Secondaries transactions offer LPs a vital liquidity route

Secondaries transactions are providing limited partners with a much-needed route to liquidity as the global buyout industry faces a persistent cash crunch. According to a report by Panos Katsambas and Matthew Evans, there is a growing need for funds to return capital to investors and exit investments amidst challenging market conditions. As a lack of liquidity has slowed fund exits, secondaries transactions globally are reaching record highs, offering an alternative path for investors to cash out.

A significant portion of these transactions can be attributed to the rise in continuation funds. These are principally GP-led secondary transactions, which result in one fund managed by a general partner transferring portfolio assets to a new continuation fund managed by the same GP. These funds provide an extension to the period for which the GP can hold assets beyond the life of the original fund. Typically, they aim to provide LPs with a choice of exiting or rolling their exposure to such assets via the continuation fund.

The LPs in the original fund that elect to exit are cashed out using proceeds contributed to the continuation fund by incoming LPs, who often include a specialist secondaries fund as the lead new investor. Meanwhile, LP-led secondaries, where investors sell their existing stakes in a fund to new investors, are also on the rise. These deals often occur with approval, but otherwise little input, from the GP.

Slower-than-hoped interest rate cuts and a stalled volume of IPOs and private market deals have led to a large backlog of unsold assets held by funds. In situations where GPs are holding on to portfolio investments for longer, seeking to extend the life of funds beyond their original terms and transferring assets into liquidation trusts, a secondary sale can provide LPs with a return of capital and more flexibility in their investment program. LPs often need to rebalance their holdings to ensure their allocation percentages are compliant with internal policies and to commit capital to new vintage launches, making these secondary transactions an attractive option for early exit opportunities.

Secondary transactions enable investors to offload underperforming or non-core investments, reducing risk exposure. GPs that are unable to sell underlying assets or raise new capital have sought to use financing products, such as NAV lending facilities, to fund distributions out of debt. GPs may use NAV financing because it can result in a quicker, less complex process than a full exit process. It may also initially result in capital being returned to LPs based on the established NAV of the fund’s portfolio rather than realised (and discounted) sale proceeds in a tough market.

However, LPs have increasingly questioned its efficacy as it can result in LPs being required to hold and return distributions to repay the facility in the event that the assets are not ultimately realised at NAV. Similarly, questions have been raised over GPs’ use of dividend recapitalisations to return capital to investors. This model involves GPs issuing debt over the underlying assets of a fund, allowing GPs to return capital to investors but weakening the financial position of those underlying assets. A common provision in closed-ended fund agreements permits GPs to distribute assets in-kind to LPs on a winding-up. In the absence of another viable form of exit, or where GPs are time-constrained during the liquidation period of a fund’s term, GPs may enforce this provision and distribute shares in investment holding companies or interests in underlying assets themselves. For LPs that cannot, or do not want, hold direct assets, a secondary sale offers a way to cash out in advance of that risk materialising.