The secondaries market is broader, deeper and more sophisticated than it was during the global financial crisis. This is particularly evident in the variety of financing and structuring options available to funds to help them maximise returns.

Private Equity International has examined the subject from the fund-, transaction- and portfolio company-level to find out how leverage is affecting secondaries funds during the time of covid-19 and how it might actually help them and their portfolios.

At the fund level, capital call facilities have been employed much more aggressively in recent years. The growth of net-asset-value-backed financing and dividend recaps has further complicated the picture. Shrinking NAVs, weaker distribution forecasts and distress among limited partners brought about by coronavirus could prove a bitter cocktail.

For some buyers, it has become the norm to form special purpose vehicles around individual transactions and apply leverage with recourse to those assets. With the values of many of these portfolios dropping, there is a real risk covenants could be triggered. If credit markets remain tight, how will it affect secondaries firms that have SPV leverage at the centre of their strategies?

The soaring market for GP-led transactions has made individual company risk a preoccupation for secondaries firms in a way it was not during the last crisis. How much support have businesses needed from their secondaries backers? And what does this mean for the ultimate returns of GP-led transactions?

Leverage has been a successful tool for juicing returns during the bull run over the past 10 years. For some firms, it has been integral to success. The coronavirus crisis could well sort the savvy dealmakers that used leverage judiciously from those relying on a rising market to deliver performance.

Fund-level financing

The frequency with which secondaries funds make capital calls has made them ideal users of subscription credit lines. Backed by limited partners’ undrawn commitments, these facilities allow funds to invest in deals without having to continually call capital. Many secondaries funds supplement these with a longer-term credit line – also backed by uncalled capital – putting a portion of each deal on the facility.

Net asset value-backed credit facilities have also taken off in recent years. Secured against the equity value of a portfolio, these allow funds that are fully drawn to access liquidity in order to make bolt-on investments or provide follow-on capital for portfolio companies in need. These facilities typically have less stringent covenants than asset-level debt.

According to data compiled by UBS, 86 percent of secondaries firms used a fund facility for at least one transaction last year.

The coronavirus pandemic is the first real test of these facilities, and sources sister title Secondaries Investor spoke to for this report pointed out several key issues to be aware of.

LPs’ promise is gold

Facilities secured against uncalled commitments are of little concern, according to three sources. While news of LP defaults has caused uproar, most expect defaults to be fewer than anticipated and confined to the smaller end of the market.

LP commitment-backed facilities are flexible, in that they are not assigned to particular deals, and also tend to have a loan-to-value of around 20 to 40 percent – lower than many forms of transaction financing.

PEI reported in March that some GPs are calling capital to repay subscription lines early out of fear that a prolonged slump could cause liquidity issues for LPs. Secondaries Investor is not aware that this trend has hit the secondaries market due to the covid-19 crisis.

“Even in the GFC, when there was a big liquidity crunch, people were not defaulting,” says one senior buyside source based in London. “There’s such a stigma about it and you avoid it at any cost. The denominator effect is certainly not a reason to default and I think [early repayment of credit lines] is a spurious reason to call down capital.”

Current economic conditions could mean these facilities are used less aggressively, says a New York-based director at a large secondaries firm. LP capital-backed financing is most effective when distributions are quick and immediately recycled – a scenario that looks unlikely over the medium term.

NAV based woes

NAV-based facilities are potentially more problematic. A covenant is triggered when the loan-to-value of the portfolio rises above a certain level, which is more likely to happen at a time when asset values are shrinking. The borrower can request for the covenant to be reset, though the lender may require the borrower to inject equity in order to bring the facility back into compliance.

These facilities are paid via a sweep of cashflow distributions. In recent years, bumper distributions have allowed GPs to repay five-year facilities in as much as half that time, says Matt Hansford, head of the UK fund finance team at Investec. This is unlikely to be the norm from now on.

“You’ve got covenant testing every quarter and at some point, some of those will kick in … There might be some in the market who put something in place at the wrong time, probably pre-covid at a relatively high LTV in the expectation of material distributions,” says Hansford.

Exotic instruments

There is another form of fund-level leverage, which could also pose a concern. Distribution accelerator facilities, or distribution recaps, allow secondaries funds to borrow a portion of their expected next-12-month distributions and pass these on to LPs. Secured against the portfolio, such facilities can be as high as 60 percent of expected cashflows and help boost the fund’s internal rate of return.

“These facilities work 99 percent of the time because it’s really hard to get your projected distributions number wrong by 40 or 50 percent,” says one secondaries veteran. In an event such as a global health pandemic, it is of course possible to miscalculate projections by that amount.

A combination of multiple lending facilities could have a material impact on a fund, and if a secondaries fund receives a high volume of capital calls at once from its underlying GPs wanting to pay down their own credit lines early, it could end up with less uncalled capital to plug holes elsewhere: “All of these things compound on each other, right?” the veteran adds.

Transaction-level financing

Deal-level leverage ratios have increased in recent years, with loan-to-value proportions rising last year to around 40-50 percent, from below 40 percent a year earlier, according to research by Campbell Lutyens.

Transaction leverage in the secondaries market is applied by forming a special purpose vehicle around the portfolio being acquired. The size of the LTV, and the number and stringency of covenant tests, are applied on a case-by-case basis with recourse to the assets. The loan is paid via a cash sweep of distributions. LTV on the loans employed by some of the largest secondaries buyers are often in the 50-60 percent range, market sources tell Secondaries Investor.

What does the coronavirus-related shutdown mean for the health of these outstanding financings? And how will this in turn affect dealmaking?

Early wobbles

Secondaries Investor is aware of one portfolio, acquired by a mid-sized, US-headquartered secondaries firm, in which the LTV of the debt used in the deal has risen enough to trigger a covenant. We are also aware of a secondaries fund that has called capital from limited partners in order to de-lever several special purpose vehicles. Early signs suggest second-quarter valuations have not collapsed in the way some feared, reflecting public comps buoyed by economic stimulus. A second wave of coronavirus and the risk of another economic shutdown is, however, very real.

Still, according to most market participants we spoke to, a full-blown crisis related to transaction-level debt is unlikely. SPV-level leverage tends to be more popular among larger firms, which have been able to take advantage of their reputations and a borrower-friendly market to secure flexible lending conditions. LPs who may be facing an increase in capital calls are still unlikely to default en masse, sources say.

“Usually there is enough cushion, even if NAVs fall 20 percent,” says one senior London-based buyer. “I don’t think you’ll find too many of these structures tripping their covenants. Even if they did, they can just call capital.”

The deals that are closing amid the coronavirus-induced downturn must contend with a changed environment for deal financing. Secondaries Investor is aware of one large portfolio transaction – agreed prior to the onset of covid-19 – which closed as a 100 percent equity trade due to the inability to secure SPV-level finance at the desired cost.

Unlike during the global financial crisis, banks are in good health. None of the market participants that we spoke to say they expect mass withdrawals from the SPV lending market.

According to Tristram Perkins, co-head of secondaries at Neuberger Berman, a pause on lending by many banks could mean portfolios trade at lower prices, portfolios are dismantled into smaller pieces and a more level playing field emerges.

“Given the scarcity of leverage, given the cost of that leverage, I think those big buyers, the most aggressive pricers of risk, could be sidelined for a period of time,” Perkins says.

Deferrals – where buyers can agree to a higher price in exchange for a portion of the total being paid later – were on the rise prior to this year’s pandemic.

According to research by advisory firm Campbell Lutyens, 43 percent of buyers last year used deferrals, compared with 38 percent the prior year. Their use has also become more aggressive, with 55 percent of deferred payment structures extending beyond 12 months last year, compared with 28 percent in 2018.

Many of these deals are done under the assumption that interim distributions will finance part or all of any deferred component – something that is no longer a given in the downturn of 2020. During the deferral period, the value of the portfolio could drop far below the amount the buyer agreed to pay for it. The buyer could have to choose between making more payments on a portfolio that is already underwater or defaulting.

“The counterparty is not a commercial bank with which you can negotiate an extension or do an equity cure,” says Benjamin Revillon, managing partner of Nice-based secondaries firm BEX Capital. “It’s a seller to whom you owe money and who has a pledge over those assets.”

We could now see an increase in the use of deferment mechanisms, according to two sources. With credit tightening, they could be the easiest way to bridge gaps between buyers and sellers.

Choosing a fund

In the long run, this crisis could have a notable impact on how LPs choose secondaries funds, says Johanna Lottmann, managing director at PJT Park Hill. Funds that use the most leverage will experience greater volatility, making it clear how they achieve most of their target return.

“LPs should start to dissect track records to see what was returned on a levered and what was returned on an un-levered basis,” Lottmann says.

According to data from Refinitiv LPC, more than 75 percent of US buyout deals in 2019 had leverage multiples of more than 6x EBITDA, compared with just 25 percent in 2008 and 38 percent in 2010.

The rise of concentrated GP-led restructurings including single-asset processes, combined with the impact of the coronavirus, means this is a potential problem for secondaries funds in a way that was not the case 10 years ago.

How are debt-laden assets experiencing distress likely to affect returns for GP-led transactions? And what can secondaries investors do about this?

The steep drop in Q1 valuations compared with the previous quarter has led to some GP-led deals being valued below cost, several sources told Secondaries Investor.

Some deals were done with “toppy leverage levels”, says one London-based buy-side director, on the assumption that if the companies performed as expected, they would be able to refinance.

“If operating performance is impacted, they’re not going to be able to [refinance],” the director adds.

Companies have gone bankrupt and will continue to do so as a result of the coronavirus, but not before all options are exhausted. Banks typically do not want to take businesses away from sponsors. According to one debt advisory partner, GPs can negotiate new credit lines, though heightened risk aversion on the part of lenders is making this difficult.

State aid is also proving hard to come by for many PE-backed companies due to difficulties meeting the criteria. Consequently, secondaries funds will have a significant part to play.

“The GFC was a Wall Street-driven liquidity crisis; this is Main Street-driven,” says David Wachter, co-founder of direct secondaries firm W Capital Partners. “Because economic sectors will be impacted very differently, secondary solutions will have to be targeted and asset-specific, not just about leverage and LP liquidity.”

Many GP-led deals may not have sufficient follow-on capital to help assets through a crisis. If more capital is required, secondaries funds will be dependent on having flexible recycling provisions which allow them to direct distributions from elsewhere in the portfolio to service debt or make follow-on investments. Those with weaker provisions than their peers will have their returns “crushed on a relative basis”, says a New York-based managing director at an advisory firm.

The alternative is to raise extra capital from LPs on an ad-hoc basis, which is potentially messy. If a continuation vehicle has 10 LPs, all of them will have to be convinced to put up their share of capital, says one US-based buy-side veteran. What happens if they do not or cannot is not always clear.

“The legal documents aren’t necessarily built to say, ‘If you need capital and certain LPs don’t have it, the rest of you can put up the money and those that can’t get diluted,’” the buy-side veteran adds. “The syndication of fund restructurings to manage risk created a different kind of risk.”

Preferred opportunity

This situation represents a challenge for secondaries funds and an opportunity in the form of preferred equity, according to Michael Hacker, managing director at AlpInvest Partners, which is one of several large firms to have written preferred equity cheques since the covid-19 crisis began.

Many GPs see it as the quickest, least-conflicted way of injecting capital into fully called funds. Unlike when taking on new debt or doing a GP-led restructuring, it does not require LP approval – though approval is advised.

On the flip side, it tends to be more expensive than NAV-based debt and more difficult to explain to LPs. The lower risk-return profile of preferred equity deals and their limited upside mean they do not fit neatly with the transactions that large secondaries funds typically invest in.

Secondaries funds are exploring ways around this: for example, by extending hybrid preferred equity and debt tranches. The coupon attached to the latter gives comfort to LPs more familiar with the structure of debt financing, and the blended cost is lower than it would be for straight preferred equity.

Last year, Pomona Capital extended a back-levered preferred tranche to London-headquartered Palamon Capital. Borrowing a portion from the bank at a lower interest rate allowed it to lend more cheaply, with the bank being paid via preferential cashflows from Palamon’s portfolio. As more secondaries funds move into issuing preferred equity as a result of covid-19, there could be more similar deals, according to two market sources.

Whether the steady trickle of preferred deals turns into a flood depends largely on the availability of debt financing – preferred is rarely the cheapest option – and a lack of other options. There are signs that the fund restructuring market is opening up after a period of paralysis due to price dislocation, giving GPs another liquidity option. Vertex, a subsidiary of Temasek, launched a process in July.

Yet, the strategy is already playing a role in providing extra capital to portfolio companies and helping secondaries funds put money to work in a market where all-equity deals are, for the moment, thin on the ground.