Insights
Increasing Duration Opens Up New Realms for the Private Equity Secondaries Market
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Insight Article
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July 31, 2021
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Increasing Duration Opens Up New Realms for the Private Equity Secondaries Market
Increasing Duration Opens Up New Realms for the Private Equity Secondaries Market
Increasing Duration Opens Up New Realms for the Private Equity Secondaries Market |
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Today, private equity represents 11% of the average portfolio allocation, significantly above the 4% allocation in 2005.1 Despite this increase, one could argue this level of adoption is still below the optimal exposure given the asset class’ strong performance relative to public equity.2 Increasing duration and the associated illiquidity, in our view, are the reasons why this allocation gap persists. However, we believe that there are solutions available within the private equity industry to check or reverse this upward trend in duration and allay investors’ concerns about increasing their allocation to the asset class.
Prior to the Global Financial Crisis, approximately 40% of private equity portfolio companies were sold within three years of acquisition. From 2009–2020, however, the average holding period has increased by 31%.3 As a consequence, the median time it takes for a private equity fund to liquidate fully is now longer than 13 years, while the average term for a PE vehicle remains at 10 years.4 Although funds can be extended, Limited Partners (LPs) have become increasingly frustrated with the frequency at which fund durations exceed a decade. Logically, the longer hold periods for these investments have led to greater capital needs for the existing portfolio (often described as “follow on” investing). The quantum of follow on capital has increased meaningfully since 2009, with add-ons representing 72% of all private equity deal flow in 2020 compared with 57% in 2009, straining the capital reserves that exist within the PE fund structures.5
This mismatch of duration and capital needs has a variety of root causes. The typical private equity fund structure has not adapted to the growing and maturing private equity market. The ten-year fund life structure, which was perhaps fitting twenty-five years ago, is still the backbone of the vast majority of funds today. As the private equity market has become more competitive and, hence, more efficient, General Partners’ (GPs) value creation plans often take longer to execute than expected, elongating hold periods. Thus GPs have often wanted to hold on to their ‘winners’ in order to maximize their potential value. These situations frequently create conflict between GPs and LPs and among the LPs themselves—some of whom want to stay on for a longer period of time, while others demand nearer term liquidity. In our view, three solutions have emerged to combat the duration dilemma while allowing the GP to continue to manage a particular investment.
One answer to this challenge has been the launch of longer duration or even evergreen private equity funds such as those introduced by a number of reputable firms such as Apollo, KKR, and Carlyle. In our opinion, while these funds are a natural solution to this issue and a laudable business extension for these private equity firms, they appear unlikely to penetrate the private equity market on a broad level. We believe only the largest private firms are able to provide investors with comfort that the governance, talent and focus required will continue to exist over these extended fund lives despite the fact that few professionals are likely to stay engaged for the full duration of the vehicles. Furthermore, few investors in private equity funds have a structure that allows them to participate in such a long-dated vehicle.
Another answer is the sale of positions held within funds that have surpassed their fund life to another fund of more recent vintage that is managed by the same private equity firm. This solution enables the manager to continue owning an asset that is viewed as attractive. However, a conflict of interest stems from the fact that a GP acts as a seller and a buyer simultaneously. In certain cases, a GP may not transfer 100% of the ownership of the asset into the more recent fund, creating misalignment of interest. In our experience, there are only a handful of situations in which these issues were examined and addressed when Limited Partner Agreements (LPAs) were in the draft stage. As such, a number of LPs have struggled with lack of transparency, information asymmetry and limited time and resources to fully diligence such transactions. Most problematic is the fact that, in most cases, there is not an independent third party responsible for pricing these transactions.
We believe the best solution to this problem has come from the private equity secondaries market. The most common transaction type within this space is the acquisition of a diversified portfolio of limited partnership interests by a dedicated secondaries fund.7 A select number of secondary buyers, however, have abandoned this practice a number of years ago in favor of a more concentrated approach that enables them to isolate and invest in assets that they believe offer the greatest return potential. These transactions are alternatively known as “single-asset lift outs”, “transformational secondaries” or “GP-led secondaries”. This segment of the market has expanded significantly in the past two years; Evercore estimates the single-asset market has ballooned from $2Bn in 2018 to $14Bn in 2020.6 Secondary buyers in these instances work with GPs to create vehicles that will hold one or more “winners” that the GP wants to continue to own and/or attractive investments that require more time to achieve their full growth potential. Single-asset lift outs may provide significant benefits to both GPs and LPs. First, they allow GPs to continue to manage certain holdings for a longer period of time and provide them with follow on capital for use when needed. Second, they offer existing LPs the option to cash out or to remain invested for a longer duration. Managers that pursue concentrated strategies benefit from the GP’s deep knowledge of a specific asset and exposure to the assets with the greatest return potential within the GP’s portfolio.
The magnitude of the recent evolution in the secondary market came as a surprise to many market participants, with total secondary deal volumes doubling from 2016 to 2019.8 We believe that single-asset lift outs will serve as a catalyst for the continued growth of the secondary market and, more importantly, address the duration concerns that may be preventing asset allocators from dedicating a greater proportion of their assets to private equity.