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Ropes & Gray attorneys provide timely analysis on legal developments, court decisions and changes in legislation and regulations.
Deb Lussier: Hi, everyone. I’m Deb Lussier, a partner and co-leader of the sponsor solutions practice at Ropes & Gray. Welcome to our podcast, A Word for Our Sponsors, where we talk with private equity insiders about the issues that matter most to them. On this episode, the first in a two-part series, I’m joined by my colleague Marc Migliazzo, counsel in our sponsor solutions practice. Marc, what do we have in store for our listeners on this first part?
Marc Migliazzo: Today, on the podcast, we’re joined by Jon Costello, founder of Devon Park Advisors, to give us his perspective on the current market and evolving landscape of GP-led secondary transactions. Jon, welcome to the podcast.
Jonathan Costello: Thank you, Marc and Debra. I really appreciate you all inviting me today.
Marc Migliazzo: To kick us off, Jon, can you share a bit about Devon Park?
Jonathan Costello: Sure. Devon Park is a boutique investment bank. Our core business is advising sponsors on continuation fund transactions. We are active in both single and multi-asset deals. We’re also agnostic, as it relates to the underlying exposure industry segments, so we’re active in real estate, private equity, private credit, and control and non-control PE.
Marc Migliazzo: In deciding to launch Devon Park with an early focus on continuation fund transactions, you’re obviously bullish about the trajectory of the fund-level secondary market. Why is that? And how do you see the market evolving over the next couple of years?
Jonathan Costello: I’ve pretty much bet my career on the secondary market, more broadly. I’ve been involved in this space for more than 20 years and got really excited about continuation funds, which they weren’t called at that time. Fifteen years ago, coming out of the GFC, the global financial crisis, we started to see some trends back when I was on the buy side of really interesting opportunities to gain exposure to assets. That’s continued to evolve pretty rapidly to a point today where it’s almost considered a strategic alternative that most sponsors would consider alongside other potential exit options. There are a lot of positive trends, which we can talk about more and dive into, but I think from our vantage point, we see this as a market that’s continuing to expand, there are new entrants, there are new applications of the technology, if you could call it that, along with continued underlying growth in all of the types of deals that we’ve seen so far.
Marc Migliazzo: Can you tell us about the applications you’re referring to and some of the recent innovations in the marketplace?
Jonathan Costello: Yes, maybe it’s helpful to give a little bit of history. Back when this all started, it was really targeting situations where you had an underperforming fund or underperforming manager—they were mainly full fund. At the time, we called them “recapitalizations” or “restructurings,” and they’re really targeting situations where there was the potential for managers—they may not raise another fund, or it was more of a question mark of whether they would be able to do that.
In terms of the evolution in the market, it was really around 2018 where we saw a major inflection point, which is now going on five or six years ago. And, at that point, the globally branded sponsors really decided that this was an interesting application for assets that had been very successful for them, and they wanted an opportunity to hold them longer. In many cases, there were buy-and-build platforms, and the funds that they were sitting in were more looking for exits than continuing to compound value. It was really in 2018 where we started to see those sponsors pull out highly successful investments, either as a single-asset deal or into multi-asset CVs—and that was, for me, at least, the main inflection point.
What we’ve seen today is, because the globally branded sponsors, once they embrace things, then it permeates through into the middle market. We’ve seen this broader ecosystem evolve and many sponsors embracing these transactions. Processes got better. Limited partners (LPs) got more comfortable with what was happening. There was a regulatory framework in ILPA guidelines. The original ones are now four or five years old—those were all established. And then, we started seeing this starting to take share from traditional sell-side M&A, which then created new entrants on the advisory side, as well.
Deb Lussier: Jon, we agree with you, in terms of a tipping point being around 2018 and share the observation on the acceleration of the market since then, with sponsors reaching out to us with a lot of frequency to better understand these, to engage on them, and to complete their first continuation funds. We haven’t yet felt the same acceptance from the limited partner community. I agree with your view that there’s more acceptance, but we still are sensing that LPs are hesitant about these transactions. Can you talk a little bit about your experience with the LP community and how they’re interacting with continuation funds?
Jonathan Costello: Sure. I think it all comes down to communication and transparency. I think that the market has gotten much better—both sponsors, advisors, and their counsel—at communicating the motivations and why this makes sense, and giving the LPs plenty of time to both react and evaluate what their options are. Parity of information and communication with LPACs ahead of a process, there’s just overall process improvements that have occurred. It’s not like they’re getting election materials between Thanksgiving and the end of the year and being forced to make a decision when they might not have any more investment committees scheduled for the year. I think people have gotten better at the communication side of this. I would say that the challenge continues to be for LPs, that this is incremental work that they’re being asked to do. They want to allocate capital, they hire sponsors to make a lot of these decisions, and so, they get a little bit uncomfortable when they’re being asked to make a decision that might be different than what the sponsor’s doing with the asset. There’s always going to be a little bit of tension in the system, but I think that, overall, it’s gotten much better all around.
Deb Lussier: Do you have a sense of what percentage of limited partners are electing to roll over versus cash out in these transactions? And do you see that percentage shifting over the next several years?
Jonathan Costello: The percentage, at least, from the transactions I’ve been involved with, historically had been in the mid-60s, so two thirds would take the liquidity option. I think, in the more recent year and a half, we’ve seen that tick up dramatically, particularly in situations where the asset has performed extremely well. If you’re an LP and you’re sitting on a four-, five-, six-, or ten-X return, it’s probably easier for you to make that election to sell and to take your liquidity. And so, I think we’ve seen that tick up, and that’s partly driven by the fact that you still have a lot of major LPs in these funds that are over-allocated at the moment. It’s a way for them to get quiet liquidity without running a process to sell a whole bunch of LP positions. So, I think that continues to persist, at least in the current environment. Maybe it will normalize back, but the range of outcomes that we’ve seen is a 50/50 sell / roll up to, in some cases, 100% selling. From our vantage point, that’s unrelated to the opportunity itself—I think it has to do with portfolio management decisions going on at the underlying investor and then their perception of what the go-forward is.
Deb Lussier: Do you have a piece of advice for a sponsor who’s considering undertaking its first GP-led secondary?
Jonathan Costello: I think we’d have a lot of advice. It requires real planning, number one, and I think, number two, it has to be thesis-based, like, “I would like to continue to own this asset or set of assets for these reasons.” One example would be to fund a highly transformative acquisition. To me, that’s a great thesis for why to contemplate a continuation fund because you’re not going to immediately get credit. Even if you could fund the deal within your current fund or in a newer fund, you’re going to need to hold it for a little bit longer in order to get full credit for that on the exit, and that should be highly accretive to all of the stakeholders. I think the more that this is thesis-driven, the better. The investors in these transactions are highly sophisticated and they’re looking for most of the same information that you would assemble in a sell-side process.
I think one of the nuances of these deals—and it’s really important for sponsors to understand this—is in a sell-side process, from my vantage point, you’re trying to get credit for all the potential outcomes and equity opportunities that the business has during this next phase of ownership. In these deals, the investors that are backing these transactions, they’re looking to underwrite the thesis of the current sponsor, so it’s a slightly more nuanced, I think, sale in the sense that you’re selling what you think your equity case is. It would be very similar if you were needing to secure co-invest to execute on a major new investment, and you’d have to share what your thesis is with the both existing and new investors that you hope to be part of the next phase of ownership versus what is a traditional sell-side process. So, I think those are some of the key things, as you need a deal team that’s ready, willing, and able to spend time engaged in this process because it doesn’t sell itself.
Marc Migliazzo: In your experience, when do clients tend to reach out to Devon Park to engage in a possible transaction? And when do you think an ideal time is for them to engage you?
Jonathan Costello: I would say the earlier, the better. We do have clients who we talk to when they’re thinking about exit planning for a particular asset more broadly and trying to evaluate what their overall alternatives might be—that’s the ideal timeframe. I think, sometimes, we get called in the middle of a sell-side process that isn’t going as planned or on the back of a failed sell-side process, where the market wasn’t, at least, ascribing the value that the sponsor thought was necessary to exit the business. So, we get called across the entire spectrum. But, ideally, going back to the advice that I would give sponsors, is I would make it part of your overall exit planning. There are assets that are better than others that make better candidates, I would say, for these types of transactions.
Some examples of that would be situations where there are growth initiatives underway but not yet fully realized, where sponsors may have recently identified and are looking to complete a transformative acquisition, or maybe they recently completed one and they’re not done integrating that deal into the broader platform. We also are seeing a trend where well-regarded sponsors are coming in and buying minority stakes into mature businesses that are performing extremely well and injecting some growth equity. As a result of that deal—that specific type of transaction—obviously, the new sponsor wants to have an extended hold period to make their return. As a result of that, we see an increase in conversations with the sponsor that was originally owning the asset to want to extend the hold period through a continuation-type deal so that their new hold periods align with that of the new investor. I would say what is most important for sponsors that are considering continuation fund transactions is that they’re thesis-driven—so, all of these examples are really tied to re-underwriting by the current sponsor of this asset and them wanting to do more with the asset before exiting their position. We find that transactions that are thesis-driven get the best pricing and they also have the broadest acceptance in the market from prospective new investors.
Deb Lussier: Thanks so much for sharing these insights, Jon. I’d also like to thank our audience for joining us today. Please stay tuned for the second part of our conversation, where we’ll further discuss the evolving landscape of the GP-led secondary market, including the entry of new investors and platforms, the role of various investor types, and the innovative trends and future applications of continuation funds. For more information on the topics that we discussed, please visit our website at ropesgray.com. Of course, if we can help you navigate any of the topics that we discussed, don’t hesitate to get in touch with us. You can also subscribe to A Word for Our Sponsors anywhere that you listen to podcasts, including on Apple and Spotify. Thanks again for joining us.