On this episode of Deal-by-Deal, host Greg Hawver is joined by Darren O'Brien, Managing Director of Campbell Lutyens, the largest independent private capital advisory firm. 

Tune in as Greg and Darren discuss the hot topic of secondary transactions, a growing niche area. Starting with a high-level introduction to secondary transactions and the secondary market, Darren covers the distinction between LP-led and GP-led secondaries, continuation funds and why a sponsor might choose to pursue a continuation vehicle, how valuations are calculated, market drivers, what to expect going forward, and next steps for interested investors.

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Name: Darren O'Brien

Company: Campbell Lutyens

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

You are listening to Deal-by-Deal, a McGuireWoods podcast. Deal-by-Deal invites you to conversations with experienced independent sponsors and other private equity professionals. Join McGuireWoods Partners Greg Hawver and Jeff Brooker as they explore middle market private equity M&A to provide you with timely insights and relevant takeaways.

Hello and welcome to Deal-by-Deal, a private equity podcast exploring topics of interest to independent sponsors and other PE professionals in the middle market. My name is Greg Hawver. I'm an M&A partner at McGuireWoods in the Chicago office. And today I'm excited to be discussing a hot and trending topic of secondary transactions. And I'm excited to be joined by Darren O'Brien of Campbell Lutyens to discuss this. And before we get into more about Darren and his practice at Campbell Lutyens, I wanted to just start off with a definition of secondary transactions for listeners because it is kind of a niche area that is growing in importance, I would say. So at a high level, I think of secondary transactions as just transactions whereby you're seeking to create liquidity in an otherwise illiquid private equity investment or set of investments. And Darren, would you agree with that or expand on that?

Yeah, Greg, nice to be here first of all. And that's right, the secondary market, it's really a broad term that defines a set of transactions whereby investors can monetize an illiquid investment in a fund or sometimes a private company. So that is the secondary market. The secondary market for public investments is where you sell a stock that had had an IPO. The secondary market, which implies the private equity market or private markets, it really applies to selling those investments that are illiquid.

Great. That's helpful. I just wanted to set the table generally to understand what we're going to be talking about today. And so with that, Darren, welcome. And could you tell us a little bit more about Campbell Lutyens and about yourself?

Yeah, absolutely. So Campbell Lutyens is the largest independent private capital advisory firm. We started in 1988 and we've grown to have 250 people across the globe. 80 of those are in the US. We have been advising on primary fundraising and secondaries since we started in the late '80s. We did our first secondary transaction in 2000. And we've built this purpose built organization that does only two things. We advise GPs on their interactions with capital sources, and then we help LPs access the best private investment opportunities. So that's Campbell Lutyens in a nutshell.

I'm a managing director at Campbell Lutyens. I'm based in Chicago. And then I work with GPs to help them think through and strategize and take advantages that the growth in the secondary market has presented. And I've been at CL for three years. And my background, I spent eight years in the buy side of the secondary market so I've been in this market for more than 11 years now. And then I also have a couple of years of experience at traditional private equity firms, which gives a really nice, well-rounded approach to how GPs think, how independent sponsors think, and then how secondary investors and LPs think.

Great. Yeah, really excited to have you here with all of your experience in this. I think that for those who have not been through one of these transactions, it'll be helpful to understand the nuts and bolts to a certain extent because these are an option for many of our independent sponsors and other funds with these assets that are getting later in the lifespan. And so this'll be interesting. But let's continue with a broader overview. Do you want to talk a little bit about the distinction between a GP-led secondary and an LP-led secondary?

Yeah, it's a great place to start because as I mentioned at the start of the podcast, the secondary market is very broad. We, who practice in the secondary market, we typically think about the market as being LP-led, and that's where an LP chooses to sell the portfolio of liquid interest, typically LP interest in funds, or a GP-led transaction. And that would be where a GP initiates some form of transaction that creates liquidity for their LPs often without selling the assets. So that's really what the secondary market is. I think what's really relevant here is the GP-led side of the market where an independent sponsor or a fund manager chooses to initiate a transaction but retain the assets and the fee paying AUM that comes with it.

And we've all seen more examples of these in the press and even around the halls of our offices, but could you tell us about how big is the market for these secondary transactions?

Yeah, there's a reason that you've been reading so much about this. I actually had to go back and look. So in about 10 years since I've been doing this actively working in the secondary market, the market has really grown dramatically. So in 2013, the whole secondary market was 23 billion. And in 2023, we just completed a market survey. It's a very opaque market, so we have to do this market survey to really get data that we feel is reliable. There was 111 billion of transaction volume in 2023.

A big part of that growth was GP-led transactions, and we'll talk about that a little bit more. But just to give you a little sense of what the market is, I talked about LP-led versus GP-led, 50% of the volume in the secondary market. Of that 111 billion, 50% of that was LPs selling fund interests. And then 41% of that volume was GPs that are leading transactions to offer liquidity to their LPs. So 45 billion in GP-led volume. And about 90% of that is what we call a continuation fund, which I think is where the mainstream press and most private equity sponsors or independent sponsors, they would be thinking about continuation fund, which is really a subset of the secondary market.

Yeah. Yeah, I mean, why don't we dive right in? Could you just describe what is a continuation fund?

Yeah. So a continuation fund, it really is a continuation of a successful investment on a very high level. And so the mechanics are, a financial sponsor chooses to offer their LPs a choice, a choice to sell their ownership interests in an asset or a portfolio of assets or to maintain their exposure in these assets. And so effectively, rather than a sponsor selling an asset and then distributing those proceeds back, which is a transaction that is entirely driven by the sponsor, the continuation fund is a sponsor choosing to hold its asset and sell it into a vehicle that is managed by the sponsor but giving each LP a choice to take liquidity or roll into a new vehicle. And then the consideration for those who seek liquidity, so the LPs or the underlying investors who seek liquidity, that consideration is funded into the continuation fund or SPV. And that consideration is then distributed out to the LPs that choose to sell. So it's effectively a synthetic sale of an asset where the sponsor retains ownership, but each LP gets the choice to sell or not sell.

Got it. And that's a really helpful overview. What are some drivers behind why a sponsor might choose to pursue a continuation vehicle as opposed to selling the underlying asset or portfolio company?

Yeah. So maybe I'll talk a little bit about some of the drivers and what we see leading to a continuation fund. So we typically see three primary drivers of a continuation fund. One, usually an asset has delivered strong performance and the sponsor has an opportunity to crystallize an attractive gain. And so in real numbers, what that means is if a sponsor has an asset that's generated a two and a half MYC or more on an unrealized basis, so they've got an unrealized gain, that is usually step one.

The second driver is typically a sponsor looking at an asset and realizing that there's upside beyond that past performance. So a business that is continuing to perform has strong tailwinds, an active M&A pipeline, and the sponsor would like to capture this upside. So that's usually the second major ingredient.

And then the third is we often see strong rationale. So does the asset's gotten very big for the sponsor or the LPs? The asset would benefit from dry powder and new capital to continue growing the asset. So what is the rationale beyond just holding the asset? And what we see from the sponsor's perspective is if these three key building blocks are in place, this is a great way to continue owning an asset, but also offering liquidity to LPs. And I'll talk a little bit more about the market dynamics, but the liquidity is really valuable in today's market. And from a sponsor's perspective, again, an independent sponsor or a fund manager, that liquidity being repatriated to LPs is really helpful because those LPs can then recycle those dollars into new funds or new deals. And I guess the last point, Greg, is the economics to a sponsor in a continuation fund can be quite compelling.

Yeah. And maybe let's stick on the economics for the sponsor. I know these can take a lot of different shapes, but assume we have an independent sponsor who owns a controls and runs a platform company. So it's a single asset, single platform company with a sort of unique, because each set of investors is deal-by-deal. So a couple significant family office LPs and maybe play that out after the independent sponsor has led that acquisition and held that portfolio company for a couple of years. You just said, what are the drivers? Why would the independent sponsor want to pursue a continuation fund? But assuming that independent sponsor had a carried interest there that upon a 2.5X MOIC return, they fully hit their hurdles and they're in kind of the highest rung percentage returns there. How do those economics work for that independent sponsor?

Sure. So the way it works for a sponsor, whether it's independent or a fund management sponsor, there's unrealized carried interest in an asset that's appreciated. And if you sell that asset, that carried interest becomes realized and it's distributed to the sponsor as part of the consideration on the sale.

In a continuation fund, that is also a realization event. But what we often see from new investors is they're very focused on alignment. So they expect the sponsor to reinvest that carried interest into the new transaction. And so we call it a crystallization event rather than a realization event. And so it crystallizes, it locks in that carried interest, it de-risk it by converting it into an LP interest, and it can often be done on a tax-free basis. It can be exchanged in kind. The sponsor would defer that and invest it into an asset which they expect to appreciate.

Then on the new continuation vehicle, the sponsor would get a new set of economics at the new basis, a new management fee, and then also a new carried interest from that stepped up basis. And they also benefit from the appreciation on their LP interest, that carried interest that has been converted into a pari-passu investment alongside the new investor. And so the way I like to think about it, Greg, is if the sponsor has call it $10 million of unrealized carried interest. In a continuation fund, they would roll that $10 million of unrealized carried interest tax-free into the new investment, into the continuation fund. And they could turn that $10 million into $30 million, $40 million from the appreciation on that investment, plus the carried interest plus the management fees going forward. So it could be quite attractive.

And that sort of crystallized equity interest going forward, that's not subject to any hurdles or anything like that. That's a pari-passu with the other LPs going forward?

Correct. That's right.

Yeah, that's a really helpful and very granular description. And so going back to the valuation point, so how has the valuation done? I mean, you don't necessarily have an arms length transaction here with a new buyer of the portfolio company, but you need a valuation to determine all these economics.

Yeah, so there's two important pieces of the valuation. One is, we as a financial advisor, we do two things. We run an auction. So we go to a group of sophisticated investors, typically secondary funds, but some family offices and institutional LPs will participate as lead investors. And so that auction is used to set two things, the value of the asset and the transfer price at which the asset would go from an older vehicle into a new vehicle, but also the economics of the new vehicle. And so we run an auction where investors bid on the value of the asset and they bid on the economics, and then we take the best price and then we present the results of that auction to the selling LPs or the existing LPs.

The second feature, which is becoming much more common is a fairness opinion. And so you can hire another third party group to provide an opinion that the valuation is reasonable and the supporting comps. And that gives LPs a lot of comfort that although this is an affiliated transaction as you point out and there's an inherent conflict of interest, this was done in a fair way where each LP... I guess the last piece, each LP gets a choice. And so there's three major pieces. So there's the auction process to set the price, there's the fairness opinion to validate and give the supporting data from an independent third party from the transaction. And then each LP has the choice of buying or selling. If they feel like it's an attractive buy, they can roll. If they feel like it's a full value, they can sell.

Great, great. There's a lot of detail and steps in the process around these, and I think that protects all of the different constituents here, which makes sense. So to that point of, there are a lot of moving pieces here. I know these are relatively prevalent in larger platform companies with maybe enterprise values in the 200, 300, $400 million range, et cetera. For those in the lower half of the middle market, lower middle market, is there a size that's too low to really do this type of transaction?

Yeah. So the size where we see the most activity is 10 to 50 million of EBITDA. Below that, it might be on the smaller side of the middle market where there aren't as many investors. And above that, it starts to get too big for the continuation fund market. One thing that we've seen is a real move to businesses that have 10, 20 million of EBITDA true middle market businesses. And the reason we see so much interest in those businesses is they don't need an IPO to exit and they can be sold to middle market or upper middle market sponsors or even mega cap funds. And so that 10, 20, 30 million size of EBITDA business, it really maximizes the opportunities for exit.

Yeah. Yeah. And that's where a lot of the listeners here are playing, I would say in that space. Maybe not on the initial acquisition side as they're buying founder owned businesses and maybe buy and build. But certainly when we're working on the sell side for our clients, et cetera, we're often in that range or above it. So definitely in the sweet spot of the independent sponsor and middle market private equity space.

So again, I think that was a super helpful discussion on the mechanics of these. Zooming out a little bit, I guess, what are the drivers of the prevalence of the continuation fund and what are you seeing ahead over the next couple of years?

Yeah, so there's two huge drivers, and they're both related to capital markets. One is the M&A market is down and the fundraising market is also challenging. And so what we see is the exit cycle of raise money, buy assets, sell companies, LPs redeploy that into new funds. That virtuous cycle of private equity, it's a little bit bogged down right now. And so just to give some data to support that. So private equity exits were down 44% in 2023, that's according to Bain. And we saw a secondary volume, GP-led secondary volume specifically up 5%. And the reason we see this mismatch in these markets is to us it's really about valuations and capital availability. So we think that a lot of sponsors are looking at uncertainty in valuations, difficulty in comping businesses, and they're choosing not to sell their assets in a suboptimal environment. They're choosing to hold their best assets and really maximize the value, continue growing them, and then look to sell them in a better capitalized environment.

I guess the other thing that we see, Greg, is there's been a lot of brand name sponsors, really big sponsors or well-known middle market sponsors that have executed continuation funds. And that's really given a lot of recognition to the market. We're busier than ever educating sponsors both independent and fund managers on why Hellman & Friedman did a continuation fund. Why did this sponsor do this? What were they thinking? So there's sort of a lot of drivers, but it's a really busy environment right now.

Yeah, no, I mean it makes a lot of sense based on what we're seeing in the M&A market. There seems to just remain a disconnect between what buyers are willing to pay and what sellers want for these assets. And sort of in that market, if you're a sponsor with confidence in your platform, this seems like a viable option that makes sense. So I guess thoughts on 2024 and beyond?

So context wise, again, 2023 was 111 billion. That was the second-highest year on record for secondary volume. Given the level of activity we see and the level of dry powder, there's 174 billion in dry powder that's controlled by secondaries funds. And the adoption by GPs, we see more capital than ever, and we see more GP embracement than ever. We think it's going to be a big year. We saw a lot of activity in the second half of 2023, and that seems to be carrying over into 2024. We think there could be 135 billion of volume, and that would be approaching the record, 135 in 2021 was the record. So we think it's going to be a really big year, Greg.

Great. That's exciting and definitely glad you were able to join us and give us a download on this as it continues to grow into 2024. Before we let you go, Darren, so if people are thinking about exploring this as an option, what are some initial first steps reaching out to someone like yourself? Any other kind of first steps into exploring this?

Yeah, I think there's three first steps. So first is legal counsel is really important. So having professional advisors like McGuireWoods or people who really understand fund dynamics and M&A, that's one. Two is talking to your LPs and just making sure that they understand that they desire liquidity and really understanding their perspectives is important. And then three would be talking to an expert in the field, a placement agent or investment bank like Campbell Lutyens that can help people think through the mechanics where the market demand is. So we'd welcome those conversations, Greg.

All right. Great. Well, Darren, thank you very much for your time today. This was a really informative discussion. I really appreciate it.

Thanks for having me, Greg. It was a pleasure.

Thank you for joining us on this episode of Deal-by-Deal, a McGuireWoods podcast. To learn more about today's discussion and our commitment to the independent sponsor community, please visit our website at mcguirewoods.com. We look forward to hearing from you.

This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.