Seven Things to Know About Secondaries Funds
The secondaries market has experienced explosive growth in recent years, with $108bn in transaction volume in 2022 compared to $37bn in 20161. This makes 2022 the second largest year on record for secondaries transactions, surpassed only by 2021’s epic $132bn in volume.
As secondaries transaction volumes have surged, so too has interest in secondaries funds. Secondaries fund assets under management have quadrupled in the last decade, from just shy of $100bn at the beginning of 2012 to approximately $400bn in assets under management as of Q1 20222, with approximately $95bn of additional capital projected to be raised by secondaries funds in 20233. Recent years have also seen a wave of acquisitions by private equity sponsors of secondaries-focused firms. Other private equity sponsors looking to enter the space have sought to build their secondaries track record more organically – albeit incrementally.
This surge in new entrants and maturation of the secondaries market has also led to more specialized secondaries funds. Historically, secondaries funds focused primarily on investor-led transactions (“LP stakes”). As sponsor-led secondaries transactions (“GP-leds”) became more popular, many secondaries funds built in the capability to participate in both types of transactions. While it remains the case today that most secondaries funds may invest in both LP stakes and GP-leds, an increasing number of funds are focusing on one or the other.
The secondaries market has experienced explosive growth in recent years, with $108bn in transaction volume in 2022 compared to $37bn in 20161. This makes 2022 the second largest year on record for secondaries transactions, surpassed only by 2021’s epic $132bn in volume.
As secondaries transaction volumes have surged, so too has interest in secondaries funds. Secondaries fund assets under management have quadrupled in the last decade, from just shy of $100bn at the beginning of 2012 to approximately $400bn in assets under management as of Q1 20222, with approximately $95bn of additional capital projected to be raised by secondaries funds in 20233. Recent years have also seen a wave of acquisitions by private equity sponsors of secondaries-focused firms. Other private equity sponsors looking to enter the space have sought to build their secondaries track record more organically – albeit incrementally.
This surge in new entrants and maturation of the secondaries market has also led to more specialized secondaries funds. Historically, secondaries funds focused primarily on investor-led transactions (“LP stakes”). As sponsor-led secondaries transactions (“GP-leds”) became more popular, many secondaries funds built in the capability to participate in both types of transactions. While it remains the case today that most secondaries funds may invest in both LP stakes and GP-leds, an increasing number of funds are focusing on one or the other.
Secondaries funds may resemble the underlying funds that comprise their portfolios, but there are critical differences in the way the asset class operates that should be reflected in the fund terms. Although there may be some variation in how these are addressed depending on whether a secondaries fund strategy is broader or more specialized, there are some common themes that are rooted in the nature of secondaries investing.
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Below we highlight seven of the ways in which secondaries funds are unique.
Tailored Investment Restrictions
Given that secondaries funds are generally not making direct investments, the investment restrictions must be tailored to the business. For example, while a typical private equity fund may include a limit on the percentage of the fund that may be invested in a single portfolio company, a secondaries fund may instead have a limit on the percentage of the fund that may be invested in a single transaction, a single fund or in funds managed by a single sponsor. Instead of a limit on the percentage of a private equity fund that may be invested in certain investment sectors, a secondaries fund could include limits on the percentage that may be invested in certain fund strategies.
Secondaries funds may sometimes make strategic, primary investments in order to build relationships or as part of a stapled secondary. In some cases, a GP may include a cap on the amount of primary investments a secondaries fund can make in order to assure investors that those investments will only represent a small subset of the strategy.
Tailored Investment Restrictions
Given that secondaries funds are generally not making direct investments, the investment restrictions must be tailored to the business. For example, while a typical private equity fund may include a limit on the percentage of the fund that may be invested in a single portfolio company, a secondaries fund may instead have a limit on the percentage of the fund that may be invested in a single transaction, a single fund or in funds managed by a single sponsor. Instead of a limit on the percentage of a private equity fund that may be invested in certain investment sectors, a secondaries fund could include limits on the percentage that may be invested in certain fund strategies.
Secondaries funds may sometimes make strategic, primary investments in order to build relationships or as part of a stapled secondary. In some cases, a GP may include a cap on the amount of primary investments a secondaries fund can make in order to assure investors that those investments will only represent a small subset of the strategy.
On the Outs with Opt-Outs
Many private equity investors are accustomed to receiving excuse rights in the event that participation in a particular fund investment would be contrary to the laws applicable to, or internal policies of, such investor. While a secondaries fund GP may be sympathetic to those requests, they can be very difficult, if not impossible, to accommodate. A typical secondaries fund will acquire interests in multiple underlying funds that may still be actively investing. Secondaries funds, particularly those acquiring LP stakes, may also not have negotiating leverage to obtain bespoke excuse rights from the underlying fund. Even where the GP may be able to secure excuse rights, passing through those rights to particular investors is often administratively unworkable given the number of underlying funds and their respective investments. Opt-out rights may be more feasible for a secondaries fund utilizing a single-asset GP-led strategy, where such rights are easier to apply and track.
As a result, many secondaries funds may provide limited or no investor opt-out rights. For example, excuse rights could be limited to GP-led investments, or more specifically single-asset GP-leds, or may be limited to circumstances where the investor’s participation would result in a violation of applicable law or a materially adverse tax effect.
On the Outs with Opt-Outs
Many private equity investors are accustomed to receiving excuse rights in the event that participation in a particular fund investment would be contrary to the laws applicable to, or internal policies of, such investor. While a secondaries fund GP may be sympathetic to those requests, they can be very difficult, if not impossible, to accommodate. A typical secondaries fund will acquire interests in multiple underlying funds that may still be actively investing. Secondaries funds, particularly those acquiring LP stakes, may also not have negotiating leverage to obtain bespoke excuse rights from the underlying fund. Even where the GP may be able to secure excuse rights, passing through those rights to particular investors is often administratively unworkable given the number of underlying funds and their respective investments. Opt-out rights may be more feasible for a secondaries fund utilizing a single-asset GP-led strategy, where such rights are easier to apply and track.
As a result, many secondaries funds may provide limited or no investor opt-out rights. For example, excuse rights could be limited to GP-led investments, or more specifically single-asset GP-leds, or may be limited to circumstances where the investor’s participation would result in a violation of applicable law or a materially adverse tax effect.
Recycling to Cover Cashflow Gaps
Cash management is typically a key concern for secondaries fund GPs due to the nature of secondaries investing, where the fund will have a total amount of uncalled commitments to its underlying funds at any given time and not know with certainty when that capital will be called and what portion of it may never be called. It is fairly common for a secondaries fund to be “overcommitted” (i.e., to have more total uncalled commitments to its underlying funds than it has uncalled commitments from its own investors), which is often an intentional strategy of the fund’s management to deploy maximum capital in light of its estimates for future capital calls by the underlying funds in the portfolio. While overcommitment typically does not compromise the fund’s ability to meet its call down obligations, it is possible.
For this reason, secondaries funds will generally have more generous provisions regarding when the GP may retain potential distributions to make additional investments or pay fund expenses (“recycling”) than typical private equity funds, in order to smooth any gaps between estimated and actual capital calls by underlying funds. Private equity funds typically include one or more of (i) a cap on the aggregate amount of potential distributions that may be recycled, (ii) a stated time frame during which a potential distribution may be recycled, and (iii) a limit on the scope of distributions potentially subject to recycling (such as those representing a return of capital contributed, but not profits) or purposes for which otherwise distributable amounts can be recycled. A secondaries fund may often have no cap on aggregate recycled amounts and a longer time frame for recycling, and in some cases could include additional flexibility to recycle distributions that are themselves subject to recall by an underlying fund.
Recycling to Cover Cashflow Gaps
Cash management is typically a key concern for secondaries fund GPs due to the nature of secondaries investing, where the fund will have a total amount of uncalled commitments to its underlying funds at any given time and not know with certainty when that capital will be called and what portion of it may never be called. It is fairly common for a secondaries fund to be “overcommitted” (i.e., to have more total uncalled commitments to its underlying funds than it has uncalled commitments from its own investors), which is often an intentional strategy of the fund’s management to deploy maximum capital in light of its estimates for future capital calls by the underlying funds in the portfolio. While overcommitment typically does not compromise the fund’s ability to meet its call down obligations, it is possible.
For this reason, secondaries funds will generally have more generous provisions regarding when the GP may retain potential distributions to make additional investments or pay fund expenses (“recycling”) than typical private equity funds, in order to smooth any gaps between estimated and actual capital calls by underlying funds. Private equity funds typically include one or more of (i) a cap on the aggregate amount of potential distributions that may be recycled, (ii) a stated time frame during which a potential distribution may be recycled, and (iii) a limit on the scope of distributions potentially subject to recycling (such as those representing a return of capital contributed, but not profits) or purposes for which otherwise distributable amounts can be recycled. A secondaries fund may often have no cap on aggregate recycled amounts and a longer time frame for recycling, and in some cases could include additional flexibility to recycle distributions that are themselves subject to recall by an underlying fund.
Giveback Provisions Go Big
Private equity investors are familiar with the provisions requiring that they return capital previously distributed to them should that capital be required to satisfy certain fund obligations (such as indemnification expenses) that may arise later in the life of the fund or even after the fund’s dissolution (the “LP Giveback”). In the typical private equity fund, however, there are usually limits on the aggregate amount an investor can be required to return and/or the time period during which a distribution can be required to be returned.
Secondaries
Secondaries funds, typically need more permissive giveback provisions because the underlying funds in the fund’s portfolio have their own giveback obligations.
It is common for secondaries fund documentation to provide that investors must return distributions to satisfy their share of any amounts that are recalled by an underlying fund without being subject to any caps or timing limitations.
Reporting at the Mercy of Portfolio Funds
Reporting timelines are frequently negotiated in private equity funds, but in secondaries funds it is important that the fund’s GP retain maximum flexibility. As a secondaries fund needs to receive reporting information from its underlying portfolio funds before it can compose its own reports, secondaries fund reporting timelines should be longer than in a typical private equity fund. Quarterly unaudited financials are often due 60 to 90 days after quarter end, with annual audited financials often due 150 to 180 days after fiscal year end. Perhaps more importantly, these deadlines are typically soft and can be exceeded, reflecting the fact that receipt of the necessary information is often outside of the GP’s control.
Reporting at the Mercy of Portfolio Funds
Reporting timelines are frequently negotiated in private equity funds, but in secondaries funds it is important that the fund’s GP retain maximum flexibility. As a secondaries fund needs to receive reporting information from its underlying portfolio funds before it can compose its own reports, secondaries fund reporting timelines should be longer than in a typical private equity fund. Quarterly unaudited financials are often due 60 to 90 days after quarter end, with annual audited financials often due 150 to 180 days after fiscal year end. Perhaps more importantly, these deadlines are typically soft and can be exceeded, reflecting the fact that receipt of the necessary information is often outside of the GP’s control.
Valuation Policies Need to Play Nice With Portfolio Funds
In a typical private equity fund, the GP will generally determine the valuation of the fund’s assets pursuant to its own bespoke valuation policy. In a secondaries fund, however, the GP will largely be dependent on the underlying funds’ valuations and calculation of performance in determining its own marks. It is not uncommon for secondaries fund documentation to state that the GP may rely on the underlying fund’s valuation of such fund interest or an underlying asset without the GP conducting an independent valuation.
Valuation Policies Need to Play Nice With Portfolio Funds
In a typical private equity fund, the GP will generally determine the valuation of the fund’s assets pursuant to its own bespoke valuation policy. In a secondaries fund, however, the GP will largely be dependent on the underlying funds’ valuations and calculation of performance in determining its own marks. It is not uncommon for secondaries fund documentation to state that the GP may rely on the underlying fund’s valuation of such fund interest or an underlying asset without the GP conducting an independent valuation.
Waterfalls Are Predominantly European
With respect to carried interest, secondaries funds have historically resembled their funds-of-funds cousins in their use of a European waterfall structure. This is because the first secondaries funds were overwhelmingly focused on the acquisition of LP stakes, resulting in the fund holding interests in a large number of underlying funds and an exponentially larger number of underlying portfolio companies. Calculating carried interest on a deal-by-deal basis via an American style waterfall was therefore impractical. Given the evolution of the secondaries market and the emergence of secondaries fund strategies specific to highly concentrated GP-led deals, we may see such funds move to the American style waterfall more commonly used in buyout and other private equity strategies.
Some secondaries funds may provide that carried interest is calculated separately with respect to primary investments, which might also include a lower carried interest rate. This is another way that a GP may assure investors that any primary investments will not undermine the fund’s strategy.
Secondaries investing has a unique set of characteristics that should be properly accommodated and addressed in fund documentation. However, given the evolution of this space and the trend of increasingly specialized secondaries strategies, this is not a “one size fits all” exercise. GPs and investors should consult with their legal counsel to ensure that secondaries fund terms give GPs the flexibility they need to achieve the fund’s objectives, while maintaining alignment and protecting against strategy drift.
Adrian Rae Leipsic
Partner
New York
T: +1 212 225 2504
aleipsic@cgsh.com
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