Investing in secondaries in a high-priced environment
Since 2014, rising NAVs and record distributions have pushed secondary volumes to over USD 40bn a year and taken average pricing to the highest levels since the financial crisis.
In this short paper, we take the temperature of the large and small ends of the secondaries market in search of areas with the strongest potential for investors.
In an environment where we are seeing a flight to quality at the expense of returns across the market, we identify fund restructurings, secondary directs and the sale of limited partner stakes led by the general partner as the themes with perhaps the most potential for investors at the current time.
By Paul Newsome, Co-Head of Investments, Private Equity and Christiaan Van der Kam, Partner, Private Equity
In the 2009 to 2013 period, large secondary transactions of portfolios greater than USD 50m were available at attractive prices, as banks, pension funds and endowments were forced to sell to clean up their balance sheets. Today, forced sellers are few and far between, and to convince large sellers to put their portfolio on the market requires pricing at NAV or higher.
This was seen very clearly in October 2016, when the sale of listed private equity portfolio SVG Capital, with a NAV of GBP 800m, attracted a lot of interest from large secondary investors.
The public nature of the sale process gave observers a rare glimpse into the workings of a large secondary auction. Bidding for this portfolio, which consists of various mature funds managed by blue-chip firms such as Permira, Cinven and CCMP, started at a 9% discount and closed at a 1% premium to NAV.
The large end of the market: a highly competitive space
The large end of the market is dominated by a handful of players with funds of USD 5bn and above. There are several other second-tier players with funds of between USD 1bn and USD 5bn.
Such secondary investors need to execute large transactions which are typically sold through highly competitive auctions to fill their funds. This high level of competition has consequences.
- First, in order to price competitively, secondary bidders have to use leverage and price close to NAV or above. With cheap debt, secondary players typically use 30 – 50% leverage. Although the initial aim of leverage was to boost returns, it has now become essential to win deals and maintain double digit returns.
- Secondly, as well as increasing the price of a transaction, the use of leverage reduces the amount of funds invested by the secondary player in each transaction. Large secondary investors therefore need to execute more or bigger transactions to invest their funds, which increases competition even further. As an example, private equity firm Ardian, with a USD 11bn fund, has to deploy roughly USD 5bn annually.
- Finally, secondary players participating in auctions are forced to price secondary portfolios with incomplete information, since they will not necessarily have full access to every GP in the portfolio. According to intermediaries, secondary players bidding on portfolios typically only have full knowledge of around two-thirds of a portfolio.
Overall, it seems clear that the combination of higher prices, higher leverage and incomplete due diligence will bring lower returns with increased risk – an unpalatable mix. Unfortunately, it does not look like the situation will improve soon.
A fairly new development at the large end of the market is that buyers are aggressively pursuing potential sellers and intermediaries with the goal of pre-empting auctions by offering a headline price higher than the guide price of the auction.
Intermediaries talk about feeling almost harassed by certain buyers and some of the largest competitors have threatened not to participate in the formal auction if they are not given exclusivity.
The smaller end of the market: hardly a paradise of cheap deals
Meanwhile, the smaller end of the market, where deals are typically below USD 50m in size, is not the haven of low-priced deals that it used to be. Second-tier players have been lowering their deal size in the search for more attractive returns. This has pushed up prices for the funds of well-known, highly established general partners (GPs) such as Bain Capital, Blackstone and Carlyle.
Funds managed by such GPs are easier to value since there is more information available on the portfolio than, for example, funds managed by niche small and mid-market GPs. While leverage may not play such a significant role, these transactions are still aggressively priced at returns as low as 12-15% net IRR.
In response to generally lower returns in the secondary market, many secondary players are looking at GP-led situations, where there is a way to partner with GPs and either purchase the stakes of a group of existing investors (fund restructurings) or provide further growth capital to existing assets in the form of annex funds.
Indeed, there is a large inventory of mature 2006 and 2007 funds (the years when fundraising was at a record high) that are reaching the ends of their lives and are waiting to be liquidated. Even though such funds can be extended, there are often many fatigued limited partners who would prefer an early liquidity solution.
However, GP-led transactions need to be handled with care. First, tail-end portfolios are likely to contain more than their fair share of laggards. Secondly, conflicts are rife – the GP wants a deal that is optimal for itself (e.g. more dry powder to invest, or better economics) rather than what is best for its existing LPs. Thirdly, the level of due diligence required for fund restructurings before entry as well as any potential heavy lifting post-acquisition may be beyond the skills and resources of most secondary investors. Thus, secondary investors willing to undertake such deals need to be experienced and well resourced.
Nevertheless, it is now key to maintain strong relationships with the GPs of those funds which are attractive secondary targets. GPs play a more active role in the sale of limited partner (LP) stakes in their own funds than they did before the Global Financial Crisis, when GPs were usually the last to know about secondary sale processes.
Today, for example, many GPs actively manage potential sales of LP stakes in their funds and will inform their preferred buyer list of secondary opportunities.
Finding secondary opportunities in this environment
In spite of what might otherwise be seen as a relatively challenging outlook, we still see a number of areas which offer attractive secondary opportunities.
Small stakes in lesser-known small & middle-market funds
The key is to find situations where one has an information advantage over the competition. Some GPs may only give detailed information to existing or prospective investors. Other specialist GPs may be invested in companies that are difficult to value (e.g. oil & gas firms, certain financial services companies, etc.). Stakes in such funds can be acquired at attractive prices and/or where substantial upside exists that is not reflected in the NAV, leading to potentially higher returns.
Funds with hidden value
Even in better-known funds, valuations can differ because of different interpretations of fair market value accounting. A secondary player should therefore look for portfolios where NAVs are conservative. Such funds can be acquired at modest discounts, leaving room for outperformance. One should be wary of GPs that are fundraising, because they often like to show higher NAVs when they go back to the market.
In the current market of high prices, we believe that GP-led situations are attractive given the greatly reduced buyer universe/competition. With only a select few secondary players having access to such deals (through their respective relationships), these opportunities can be executed at reasonable valuations, allowing secondary investors to achieve decent returns with less risk (lower leverage, assets known well by the incumbent GP, etc.).
Here, a specialised GP backed by secondary investors purchases one or more mature companies directly from a tail-end fund. These are another way of accessing interesting private equity assets at attractive valuations. Typically, these occur when the incumbent GP prefers to liquidate, rather than extend or restructure the fund. Such a GP may want to focus on its more recent funds, or perhaps wants to wind down, having not raised successor funds. Secondary directs can therefore be an attractive way to invest in a portfolio of mature companies which still have further upside, partnering with a committed, experienced GP.
The aggregate unrealised value across all private equity funds is greater than USD 2tn globally. In this context, the current size of the secondary market is still a drop in the ocean. Competition for most deals may be rife but by focusing on the right areas and using appropriate judgement, we believe attractive opportunities can still be uncovered by the more creative secondary investors.
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