GP-Led Secondaries and Investor Choices: What Individual Investors Need to Know

Private market investors have witnessed the dramatic growth of a secondary trading market for private assets with transaction volume reaching approximately $112 billion in 2023, according to Jefferies’ January 2024 Global Secondary Market Review. While the secondary market initially served limited partners who needed liquidity or sought to rebalance their investment portfolios, a second branch of the market, initiated by the general partners of private funds, has grown significantly over the last few years. In these GP-led secondary transactions, the general partners of private equity and similar type funds see value in retaining their interests in portfolio companies beyond the term of their existing fund while also creating liquidity for investors. These transactions often involve raising additional capital from new limited partners to invest in the portfolio companies to support their growth.

What Exactly Is a GP-Led Secondary Transaction?

The most common form of GP-led secondaries is called a “continuation fund” in which the GP forms a new fund with assets from an existing fund of the GP. As part of selling these assets to the continuation fund, the existing limited partners choose either to cash out or keep their interests in the existing portfolio by transferring them into the new fund managed by the same GP but usually with different terms. This choice gives investors optionality but fundamentally shifts the investment decision about whether to liquidate or continue investing in a private company or real asset from the general partner to the limited partners.

While the secondary trading market for private assets is largely inaccessible to individual investors, the development of continuation funds still directly impacts them because, in many cases, they will need to make the same investment decision (hold or cash out) as all other limited partners, including large institutional investors. So for limited partners large and small, a passive fund investment in the instance of a GP-led secondary becomes an active “hold/sell” decision. It may not be possible to measure how much individual investors are impacted, but since there is a wide gap in access to and possession of information about private assets between large institutional investors and individual investors, the latter will be at a relative disadvantage.

In this article, we look at the growth of the private asset secondary market, how GP-led continuation funds work, regulatory and industry perspectives, and implications for individual investors. We highlight the importance of understanding how fund legal documents address continuation funds as well as the importance of closely monitoring fund investments to be prepared to make the “hold/sell” decision if it arises.

Development of Traditional Private Fund Secondary Market

Closed-end private funds are structured to allow general partners to raise money during a designated time and invest the committed funds over a period of 3–5 years. The general partners then manage the assets in the fund for a period of time and liquidate the fund’s holdings (and distribute capital and any returns to investors) through a combination of initial public offerings, recapitalizations and sales of fund assets to third parties.

In the past, if a limited partner needed liquidity (i.e., to get access to all or a portion of its capital) before the fund’s assets were realized, the options available were limited. While most funds permitted limited partners to sell their interests in the fund to other investors, sales were usually subject to some consents and limitations. This resulted in an arduous process and one that often yielded a discounted price. However, over time a secondary market for the purchase and sale of limited partnership interests in private funds has developed for large institutional investors, capable of valuing and evaluating for themselves the interests that they want to sell or purchase. Today, transaction volume for LP-led secondaries is approximately $60 billion, according to Jefferies.

The Evolution of GP-Led Secondary Transactions

As the secondary market for private fund interests grew to support liquidity for limited partners, general partners recognized that this pool of capital could also be used to support assets in their existing funds that have not yet reached their potential or those needing more time to be repositioned. Rather than sell the assets to third parties at less than full value, general partners started to create new funds that purchased existing assets, often raising additional capital and extending the maturity of the original fund.

Continuation funds are structured to allow existing limited partners to either sell their interests to new investors who want to invest in the funds’ assets (generating liquidity for the existing investor) or to continue to own the assets alongside the general partner and new investors. The continuation funds also give the general partners the associated benefits of management fees for a longer period, the opportunity to crystallize carried interest profits (which they may reinvest in the continuation fund), and the potential to earn more carried interest on the same assets in the future.

GP-Led vs. LP-Led Secondaries: Potential Conflicts and Additional Choices

Unlike traditional secondary transactions which are initiated by a limited partner and are bi-lateral transactions between the limited partner and a purchaser, GP-led secondaries are multi-lateral transactions initiated by the general partner and involve all existing limited partners as well as new investors.

General partner-led secondary sales raise a host of potential conflicts of interest and concerns with self-dealing. The general partners orchestrating both the sale of assets from the existing fund and the purchase by the continuation fund face conflicts between their duties to investors in the existing fund and those in the new one. Existing fund investors likely want a higher asset price and new ones likely want a lower one. A general partner may desire a higher price as the basis for calculating its management fee and current carried interest but a lower one for calculating the threshold for receiving future carried interest.

For limited partners, general partner-led secondaries can offer greater optionality – the ability to stay invested in particular assets or cash out. But the optionality comes with a cost. Limited partners have tight time constraints to decide which option to choose. Compounding the issue, investors do not always have robust information with which to make a decision. As a result, many investors default to cashing out, which turns out to be the overwhelming result of most of these choices. According to the Jefferies report, “approximately 80% of LPs elected to sell into continuation fund transactions in 2023, largely in line with recent years.”

Industry and Regulatory Perspectives

For many quickly evolving products or services, there are emerging market and regulatory responses to keep pace with the latest developments. For GP-led secondaries, the Institutional Limited Partner Association (ILPA), an industry association representing limited partners, and the U.S. Securities and Exchange Commission (SEC) strive to address issues facing investors. Both ILPA and the SEC have highlighted that since GPs are on both sides of a GP-led secondary transaction, they have a conflict of interest that needs to be mitigated.

In April 2019, ILPA made several recommendations to address these conflicts and protect both existing and new limited partners, including having GPs:

1. Engage existing limited partners as early in the process as possible and provide sufficient time for LPs to make their decisions,
2. Make full disclosures about the transaction such that new and existing investors are making their decisions based on the same information, and
3. Preserve a “Status Quo” option for existing investors in the transaction, meaning that investors who choose to roll into the continuation fund receive the same terms in the new fund as they had in the previous one.

ILPA reiterated these recommendations in their May 2023 guidance on continuation funds where they also presented two general principles for these transactions (from the limited partners’ perspective):

1. Continuation fund transactions should maximize value for existing LPs

2. Rolling LPs should be no worse off than if a transaction had not occurred

In its Rule published on September 14, 2023, the SEC addressed “Advisor-led secondaries,” its terminology for GP-led secondaries, and established the following requirements:

• First, the adviser must obtain a fairness opinion or a valuation opinion from an independent opinion provider and distribute the opinion to private fund investors before the due date of the election form.
• Second, the adviser must prepare and distribute a written summary of any material business relationships between the adviser or its related persons and the independent opinion provider.

Through the efforts of ILPA, the SEC, and others, there is an increased likelihood that investors will be offered a fair choice and sufficient information about a GP-led secondary transaction, albeit with a limited amount of time to decide. However, only time will tell whether fund sponsors adopt ILPA’s recommendations and whether fairness opinions improve the landscape for limited partners. Regardless of the attempts to help investors, many of them never contemplate needing to make a choice when they initially commit to a private fund.

Does the Individual Investor Have the Same Choice as Other Limited Partners?

Once a general partner decides to pursue a continuation fund, individual investors may or may not be offered a choice of whether to keep their existing interests in the fund under its new terms or cash out. If individuals invest directly in the primary fund established by the GP (“primary fund”), they will be presented with the offer just like all other limited partners. However, if they invest through a vehicle established by a financial institution or platform that aggregates individual interests (“feeder fund”), they may or may not give decision-making authority to a representative of the financial institution or platform.

Decision-making for feeder funds is usually spelled out in a section of the limited partnership agreement (LPA) for the feeder fund, focusing on powers of the general partner or on voting by the limited partners. Some feeder funds provide full discretion to their general partner to decide whether all investors in that fund will roll their interests into the continuation fund or cash out but may require the consent of a substantial percentage of limited partners if the general partner decides to roll.

For funds that operate in this manner, the general partner of the feeder fund is more likely to opt to cash out for all investors in the feeder fund. The general partner of the feeder fund is not able to evaluate whether each investor should cash out or roll over the investment, so the safer and more prudent option is to take the cash for all. Other feeder funds provide greater flexibility and allow their limited partners to individually choose to roll or cash out. These feeder funds, in effect, put their limited partners in the shoes of investors who have directly invested in the primary fund.

“Should I Stay or Should I Go” – The Clash

As the private markets industry continues to evolve, continuation funds are a natural solution to two big constraints of closed-end funds: limited time periods for portfolio investments to reach full fruition and a fixed amount of capital. They offer the possibility of a “win-win” for limited partners and the general partner. The limited partners can decide to sell or stay invested in desirable assets, albeit on different terms. General partners can continue to manage certain assets for a fee, raise additional capital, and keep their own capital invested in desirable assets.

As previously noted, the general partners leading these transactions are conflicted, and the SEC and industry participants have made initial efforts to mitigate these conflicts through rules and recommendations. But these transactions play out on a stage of “goliaths” of both general and limited partners; small institutions and individual investors are not as well-positioned to make informed decisions for their portfolios.

Small institutions and individual investors may be disadvantaged in GP-led secondaries for a few reasons:

1. In a GP-led secondary transaction, the limited partner makes a judgment on the valuation and prospects for specific portfolio companies being traded. This is a tall order even for large institutional limited partners more accustomed to evaluating the qualities of a general partner to source and manage a portfolio. It is a rare capability for smaller institutions and individuals.
2. Limited partners are often given a limited amount of time to make their decision. Large institutions are more likely to have a staff of investment professionals who may be skilled in evaluating private asset transactions and may have been involved in shaping the transaction with the general partner before it is presented to all limited partners. In contrast, small institutions and individuals simply do not have the time, resources, or skill to do all of the necessary diligence to make an informed decision.
3. Small institutions or individuals with smaller portfolios are more likely to have had changes in the balance and diversification of their component investments which make it more difficult for them to choose to roll any given investment.

Recognizing those disadvantages, what can individual investors do to protect themselves beyond fully reading the disclosure documents?

• The most important action for investors is to look at their private funds differently, as active rather than passive investments. They should actively read the quarterly and annual statements prepared by the general partners and have a good understanding of their portfolios, performance, and prospects.
• The more up-to-speed an investor is before getting a disclosure document from a GP looking to complete a secondary transaction, the better equipped the investor will be to make a well-informed decision that suits the needs of their own portfolio in the timeframe provided.
• Similar to the first point, investors should actively think about portfolio construction and manager selection. GP-led secondary transactions provide immediate opportunities to rebalance a portfolio by reducing exposure to a particular asset class, industry, or fund manager. The economics of the specific transaction may look fair and even attractive, which would suggest rolling into the continuation fund. However, from a strategic or diversification perspective, selling the investment may offer an opportunity to rebalance to meet long-term goals.
• Avoid “disposition bias,” the natural tendency of investors to sell winners and hold onto losers. This concept has been well-researched over the past few decades and the GP-led secondary market is a natural area where it may present itself. Investors need to consider the merit of each investment and not simply sell the gains and hold the losses.
• Seek advice from advisors who can review the disclosure documents for financial, legal, and tax considerations and summarize the pertinent provisions for reference at the time and in the future. Again, investors may only have a short amount of time to decide, so it would be best to have these advisors identified before the transaction is presented.

Whether You Stay or Go – Stay Informed

GP-led secondaries are highly complex transactions, potentially involving multiple classes of investors, many assets, changes to economic terms, and changes to manager compensation, all of which often need to be evaluated in a short time frame. For individual investors to take full advantage of the democratization of private markets, the industry needs to close the information gap with large institutional investors by making meaningful information available to all investors willing to devote the time to read it, whether the information relates to broad industry trends or specific developments for the private assets that the investors hold. Two good sources of general information for investors in private funds that we recommend are ILPA and the Chartered Alternative Investment Analyst Association (CAIA Association).