Secondaries fund managers are in an arms race. For the last few years, Ardian and Lexington Partners have been vying for the top spot, raising successively record-breaking vehicles to snatch up every pre-owned PE fund stake in sight. However, they’re not the only ones amassing hefty arsenals. Nine of the ten largest firms in the market at the beginning of 2019 had raised the targets on their latest flagship funds by an average of 75%, PEI data show, in a case of “go big or go home”.
This is proof positive that secondaries are now officially mainstream. Selling PE assets has become central to any intelligent portfolio management strategy, in what is an increasingly liquid market, but what does this mean for the forgotten middle? Of the secondaries funds tracked by PEI, the four that have scaled the least have all been ones focused on the middle market.
This suggests that this middle ground is being overlooked and underserved, which is great news for buyers and bad news for sellers. An emerging anecdotal trend is for sell-side advisers to waive fees on smaller fund stakes to get their foot in the door for bigger, more lucrative deals. This should be setting off alarm bells.
The principal-agent problem
Anyone familiar with the principal-agent problem will see why this is an issue. In not taking a fee, there is no incentive for a human intermediary to achieve the best price for the sale, or even build a true auction for it at all. Owing to the information asymmetry inherent in this scenario, the adviser (the agent) can simply tell their LP client (the principal) that there was only interest from a limited number of buyers and advise them to take the deal, freeing up the adviser’s time and attention to focus on more sizable, remunerative LP stakes.
Further still, advisers are disincentivized from developing strong investor networks in the lower end of the market because it requires the same or more work for smaller commissions. This creates a natural bias towards serving the top of the market. This is comparable to a real estate agent choosing between selling a small one-bedroom apartment or a Manhattan penthouse. Certainly, the market is segmented and boutique intermediaries can serve smaller interests, but even then these principal-agent conflicts can still arise.
How can vendors achieve close-to-par or premium sales by relying solely on advisory networks when skewed incentives such as these exist? This is why building full, competitive auctions lower in the market is so important.
How to achieve competitive tension in the forgotten middle
Sellers should be able to truly test the market to achieve a fair price, even for modest-sized LP fund stakes. This requires building auctions with high participation rates, to secure numerous competing bids for assets that may otherwise fly under the buy-side radar. Speed is another important ingredient in creating competitive tension; lengthy secondaries processes can result in waning interest among bidders, especially when the financial stakes are lower. This is why it is beneficial to build momentum by exposing LP assets to the maximum number of potential bidders and move into the due diligence stage as swiftly as possible. Today, the ability to assemble a large number of potential buyers onto a single, common platform with the help of technology is making this increasingly possible.
One of the more contentious elements of traditional, LP-led secondary transactions is having the substitute LP approved by the GP. This is less of an issue in the upper echelons of the market; given the wide pool of LPs invested in these marquee funds, blocking trades is impractical. However, some GPs further downmarket have become more selective in recent years. This may be because they are concerned about the sensitive details of their fund and strategy being leaked following due diligence processes. Another motivating factor is that fund managers naturally prefer incoming LPs who are long-term partners — those who are likely to bring primary money to the table by committing to future funds — rather than opportunistic short-term buyers. That’s why, to preempt ugly surprises later on in the deal process, LPs looking to sell smaller stakes should signal their intentions early, proactively reach out to GPs, understand the GP’s desired investor base, and take concrete steps to address GP concerns where possible.
It might also be the case that fellow investors in a given fund have the right of first refusal (ROFR). The ROFR requires the seller’s stake to be offered to existing LPs first before a buyer who is not currently invested can be brought on board. This can introduce additional delays and uncertainty, and limit the seller’s flexibility to seek the most favorable pricing among the widest pool of potential buyers. Therefore, it is critical that LPs read through their limited partner agreements (LPAs) with a fine-tooth comb before initiating any sales process, whether a human intermediary is involved or not.