Complexity is your friend

In the current late cycle pricing environment, secondaries buyers need to play to their strengths, Neuberger Berman’s Tristram Perkins tells Private Equity International.

Tristram Perkins

It’s been a strong start to the year for secondaries, with transaction volume on track to surpass last year’s record of $58 billion. Record primary fundraising and strong growth in the GP-led market coupled with high secondary pricing is doing wonders for supply, but how should investors think about returns?

Tristram Perkins, managing director and global co-head of secondary private equity at Neuberger Berman, shares his thoughts on how to approach a heady market in in the late innings of an economic cycle.

How would you characterise the secondaries market?

My partners and I have invested in secondaries for well over 20 years, through a variety of economic and market cycles. No doubt we’re biased, but in our view, secondaries continue to offer attractive risk adjusted returns in the current environment, and, as a shorter duration strategy that benefits from volatility and illiquidity, late cycle secondary vintages have historically outperformed.

Looking at the market today, supply is incredibly strong. With first half volume up ~25 percent overall, and even stronger growth in GP-led transactions, we have a lot of investment opportunities to choose from. The challenge in a massively liquid market is a lack of motivated sellers.

Fairly predictable, quarter after quarter net inflows combined with low-yields have driven strong investor appetite for alternative sources of return. But thanks in part to net inflows, alternatives exposure has probably gone down as publics have climbed – almost the inverse of the denominator effect we saw coming out of the financial crisis. That makes it a very tough environment to convince a private equity investor to sell a good quality asset at a material discount.

Looking ahead, record primary fundraising should continue to prime the pump of strong secondary supply, and, if history repeats, as markets cool, liquidity premiums should increase and pricing should improve for buyers. In the meantime, you have to pick your spots.

What effect have market conditions had on returns?

Secondaries have not been immune from the late cycle compression impacting public and private markets. That being said, secondaries today is not a unified market with a single competitive dynamic and return target. In the wake of the financial crisis the secondary market split.

At the upper end, $5 billion-$15 billion funds compete for large, 25-100 fund transactions, deploying an index strategy, and targeting unlevered returns that are 500-1000 basis points lower than what we were seeing pre-financial crisis. In the current market, index funds buying a $500 million, 50-fund portfolio, could borrow upwards of 50 percent LTV to prop up returns.

Secondary mid-market strategies target high conviction, single fund and small portfolio transactions, seeking to generate 300-600bps of unlevered return premium relative to index. These transactions don’t lend themselves to leverage the way the index strategies do, so the mid-market has been a bit more immunised from the pricing dynamics and unlevered return compression we’ve seen in the index market.

Which areas are investors finding most interesting?

In the current environment, complexity is a friend to return. Transactions requiring GPs, LPs and secondary buyers to collectively solve a problem, are providing the greatest return potential.

As one example, growth in the GP-led market is fuelled by GPs and LPs working to address divergent LP duration and liquidity expectations.

This market has evolved incredibly quickly, from its origins in zombie fund restructurings, into a best in class GP portfolio management tool. With that evolution has come an increasingly sophisticated tool set, ranging from relatively simple tenders to more structured strip sales and continuation funds.

Returns in more complex transactions are driven by structural levers you don’t have in traditional LP secondaries or in GP-led tenders, including a reset of GP economics and investment clock and in some cases new capital to support value creation in legacy assets.

For these transactions to be successful, they have to be a win-win-win for the selling LPs, the GP and the buyer. When the motivation of the GP is to provide a fully transparent option to LPs that want liquidity, while also seeking to maximize the long-term value of the legacy assets for rollover LPs and the new buyer, all constituents should benefit.

As we head into the next downturn, what challenges face secondaries buyers?

For secondary buyers, uniquely, a correction can be a blessing and a challenge. On the buyside, increased volatility, lower net inflows and longer duration have historically created more motivated selling and better pricing.

The challenge is in our legacy portfolios. One factor that drives secondary returns is by buying these assets later in their life, the market is underwriting a shorter duration.

In a recession you may hit a 6-18 month period where there isn’t a lot of liquidity, and the duration of the underlyings gets pushed out. In general, those are periods without a lot of economic growth, so the underlyings aren’t accreting a whole lot of value. For a secondaries investor who is probably underwriting a three or four-year duration, a 6-18 month extension can have a material impact on IRR, although typically not as large an impact on multiple of capital.

Is it still right to think of private equity as an illiquid asset class?

Relative to 20 years ago, the market has developed a lot. You have sellside agents, you have LPs and GPs that are very experienced and actively using the market to manage their portfolios. You’ve seen both LPs and GPs execute very creative structured liquidity solutions over the last 18-24 months, all of which we would expect to continue.

Despite strong growth in the market, secondary turnover relative to primary capital raised is only a single digit percentage. If you look at any other multi-trillion-dollar asset class, turnover in private equity is a fraction of turnover in those markets and we believe the market has a long way to go.

Do you expect to see managers building liquidity options into their fund documents in the near future?

I could certainly see that. As the universe of LPs in private equity funds has expanded to encompass just about every type of investor, GPs are confronted with a diversity of liquidity and duration expectations. Historically, with GPs raising primarily from institutional LPs, with long duration liabilities, the pact has been a 10-plus year marriage. As the LP universe continues to expand, to include groups with greater liquidity expectations, GPs will have to figure out a way to satisfy both groups.

Reflected in the recent growth of the GP-led market, those divergent expectations will require a structured liquidity option backstopped by a secondary buyer. Whether that option is granted in year two, four, eight or 10 remains to be seen, but the genie is out of the bottle and GPs, LPs and secondary buyers are actively working through the options.

This article was sponsored by Neuberger Berman and first appeared in the September issue of Private Equity International.