Commentary: Single-asset deals – a structure benefiting GPs and LPs alike

The mix of an ever-competitive deal environment, a glut of liquidity and a fair bit of market uncertainty create the need for limited partners and general partners alike to consider thoughtful solutions to meet investment objectives. A number of prominent and well-respected private equity funds, instead of pursuing third-party exits, have turned to single-asset deals, backed by the secondary markets to extract additional value.

Though they can be challenging to execute, GPs and LPs should consider utilizing single-asset secondary deals when developing their exit strategies. With a significant accumulation of capital in private equity, and alternatives more broadly, it's possible to realize the full potential of every asset in a fund, especially as historically niche markets such as secondaries now offer a sophisticated alternative to traditional exits.

Single-asset deals occur through complex direct transactions where one company, currently in an existing fund of the general partner, is transferred to a follow-on fund or special purpose vehicle. There are a variety of reasons for this: The asset involved is generally promising but nearing the end of its time horizon, it needs a capital infusion and isn't yet ready to sell at its full potential value, or more time is needed to implement strategic changes. In other instances, a single-asset deal helps avoid a forced exit, when there are particular industry or economic headwinds. These transactions are intended to be value enhancing for GPs and LPs and they allow those invested to exit, maintain or increase their exposure.

Secondary buyers are able to conduct deeper due diligence around single-asset opportunities, helping the buyers build greater conviction than what may be possible in a more diversified portfolio of interests. The terms of these transactions can be flexible to ensure a fair deal to sellers, while also creating alignment with GPs to maximize future value.

In single-asset deals, GPs effectively act as the buyer and seller, creating liquidity for existing LPs by selling their stakes on the secondary market and investing capital on behalf of prospective new LPs. Deploying capital to support proven pre-existing portfolio companies with great prospects for future growth can be better than putting capital into fresh investments where the investment thesis may carry greater risk. This point is particularly important in today's market, where "winning" assets are harder to find.

The value proposition is also strong for the portfolio company executive team. Familiarity with the GP and continuity in management eliminates the risk of changing hands and fosters the success of current growth strategies. Building a good company is no easy task, and it hurts to sell one prematurely.

The GP isn't the only winner in single-asset deals; LPs also are garnering the benefits.

First, single-asset deals offer options previously unavailable through traditional monetization strategies. Now, LPs have the choice of cashing out to a secondary buyer or rolling over their position into an asset's continuation vehicle. This is an attractive proposition for both those who want to liquidate in an illiquid market and for those looking to net higher multiples on their investment.

Second, the only assets that should be involved in single-asset deals are those that would either produce a below market return upon traditional sale, or provide above market returns if retained. In this context, a single-asset deal would be the most logical path forward for LPs invested in the company.

An additional point of consideration is that single-asset deals tend to have more LP-friendly terms than the typical 2% management fee and 20% performance fee used in a primary private equity vehicle. The economics for the GP are typically structured to align with the projected performance of the asset. The GP only receives a profit share after a hurdle return is provided and in some cases there may be multiple return hurdles in order to release different levels of carried interest.

This arrangement results in a greater net return for LPs that choose to roll their interests, but also helps to drive competitive pricing for those that would like to exit, as secondary buyers will generally pay a higher price for a well-structured deal where they feel that their interests are aligned with the GPs.

Despite the positive momentum of single-asset deals, there are still detractors who cast doubt on the merits of these transactions. One assertion may be that it's challenging to convince new buyers to sign on to a deal where the GP is cashing out, signaling a lack of confidence in the investment. To address this potential concern, GPs should roll over their carry and create thoughtful incentive programs to ensure their commitment.

In other words, if carried interest is generated as part of the sale, the buyers will want a material portion of the monetized carry to be reinvested in the new deal alongside them in the form of a GP commitment. This ensures that the GP continues to have "skin" in the game.

Others say that single-asset deals encourage failure and don't hold GPs accountable — if an asset isn't ready to sell at a fund's expiry, maybe it's just a bad asset? But this argument fails to appreciate the unique circumstances of each situation. Some single-asset deals are pursued because it's in fact more lucrative to retain rather than sell, and conversely, it's important to recognize that not all good companies develop at an equal pace or time horizon.

With growing sophistication in the secondary market and a limited pool of attractive investment opportunities, we predict the popularity of single-asset deals will continue through to 2020 and beyond. According to a Campbell Lutyens survey, the data seem to back up this theory, with the typical secondary buyer completing on average five single-asset transactions in 2018, up from four in 2017, and more than 80% of polled buyers having completed such transactions thus far.

In an environment where LPs value realizations and GPs are keen to realize the full potential of their investments, single-asset deals provide a unique solution to optimize outcomes for all parties.

Gerald Cooper is a partner at Campbell Lutyens & Co. Ltd., New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.