Monday, 14 November 2022

One deal, One party – the pro’s and con’s of a GP-led secondary (for both investors and private equity)

In recent times, a cocktail of ample, free money and limited to no return on the fixed income markets, drove investors in search for yield towards private equity. These private equity funds typically have a lifespan of around 10 years. While, again in recent times, sales of portfolio companies was not a big issue considering valuations went up, taking into account the following:

  1. A booming equity market ensured that an Initial Public Offering (“IPO) was a valid option
  2. due to the significant increase of available money at the level of private equity funds, sales of a portfolio company to another private equity fund (or any other party) was a successful option considering the increase in deals and deals amounts

Different factors making sales difficult

However, the picture now is completely different with an economy facing difficulties, amongst others, due to:

  1. Inflation is back. While inflation alone is already an important factor – certainly given the height of current inflation percentages, the increased inflation has another effect, being money is no longer free. Interest rates are rapidly increasing.
  2. Uncertainty due to the war in Ukraine and Russia
  3. Uncertainty still due to the corona virus
  4. Economic hick-ups due to the revival after the pandemic

This resulted in the worst 6-months period (January – June 2022) on the stock market (a leading economic indicator) since the financial crisis back in 2008. Therefore, an IPO is a less attractive option. Moreover, overall, valuations faced a correction.

Alternative route: GP-led secondary

Therefore, given the rather strict lifespan of a private equity fund, these funds looked for other options. Rather than to sell under duress to another party, or to opt for an IPO, an increasing number of private equity funds decided to go for a GP-led secondary, i.e., umbrella term which refers to a liquidation transaction triggered by the general partner (“GP”) of the private equity fund. These transactions allow the GP to continue to manage the portfolio company, while obeying to the terms and conditions of the initial private equity fund by delivering a return to the investors. A common GP-led secondary is the establishment of a continuation fund which purchases one (typically the crown jewel of the fund) or more assets (i.e., portfolio companies), thus providing a liquidity option, i.e., cash-out on the fund, or invest in the secondary fund.

While in theory, this is a win-win for both GP and investors, in practice these kind of transactions result in a conflict of interest. Indeed, it could be more interesting from a GP perspective to deflate the value of the portfolio assets, specially if the initial fund will pass the pre-agreed return (8% on average) and thus will pay out carried interest to its GP (vice-versa, it can be interesting to inflate the value to receive carried interest). By doing so, GPs can make sure to receive carried interest (potentially twice) as well as charging management fees as a proportion of the amount it invested in a company – which will invariably be a higher amount than the initial fund paid1.

Fairness opinion

Due to this conflict of interest, the Securities and Exchange Commission (“SEC”) is scrutinizing the model and is planning to require a fairness opinion when a fund sells to themselves. It is not clear whether the Belgian Financial Services and Markets Authority (“FSMA”) or EU are planning the same.

However, for both GP as well as investors alike, a fairness opinion is highly recommended to ensure transparency and decrease the exposure to risk of conflict of interest.

Reach out to the author for more information.

Kenny Van Tulder - Senior Manager (kenny.vantulder@tiberghien.com)


1 Typically, the GP charges management fees during the investment period (the first years of the fund) as a percentage of the money committed. Afterwards, the GP charges fees as a proportion of the money used to buy the portfolio companies that the fund has not yet sold.