- The secondaries market stalled when the COVID-19 pandemic began but activity is now picking up, most notably at the smaller end of the market.
- Liquidity challenges for both GPs and LPs are creating a unique opportunity in structured and GP-led transactions at the smaller end of the market.
- Unigestion is well positioned to exploit this opportunity, having successfully closed several complex, GP-led deals this year.
COVID-19 was a shock for the secondary market. Transaction volumes fell dramatically in Q2 2020, particularly at the larger end of the market where LP portfolio sales stopped completely.
At the small end of the secondary market, activity has bounced back more swiftly than the large end of the market and is now offering more opportunities. Firstly, small sellers such as family offices have been quick to sell positions on the secondary market in order to meet liquidity needs or simply rebalance their portfolios in the aftermath of the first COVID-19 lockdown. Secondly, given that exits have dried up, we have seen a large number of small GP-led situations such as fund restructurings and sidecar funds as GPs seek to both generate liquidity for their LPs and support their portfolio companies.
At Unigestion, we focus on small, complex secondary transactions, typically in GP-led situations. With the large number of opportunities we are seeing at the small end of the market, we have successfully closed several unique deal opportunities within the last seven months. We discuss below our current outlook on the secondary market and why we believe there is such an attractive opportunity for GP-led opportunities at the small end of the market.
COVID-19 – a Shock for the Secondary Market
When COVID-19 hit western economies, the secondary market ground to a complete halt with Q2 2020 deal volumes falling to record lows.
The immediate sharp drop in public market prices led to a disconnect between reference fund NAVs (particularly Q4 2019 valuations) and market valuations in the new, post COVID-19 market reality. Negative market movements and economic uncertainty consequently disrupted many secondary processes in Q2. As a result, most transactions were put on hold waiting for markets to stabilise and for the effects of the crisis on target companies to be better understood.
Some buyers imposed a moratorium on new deals given the unknowns around the magnitude and duration of the pandemic’s impact. In the deals that have progressed, active buyers have generally underwritten deals at higher discount rates and assumed conservative EBITDA growth and exit timings. However, non-distressed potential sellers have found it difficult to accept higher discounts, leading to wide bid-ask spreads and record low transaction volumes in Q2/early Q3.
Signs of Recovery
Buyers and sellers waited for Q1 NAVs at the earliest before transacting again. In most cases, participants even waited for Q2 valuations to gain clearer visibility over the full impact of the first COVID-19 wave.
At the same time, fund managers began to update LPs on the revenue impact, financial headroom and revised projections for portfolio companies, including exit timing. This made it possible for secondary investors to price transactions again.
In most cases, portfolio valuations saw a low point in Q1 and/or Q2 with a stabilisation trend now visible across portfolios. However, COVID-19 case numbers in Europe and North America have been increasing substantially over the past few weeks, once again casting a high degree of uncertainty over secondary markets.
A Faster Bounce Back at the Smaller End
Compared to the broader market over the first few months of the pandemic (i.e. Q2 and Q3 this year), the window of opportunity for smaller secondary transactions reopened much faster.
In the case of larger LP portfolio sales, most potential sellers – typically large institutional investors – put negotiations on hold during Q2 and Q3, waiting for market and valuation visibility to improve. Moreover, large distressed sellers have yet to appear (if at all), as was seen in 2008/09 (when it was mainly banks and financial institutions).
In contrast, smaller investors (e.g. family offices) have much quicker and easier decision processes and tend to be less price sensitive. Rebalancing and liquidity requirements in the wake of COVID-19 have prompted a number of sell decisions of single LP lines or small portfolios, as well as a greater willingness to accept considerable discounts given the ongoing market volatility.
The picture is similar in the GP-led space, including fund restructurings and (single or multi asset) continuation funds. In most cases, larger GP-led deals (over EUR 150m) were put on hold but are now slowly but steadily resuming. At the smaller end, Unigestion has executed a number of GP-led deals up to EUR 80m in size. This is a segment less covered by intermediaries, with faster decision-making processes and a willingness to organise smaller club deals instead of larger, more competitive syndication-led deals. In addition, in small GP-led deals, it is easier for buyers to hand-pick the best performing portfolio companies rather than accept whole portfolios with a mix of the good and the bad.
At the smaller end, Unigestion has executed a number of GP-led deals up to EUR 80m in size.
Slowdown of Exit Activity Leading to Alternative Financing Options
In the course of the pandemic, exit markets have slowed down considerably as illustrated in Figure 1. Globally, there were only 874 exits in H1 2020, compared to 1,238 exits in H1 2019.
Figure 1: Private Equity Exits (deal count by quarter)
Source: Pitchbook. Data as at 30 June 2020
However, driven by COVID-related concerns, many LPs have had to contend with a high demand for capital calls to support stressed portfolios or to allow GPs to exploit deal opportunities in a crisis environment. This increase in net cash outflows for LPs is creating liquidity issues and portfolio rebalancing needs for certain investors. Consequently, we expect to see an increased number of LP single stake and portfolio sales from Q4 2020 onwards.
At the same time, GPs confronted with low activity in traditional exit markets are seeking alternative liquidity options for their funds in order to placate their cash hungry investors, leading to an increasing number of continuation funds and fund restructurings.
GPs confronted with low activity in traditional exit markets are seeking alternative liquidity options for their funds.
Given the much larger universe of small and mid-market GPs compared to large cap GPs, there are simply more small GPs with tail-end funds and maturing portfolios. This creates a fertile ground for smaller structured deals that fall under the radar of large secondary intermediaries and investors.
The Need for Portfolio Support
In addition to reduced exit activity, GPs are also having to carefully manage their existing portfolios. The current crisis brings both challenges and opportunities. Firstly, certain portfolio companies – typically those in cyclical industries more sensitive to the COVID crisis and with high capex requirements – might need more liquidity. Secondly, the stronger portfolio companies – either resilient to or even positively enhanced by the COVID pandemic – may require further financing to aid expansion or make selective add-on acquisitions.
This creates a significant opportunity for structured and GP-led transactions at the smaller end of the market, where transactions can be easily tailored to focus only on the best performing portfolio companies. For example, a GP can set up innovative sidecar or bridge fund structures, typically combined with preferential terms for the underlying financial instruments. In the first few months of the pandemic, Unigestion set up various portfolio support solutions at the smaller end of the market. In one example, we set up a sidecar fund to invest alongside a Scandinavian growth capital manager to support two companies that were positively impacted by COVID and in need of additional capital to continue their steep growth trajectory.
The Case for COVID-19 Resilient and Winning Companies
The future remains highly uncertain but the pandemic is likely to continue to have a disparate and unequal effect across industries and sectors, as follows:
- Highly impacted sectors: e.g. transportation, hospitality, travel industry
- Moderately impacted sectors: e.g. financial services, business services
- Neutrally impacted sectors (COVID resilient): e.g. healthcare services, food & beverage, technology/software
- Positively impacted sectors (COVID “winners”): e.g. e-commerce concepts, products that address an issue specifically generated by COVID
Investors will likely find considerable discounts for portfolios of companies in highly impacted sectors. However, Unigestion’s secondary strategy maintains a clear focus on portfolios of companies in neutrally or positively impacted sectors, i.e. COVID resilient or winning companies. Given the ongoing uncertainties surrounding the pandemic, we believe that these are the only categories where the outlook can be reasonably assessed.
Unigestion’s secondary strategy maintains a clear focus on portfolios of companies in neutrally or positively impacted sectors.
Winning Positioning in an Ongoing Competitive Market
As expected, the pandemic has taken a toll on secondaries deal activity, particularly at the larger end of the market. Furthermore, large secondary deals that have progressed despite the crisis have been highly competitive, given the high levels of dry powder amongst large secondary players.
Less expected are the unique deal opportunities that the pandemic has created at the lower end of the market. Demand from swift and opportunistic sellers as well as a strong flow of GP-led/structured opportunities to give liquidity to LPs and to support existing portfolios have appeared much sooner than anticipated.
However, a flexible and dynamic secondaries approach as well as exceptional access to deal flow are essential in order to fully exploit the current opportunity at the small end of the secondary market.
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Additional Information for US Investors
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Document issued December 2020.