Nick Lawler serves as a Managing Director and Head of Secondaries on the Private Equity and Junior Capital team at Churchill Asset Management, based in Chicago. His responsibilities include oversight of origination, underwriting and portfolio management activities for secondary investments. Ahead of SuperReturn International, read on to find out why the GP-led middle market is starting to boom and what we can expect to happen in the coming years.
What factors are contributing to the increase of GP-Led transactions in the middle market, and what impact is this having on the broader M&A market?
The GP-led market largely came into focus in the ~2012-2014 time frame with the growth of fund level “restructurings,” recapitalizing private equity funds that had been adversely affected by the Global Financial Crisis, and often carried negative connotations of supporting Zombie firms. Fast forward to 2018, when the concept of continuation funds (also referred to as continuation vehicles or “CVs”) began to emerge. In the early days of CVs, some of the largest and most respected private equity firms identified franchise businesses within their portfolios where returns had been outsized already, but there remained significant opportunity for future growth. The CV solution generated liquidity for LPs, provided them the option (but not obligation) to re-invest proceeds alongside the sponsor, and aligned all parties with new secondary investors to capitalize on future growth.
Since 2018, there has been in excess of $260B in CV volume and today, more of the largest 100 sponsors, globally, have accessed the CV market than have not [1]. Yet, that growth has also proliferated downstream, with mid-market sponsors leveraging the technology to accomplish similar goals. At Churchill, we’ve seen fewer $1-2B CVs over the last two years, and far more mid-market transactions sized in the $200M to $600M zip code. In our view, this dynamic is directly impacting the sponsor-to-sponsor M&A market. Assets that historically would have traded up to large-cap sponsors are now going the CV route, and we don’t see that slowing down. Early data appears to support this notion as the CV market continues to grow – from 5% of all PE exits in 2021, to 7% in 2022, and 12% in 2023 [2].
What are the key differences between single-asset continuation vehicles and equity co-investments?
CVs have been referred to, unfairly in our view, as “co-investments with fees.” In our view, co-investments are a very different animal. New LBOs involve meaningful up-front due-diligence by the sponsor and the establishment of a new value-creation-plan that may (or may not) ultimately prove to be successful. There are also material unknowns in a new LBO – whether risk of fraud, weaker than expected customer relationships, or unanticipated C-suite changes; until a sponsor has owned a business for some period of time, these remain risk items. With CVs, there should be far fewer unknowns. Good candidates for a CV include high-performing businesses owned for at least three years, operating in markets with significant tailwinds, and generating returns in excess of the original underwriting case, with more room to run.
While economics are structured in CVs to compensate sponsors, these are generally done so in a way to provide secondary investors downside protection and upside capture, with superior alignment of interests in terms of the sponsor’s personal capital at risk. Over time, CV-focused secondary strategies will likely be compared directly to that of co-investment strategies. Early performance data, published by Morgan Stanley in January ’24, makes a strong case for the CV asset class, with the 2018 to 2020 vintages of single-asset CVs delivering median performance of a 2.2x net MoC, and upper quartile performance of a 3.3x net MoC. Hold periods for CVs, should also be lower than traditional co-investments. Given a sponsor isn’t having to do the heavy lifting in a new LBO that oftentimes requires taking a company one step backwards to go two steps forward; in CVs, management teams are focused, and the value creation plan is already in place.
Headline market reports point to record levels of dry powder in the secondaries industry, is the market undercapitalized or overcapitalized, and how do you expect that to evolve in the next three to five years?
From our perspective, the secondaries industry is severely undercapitalized in nature. While absolute levels of dry powder are at record levels, looking at relative levels (annual deal volume to actual unfunded equity available), we are at some of the lowest relative levels seen in recent years. Market surveys across secondary advisors ranged from ~$150B to ~$180B of available dry powder as of year-end 2023, and often referenced well in excess of $200B+ inclusive of funds expected to be raised over the next year. Notably, data published by Private Equity International in April 2024, reported only $7 billion raised in Q1, 2024 for secondaries funds, a 77% drop year-over-year. Said differently, dry powder in the secondaries market is shrinking, not growing.
Like many areas of investments, capital tends to lag opportunity. But in the context of $10 trillion+ of global alternative asset NAV outstanding, and a $115B secondary market, we’re talking about a 1% churn rate. We believe the growth opportunity for the market to double or triple in size, over the next three to five years, is well within the realm of possibility.
References
[1] Morgan Stanley, The Case for Continuation Funds: An Initial Performance Review, January 2024
[2] Jefferies Global Secondary Market Review, January 2024
Want to learn more about GP-led transactions in the middle market? Join Nick at SuperReturn International 2024!