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March 15, 2022

The Pick of Private Equity: Single-Asset Secondaries

March 15, 2022

The Pick of Private Equity: Single-Asset Secondaries

Market Insights

The Pick of Private Equity: Single-Asset Secondaries

March 15, 2022

The GP-led secondary market has witnessed a brisk pace of growth in the past two decades with a flurry of transactions in recent years. In 2021, GP-led secondaries represented 51% of the $135 billion overall secondaries market, a record year in deal volume. ¹ Forecasts suggest another banner year in 2022, with deal volume expected to rise as much as 20% year on year.² In this Q&A, Nash Waterman, Portfolio Manager and Head of Private Markets Secondaries, discusses the growing opportunity set for General Partner (GP) led deals, spelling out why we believe the sector and the single-asset segment, in particular, are attracting growing investor interest.

Where did GP-led secondaries start?
NASH WATERMAN (NW): Like the wider secondaries market, GP-led deals were designed to solve a problem. In the early 2000s, financial groups needed to spin out of banks and GP-led secondaries became an efficient way to lift out these assets and teams. From there, the market evolved quickly, as the suitability of GP-led deals for use in other situations quickly became apparent.

Today, single-asset transactions are the fastest growing area of the secondaries segment. The deals are gaining favor, as they provide existing GP and Limited Partner (LP) investors the ability to double down on their best portfolio assets or for LPs to take liquidity, while opening up access to outside investors without the need for highly competitive bidding processes.

At which point did you notice a divergence from the LP-led secondaries market?
NW: In the early 2010s, GP-led secondaries experienced exponential growth driven by post-crisis fund restructurings. With the deals evolving into highly bespoke solutions, we became skilled in the more customized and surgical approach these type of transactions require.

We began structuring deals to lift out the specific assets that we found to be the most compelling. Unlike traditional LP-led deals, or multi-asset GP-led deals for that matter, where secondaries investments involve exposure to multiple assets at the portfolio level, this new approach allowed us to mitigate unwanted broader portfolio risk. Fast-forward to today and the single-asset model now stands as a functionally distinct segment of the secondaries market.

Early on, however, these deals were a novel concept and we had to convince GPs that single-asset deals could help to maximize value. To start, we oriented the conversation toward problem solving. For instance, we would ask, “Do you need a solution that brings in fresh capital?” or “Do you need more time to compound value for a prize asset?” Oftentimes, that potential value would be sacrificed due to a lack of funds or premature exit. Single-asset deals open the way to unlock that additional value, which is a key reason we coined the term “transformational secondaries” back before a standard nomenclature existed for these transactions.

Why are GP-led secondaries so attractive to investors?
NW: In our view, the sector offers the best access to top-quality assets in the middle market. Consider, too, that within private equity the penetration of secondaries activity is relatively low. In practice, this has tilted purchasing power toward buyers as primary deal activity has outstripped secondaries demand, creating a growing universe of investable assets.

As a result, managers such as ourselves can be highly selective and intentional about adding positions to the portfolio and managing risk. Put simply, we are able to cherry pick the best assets in an opportunity set of holdings that GPs view as the most attractive companies in their portfolios.

Relative to other segments of the secondaries market, single-asset deals stand out for their return potential. According to recent research by PJT Partners, nearly two-thirds of secondaries investors (62%) are targeting net IRRs of 20% or more in the single-asset segment.³ In comparison, return thresholds for the multi-asset GP and LP-led segments are much lower, with only 40% and 16% of investors targeting returns as high as 20% or more, respectively.

Based on the fundamental performance and embedded value that we see in our own strategy, we believe that these investors’ expectations for single-asset deals are realistic and achievable for allocators deploying capital into the space today.

How does an allocation typically fit into an investor’s portfolio?
NW: In our experience, investors typically see these deals fitting in a few different ways. First, they view single-asset secondaries as a definitive alpha source within private equity. They see the value of the prize assets being sold, which, when combined with their shorter duration and lower volatility characteristics, make for highly compelling investments.

Second, to the extent that assets are sold out of portfolios into continuation funds, an allocation to a focused singleasset secondaries fund can capture value that an investor might otherwise have lost—i.e. as an investment, they can help to fill a gap left in the portfolio.

More generally, we would argue that the divergence that we’ve highlighted between LP and GP-led deals should be reflected in investors’ planning. That is to say that secondaries should not be thought of as a single bucket.

The two segments exhibit different risk and return characteristics and the simple fact that the GP-led market is now larger than the traditional LP-led segment suggests that a dedicated allocation to the sector warrants consideration.

These are complex investments. What skills are involved?
NW: As with other differences discussed above, investment skillset is an area where LP and GP-led single-asset deals starkly diverge. The intricacies involved in sourcing, undertaking due diligence and executing on single-asset deals explain precisely why investors can earn a complexity premium in the space.

Below, we explain the steps that the Morgan Stanley Investment Management Private Markets Secondaries Team has taken in each of these areas to gain an edge.

SOURCING. We built a dedicated sourcing subgroup focused exclusively on deal origination. Our team members meet regularly with GPs to develop networks that will sustain a proprietary pipeline of the choicest opportunities. As incubation periods for a deals can last from three to 24 months, investing in these relationships has been critical to being a first port of call when GPs consider secondary sales.

The numbers bear this fact out. In our first portfolio, roughly 70% of our deals were either exclusive or proprietary. In our second portfolio, all transactions have been either exclusive or proprietary.

DUE DILIGENCE. Due diligence entails deep work in analyzing financial statements, understanding end markets and undertaking quality of earnings reports. We commission market studies and speak with customers, suppliers and industry experts to gain a real insight into the fundamentals of a given asset. As with sourcing, this requires a dedicated team, which we began building from the ground up in the advent of this market.

DEAL EXECUTION. Single-asset deals involve an incredibly complex negotiation process that can take three to six months to conclude with a wide array of stakeholders. Success requires a specialized skillset to navigate potential conflicts, as transactions can include the GPs, rolling LP investors, selling LP investors as well as the new buyer group. We’ve transacted on 50 deals in this space, an amount not easily matched by our peers. From our perspective, this experience enables us to drive negotiations and become a preferred buyer for GPs.

In summary, the resource-intensive nature of this space creates barriers to entry that preclude “investor tourism.” Without a dedicated and expert team experienced in single-asset deal craft, investors will find success very difficult to achieve.

¹ PJT Park Hill. “Secondary Roadmap Series.” Q1 2022.
² Ibid.
³ Ibid.

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