As a primary market matures and grows larger, offshoot industries tend to grow around it. This is certainly the case with secondaries. As the private fund universe continues to grow exponentially, secondary trades based on this industry are also growing apace. While private equity has led the way, private real estate could potentially be even better suited for secondaries. It is worth recapping (pardon the pun) some of the key issues facing the secondaries market, particularly GP-led secondaries and recapitalizations.
Among the key issues, conflicts of interest are paramount. Whatever transaction structure is used, there is a potential conflict of interest when the fund manager is effectively on both sides of the transaction. Dealing with these conflicts requires a detailed analysis of the position in the fund’s constitution and the manager’s obligations under applicable law, along with a focus on investor relations. Timely disclosure and investor dialogue are critical.
Price discovery is a vital part of solving the conflict issue. Various methods are used including full sales processes, or some combination of valuations, ‘go-shop’ processes and fairness opinions. As things stand, there are no specific legal requirements on this point other than the generic position on conflicts. However, proposed US legislation would require a fairness opinion on adviser-led transactions, and fund documentation can now include mechanisms requiring fairness opinions.
Tax is hugely important in real estate secondaries transactions. Real estate is a heavily taxed asset class, implemented on a national or, in the US, state level. This complicates the analysis. However, mitigating transfer taxes, especially for rollover investors, is of vital importance, and can come at a significant transactional cost.
ESG is also important: it remains a driving force in new funds, and continuation funds are no exception. As older funds have not had SFDR categorization and lack modern, stringent ESG policies, the buyer will need to take on these processes.
The real estate sector potentially has some subtle advantages compared with private equity. Shifting styles of funds is a common theme, and a key reason why real estate is almost perfectly suited to GP-led secondaries. It is possible in real estate to shift from a value-add risk profile to a core-plus or core risk profile, which can have very different economics. There is not a similar mix of risk/return styles in private equity.
The growth in single-sector funds is also an advantage. A manager can spin out various investments in specific subsectors such as the trendy ‘beds and sheds,’ or the even more fashionable life sciences, to form a sector-specific continuation fund.
Overall, the issues around investing should prove to be navigable. We therefore predict that GP-led secondaries will continue to increase in number – and there are some persuasive reasons why real estate transactions will likely grow even quicker than expected.
Steven Cowins is co-chair of the global real estate funds practice at Greenberg Traurig
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