This article is written by BackBay Communications.
The current private equity environment is as challenging as it’s been since the wake of the global financial crisis. Managers are struggling to raise capital and to offload assets, with the latter problem only serving to compound the former. Of course, the drivers of today’s woes are much different than they were in 2008-09. Higher financing costs in an elevated interest rate environment, and persistent macro uncertainty, have driven deal value and deal count down 60% and 35%, respectively, in 2023 from their peaks in 2021. Over this same period, exit value has declined 66%, and the number of funds closed fell by nearly 55%, according to Bain's Global Private Equity Report 2024.
Getting unstuck
Dry powder has piled up. There are currently 28,000 unsold companies weighing on buyout portfolios globally, of which more than 40% are at least four years old, according to the report. With dwindling exit routes, General Partners (GPs) are under pressure to find new, creative ways of returning capital to their investors. Distributions from buyout sponsors have plunged almost 60%, from $1.2 trillion in 2021, to just $530 billion in 2023, according to data from investment banking group Baird[1]. There were even steeper declines in distribution to paid-in capital (DPI) – the amount of capital returned to the investor, and a KPI that has overtaken the internal rate of return (IRR) as the metric in focus for many cash-deprived LPs. DPI for 2019 – 2022 vintage funds by the end of 2023, at 0.1x DPI, is 81% lower than the corresponding average DPI for 2015 – 2018 vintages was by the end of 2019. In their hunt for liquidity, Limited Partners (LPs) are looking to sell their interest or rebalance their exposure across strategies, geographies and funds.
Enter secondaries – a market with willing sellers and buyers – and an asset class that grew faster than any other in 2023, according to Bain. It is the only alternative asset class where even the bottom quartile delivers a positive return [2] and the popularity of GP-led exits through continuation funds is a key driver. Indeed, continuation vehicles are estimated to have made up around 10% of all distributions made to LPs in 2023 [3].
GP-led growth
The GP-led secondary market continues to thrive thanks to demand for both single and multi-asset continuation funds, whereby the GP sells one or more assets from one vehicle to another while giving their LPs the choice of cashing out or “rolling” their exposure over into the new fund. These vehicles have become a preferred exit route for the GPs looking to buy more time and secure more capital to maximize value in their most promising companies – an important lesson learnt from the post-financial crisis period when many managers made the mistake of letting go of high-quality assets too quickly.
Continuation funds comprise assets that have been cherry-picked by the GPs, and typically have resilient business models, strong performance potential and a shorter payback period since they are already approaching the harvest stage of the J-Curve. Since the fund is managed by the same GP, there is generally a high degree of familiarity and alignment among the management, GPs and LPs rolling over their exposure. Meanwhile, new investors can back these assets, that are not available in the M&A market, at discounts to net asset value (NAV) in the hopes of capturing the upside.
The value proposition of GP-leds is even more compelling in the middle market, where there is greater potential for outsized returns. According to Lazard’s Private Capital Advisory Secondary Market Report 2023 [4], 61% of continuation funds launched in 2023 by mid-market sponsors were equivalent to at least half of their latest flagship fund size. As more mid-market GPs turn to secondaries as a portfolio management tool – instead of selling off their best assets to their peers – we should see an influx of middle market opportunities.
It is no wonder then that single-asset continuation vehicles are expected to grow from around 40% of the GP-led market in 2024 to 50% of the overall market by 2028, according to PJT Park Hill’s latest Secondary Market Insight report. They were the largest secondaries transaction type last year, followed by multi-asset continuation funds which continue to attract those seeking diversification not just by sector and geography, but also by vintage year to mitigate point-in-time risk.
Ample room for additional capital
Market supply has been ratcheting up over the last year. There are now 181 secondaries and secondaries direct funds with a combined aggregate target of $129.9 billion, according to Preqin [5]. The question is whether demand can catch up in this capital-constrained market; Will fundraising be able to keep up with deployment? According to some estimates, the supply of potential secondaries from GPs currently exceeds demand from buyers by about three times [6]. There is just $177 billion of secondaries dry powder – going by the pace we’ve seen over the past two years of more than $100 billion of annual transaction value, this is enough to sustain just one and a half years of deal flow [7].
The good news is demand is picking up. In this buyer’s market, investors have their pick of trophy assets, which are priced at very attractive levels. Lazard found that 54% of single-asset transactions, by volume, were priced at par or above in 2023, while 60% of multi-asset transactions were priced at 90% or higher. As macroeconomic conditions stabilize, pricing is expected to continue to improve through 2024.
This will help rebalance the scales of supply and demand, as new entrants seek to take advantage of reasonably priced high-conviction assets with a clear path to financial performance. Opportunistic investors are flocking to secondaries like never before – this includes more diverse and non-traditional buyers, including wealthy individuals looking for both access to alternatives and liquidity solutions.
With heightened LP competition for deals, specialization – whether by strategy or sector – will become an important differentiator among emerging buyers, as well as an important driver of future fundraising and deal volume. Industry expertise, within and beyond private equity – in the fast-growing areas of infrastructure and private credit, for example – will allow the buyer to more effectively underwrite and value assets. This is a much needed contribution at a time when price improvements risk fuelling unrealistic expectations and lofty valuations.
Secondary funds raised 92% more capital in 2023 than they did in 2022, according to Bain. Looking ahead, there are good reasons to be optimistic for another record year for the secondaries market. More GPs with deep experience in traditional buyout strategies or with specialized sector knowledge are seeing the merits of continuation funds. The outlook for buyside capital is bright, as GPs that have successfully completed deals on the sellside join the buyside, while private markets continue to open up to a growing pool of investors. The way things are going, there will be a robust opportunity set for these investors to capitalize on.
References
[1] https://www.nb.com/en/global/insights/insights_opportunity_in_the_undercapitalized_world_of_private_equity_secondaries
[2] https://www.preqin.com/news/fundraising-boom-as-private-equity-secondaries-market-heats-up
[3] https://www.ft.com/partnercontent/guernsey-finance/continuation-funds-the-rise-of-gp-led-exit-liquidity.html#:~:text=A%20Continuation%20Fund%20is%20a,invest%20their%20holdings%20into%20the
[4] https://www.lazard.com/media/4olcdlm2/lazard-2023-secondary-market-report.pdf
[5] https://www.preqin.com/news/fundraising-boom-as-private-equity-secondaries-market-heats-up
[6] https://ionanalytics.com/insights/mergermarket/pe-continuation-funds-gp-appetite-for-secondaries-faces-supply-demand-imbalance/
[7] https://ionanalytics.com/insights/mergermarket/pe-continuation-funds-gp-appetite-for-secondaries-faces-supply-demand-imbalance/