In the latest article in our series on private equity secondaries1, we consider some drivers of the persistent growth in the market and how they are creating an acute capital shortage—especially for General Partner (GP)-led continuation funds. We believe this undercapitalization presents an attractive and likely lasting opportunity for investors.
- Challenging exit environment pushes Limited Partners (LPs) and GPs into the secondary market: The lack of traditional M&A and IPO exits, and consequent drop in distributions, has LPs urging GPs to engineer exits and return capital more quickly.
- The secondary market is undercapitalized: Secondary funds are being raised, but industry estimates suggest that dry powder will barely cover this year’s transaction volume.2
- The GP-led market is especially undercapitalized: We believe capital available for the GP-led market is even tighter than the broader secondary market—despite seeing more GP-led transactions coming to market, fewer are making it to closure.
- The lack of traditional exit routes is not the only driver of GP-led growth: Continuation funds enable GPs and LPs to retain ownership of high-quality assets with proven management teams and a predictable track record to grow earnings, generate free cash flow and respond to operational enhancements; we believe these assets are becoming increasingly sought after in an environment where returns depend on earnings growth rather than multiple expansion and leverage.
- Institutionalization supports further GP-led growth: The GP-led ecosystem is rapidly expanding beyond a small group of specialists as M&A advisors without a historic presence begin to build GP-led capabilities.
The Secondary Market Grows as Traditional Exit Routes Are Challenged
Not since the Great Financial Crisis have private equity investors faced such a pronounced and prolonged period of net capital outflows. According to Goldman Sachs Secondaries Advisory, LPs have been experiencing net capital drawdowns since 2019. This was initially driven by increased commitments to the asset class and faster capital deployment by sponsors and then, in 2022 and 2023, by substantially reduced exit activity due to economic uncertainty, increased interest rates and market volatility.
Since 2021, according to data from the investment banking group Baird, distributions from buyout sponsors have fallen by almost 60%, from $1.24tn to just $530bn. At the same time, private equity firms continued to call capital for portfolio investments from their investors. Consequently, the total distribution to paid-in capital (DPI) for 2019 – 2022 vintage funds by the end of 2023, at 0.1x DPI, is 81% lower than the corresponding average DPI for 2015 – 2018 vintages was by the end of 2019.3
Figure 1. Significant and Rapid Decline in Exit Activity
Distributions by private equity buyout sponsors, $bn
Source: Baird, cited by PEI Group, “Percentage of GP-leds in PE distributions nearly doubled in 2023” (January 2024).
As a result, unrealized value in private equity has doubled over the past five years topping $10tn. In addition, this “new” cash flow profile is creating significant challenges for private equity investors, many of whom defined their commitment plans years ago, based on “old” self-funding cash flow assumptions whereby capital calls would be offset or funded by expected distributions from their existing portfolio. Many now don’t have the capital available for the new primary commitments necessary to maintain investment pacing, and some are struggling with their obligations to fund preexisting capital commitments and add further to their illiquid private market exposures when they are already overexposed.
As a result, many LPs are selling positions on the secondary market and urging GPs to engineer exits and return capital via many different avenues, including GP-led continuation fund transactions.
Closed transaction volumes in the secondary market in 2023 stood at $112bn, up 4% compared to 2022. Jefferies, in its latest Global Secondary Market Review, expects 2024 transaction volume “to surpass $130bn, potentially eclipsing 2021 record volume levels.”
Figure 2. The Secondary Market Has Grown Substantially Since 2020
Private equity secondary market transaction volume, $bn
Source: Jefferies, Global Secondary Market Review (January 2024). Data as of Q4 2023.
The Secondary Market Is Undercapitalized… Despite recent headlines on record fundraising for secondary private equity funds, dry powder in the secondary market stands at a very modest 1.3 times 2023 transaction volume or 1.1 times expected 2024 volume.
We believe this attractive supply-and-demand imbalance is likely to persist for some time. Jefferies anticipates a “gradual reduction” in the dry powder to transaction volume multiple during 2024 and 2025, “as deployment will likely outstrip fundraising.”4 The investment bank PJT Partners sees “the lack of investor capital given the rising supply” of transaction volumes as the largest challenge facing the secondaries market today.5
Figure 3. Secondary Market Capitalization is Tight
Secondary market transaction volume relative to estimated secondary market capital
Source: Jefferies, Global Secondary Market Review (January 2024). Data as of Q4 2023. NB analysis as of January 2024.
… And the GP-Led Secondary Market Is Especially Undercapitalized
We have heard from leading advisors that they too estimate that the majority of secondaries dry powder is earmarked for traditional LP transactions. As a result, we believe the GP-led market may be the most undercapitalized segment of the private equity industry, with a dry powder to transaction volume multiple well below that suggested in figure 3 for the overall secondary market.
The data in figure 4 shows the growth in GP-led transactions being offered to the market—proxied by the extensive pipeline of opportunities that we sourced at Neuberger Berman.6 It also shows that the value of successfully executed transactions has been falling over the past two years. We believe this reflects not only a mismatch of buyer and seller valuation expectations, but also the general undercapitalization of the GP-led secondary market.
While private equity investors are starting to recognize the attractive opportunity to invest in dedicated GP-led secondary funds, we believe that transaction supply will continue to outstrip available capital: 33% of LPs have already committed to one or more dedicated GP-led secondary funds, while an additional 16% are planning to make their first investment in a dedicated GP-led secondary fund.7
Figure 4. Gp-led Secondary Market Capitalization Has Been Getting Tighter
Volume of GP-led transactions being brought to market versus volume closing, $bn
Source: Neuberger Berman internal pipeline; Jefferies. Data as of Q4 2023. NB transaction volume sourced is used here as a proxy for GP-led secondary transactions brought to the broad market.
GP-Led Transactions: Liquidity and Continuity In continuation funds, a GP sells one or more portfolio companies from a typical, 10-year primary fund to a new investment vehicle—the continuation fund—managed by the same GP and structured in negotiation with secondary investors.
We believe continuation funds can meet the liquidity needs of primary fund LPs and GPs while also generating potentially attractive risk-adjusted returns for GP-led investors:
- LPs in the primary fund can either cash out their current exposure or roll or reinvest into the new continuation fund to generate additional value from these select portfolio companies, allowing them to manage their specific duration and cash flow objectives.
- GPs get extra time and capital to create more value in some of their most successful portfolio companies. Rather than sell their best holdings to other private equity sponsors, GPs can partner with secondary investors while still maintaining ownership and control of high-conviction assets.
The Lack of Traditional Exit Routes Is Not the Only Driver of GP-Led Secondaries Growth
The market broadly expects GP-led volumes to resume meaningful growth in 2024. We see three drivers behind this continued growth.
First, capital formation for dedicated GP-led strategies is expected to continue. Second, traditional M&A and IPO exit options remain largely closed: GP-led secondaries accounted for 9% of private equity distributions in 2023, up from 2% in 2018.8
We expect growth in the GP-led market to continue even when traditional exit markets re-open. The GP-led market developed and had already become one of the fastest-growing segments of private equity in the years before 2022, during one of the most liquid periods in private equity history. While a backdrop characterized by challenged traditional exit routes raises the prominence of the market, we do not believe it is necessary for it to thrive and remain attractive.
Third, and, in our view, the most important driver of growth, we increasingly see GPs turn toward secondary transactions not just to generate liquidity for their LPs, but to retain ownership of high-quality assets with proven management teams—and we think the changing dynamics of the private equity environment will continue to support this trend.
From 2008 to 2018, some researchers estimate that over 50% of private equity returns resulted from multiple expansion and the use of leverage.9 In a world of more expensive and lower leverage and potentially flat or contracting valuation multiples, we believe operational improvement, earnings growth and free cash flow generation will need to be the core drivers of value creation. Companies with a proven, predictable track record to grow earnings, generate free cash flow and respond to operational enhancements are hard to find. As such, we expect GPs who own these assets to be keen to hold onto them in continuation vehicles rather than exiting them to a competitor who may potentially capture a two- or three-times return.
Despite the new dedicated GP-led secondaries funds being raised, we anticipate continued undercapitalization and limited competition given the size of the continuation fund transaction opportunity and overall growth in the GP-led market. We think this provides a valuable opportunity for an experienced GP-led investor to price the risk of the assets, set the purchase price and negotiate terms to ensure that GPs’ interests are aligned with the secondary investor.
A Rapidly Institutionalizing Market
On the back of the strong growth of the GP-led secondaries market over recent years, we observe a continued institutionalization of the market ecosystem which we think will support further growth.
For example, the International Limited Partner Association (ILPA) has provided a constructive perspective in its latest commentary on GP-led transactions, supporting the creation of reliable market standards. Furthermore, leading investment banks without a historic presence in GP-led transaction advisory are building out teams or partnering with specialized secondary market advisors, as they recognize that they cannot offer holistic financial sponsor coverage without GP-led transaction advisory capabilities.
