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Why Private Equity Secondary Investors Should Look Twice at GP-Led Deal Terms
Justin Pollack
Managing Director, Private Funds Group
In a constrained exit environment for private equity funds, more managers are pursuing transactions that recapitalize their own portfolio companies with the support of secondary managers – a supposed “win-win” proposition that allows existing investors to take liquidity, while the fund manager is able to get a “second bite of the apple” by holding the business for several more years. Yet secondary investors must be careful that the deal terms extend the win to them.
To align the interests of new investors with those of the general partner, carried interest realized from the sale of the company is typically rolled into the business as equity. Further, participants commonly agree to a tiered carried interest structure that starts below the typical 20% of profits that most PE funds employ and only ramps above that level if the investment is a clear success. However, these terms alone may not be enough to avoid a situation in which a manager can essentially have its cake and eat it too, as the chart below illustrates.
This simple hypothetical example shows what might happen when a fund manager turns a business with $250 million of equity into a $500 million organization, then pursues a GP-led secondary transaction rather than a sale to a third party. The result is that the fund manager converts the option value of its prior carried interest arrangement into more stable equity and takes carried interest in the new transaction. This reduces the GP’s risk of loss if the company falters and loses value while also providing more upside if the business gains in value.
The upshot for secondary buyers is that they need to consider how to mitigate these potential conflicts of interest – including by pricing an asset at a discount to a prevailing valuation and negotiating terms that won’t reward a manager for disappointing performance.
GP-Led Secondaries Can Benefit General Partners Even If Performance Disappoints
Hypothetical transition of a $250 million business to a $500 million business
Source: PineBridge Investments calculations as of August 2023.
Disclosure
Investing involves risk, including possible loss of principal. The information presented herein is for illustrative purposes only and should not be considered reflective of any particular security, strategy, or investment product. It represents a general assessment of the markets at a specific time and is not a guarantee of future performance results or market movement. This material does not constitute investment, financial, legal, tax, or other advice; investment research or a product of any research department; an offer to sell, or the solicitation of an offer to purchase any security or interest in a fund; or a recommendation for any investment product or strategy. PineBridge Investments is not soliciting or recommending any action based on information in this document. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author, may differ from the views or opinions expressed by other areas of PineBridge Investments, and are only for general informational purposes as of the date indicated. Views may be based on third-party data that has not been independently verified. PineBridge Investments does not approve of or endorse any republication of this material. You are solely responsible for deciding whether any investment product or strategy is appropriate for you based upon your investment goals, financial situation and tolerance for risk.
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