and assume that there’s been a portfolio company change of control or sponsor exit.
- Alignment with Buyer: As noted above, these transactions often involve a reset of carried interest calculations with respect to secondary capital providers (and, in some transactions, the option for existing limited partners to elect into such economics as well). Waterfalls in secondary transactions, including single asset deals, typically reset invested capital at the secondary buyers’ purchase price and often involve multiple hurdles and tiers. The secondary market views such waterfalls as creating a strong alignment for a sponsor to maximize returns. Note that for those existing limited partners rolling on the “same” terms as the existing fund, economics should be thought of like they would be for an “alternative investment vehicle”, and thus economics will continue to be “netted” with the performance of the existing fund.
It should also be noted that in a single-asset secondary, secondary buyers will often negotiate caps on transaction fees and monitoring fees that can be taken by the sponsor (even with management fee offsets remaining intact). They will also negotiate for a minimum investment amount, which requires setting the deal price at an amount that generates sufficient interest by limited partners to sell rather than roll.
- Sponsor Considerations: Sponsor are often required to “roll” realized carried interest from a single asset secondary into a deal. However, secondary buyers will often take a more granular view as to “who” is rolling, with a focus on senior management of the sponsor and the deal team. Therefore, there may be an opportunity in a single asset deal to cash out former team members, and to incentivize more junior team members.
- Buyer Considerations: Given the sponsor economics that are customarily attached to a single-asset deal as compared to a co-investment (which is oftentimes done on a “fee-free” basis), some may question whether single-asset GP-led transactions are akin to a promoted co-investment. In order to justify the promote and fees paid to a sponsor, a secondary buyer will look for certain critical factors. In addition to GP-alignment, secondary buyers in a single-asset deal are going to be laser-focused on the quality of the portfolio company and the pathway and time horizon to achieving a successful exit. Secondary buyers will want to understand any previous attempts by the sponsor to exit the portfolio company and why such exit did not get across the finish line – prior failed deal processes and gaps on exit valuation should be considered with some skepticism as to whether the particular portfolio company is a suitable candidate for a single-asset deal. Additionally, secondary buyers will hone in on the quality of the portfolio company’s management team and whether the company is already executing on a solid business plan which requires more time to continue growing and creating value or whether there is a re-tooling of the company’s strategy which could subject the company to meaningful execution risk and a longer time horizon (i.e., more akin to that of a co-investment) to achieve an exit.
Properly executed, a single asset secondary can be beneficial to all of the relevant parties. As the popularity of single asset secondary deals grow, sponsors and their advisors should be taking steps to make them easier to execute. Fund documents should have clear rules about how such transactions are approved along with a waiver of liability for a sponsor who complies with such rules. Lawyers drafting contracts should be thoughtful whether a single asset deal should result in change of control, tag-along rights, vesting of management incentives and other predictable consequences.