This article is sponsored by AlpInvest Partners.
How do you view the growth of the secondaries market in the past few years?
Wouter Moerel: If you think of the $70 billion that transacted last year, around two-thirds of that was the LP market and one-third was the GP-led market. The LP portfolio market has seen exponential growth. High valuations have meant there are more sellers. Buyers that focus on that market increasingly used structuring and leverage to continue buying assets at higher prices and at higher underlying valuations. At the end of the day, it is becoming a bit of a vicious circle. In this market segment, we see more lower quality assets being sold out of older funds that already contain difficult-to-sell companies or companies that have been underperforming, as well as funds where there is less future value creation.
In the GP-centred market, the growth has been fuelled by a broader set of GPs who now see the secondaries market as a tool for them to try to meet their objectives and as no longer carrying a negative connotation. This development has played into our theme of partnering with quality GPs as the universe of opportunities now includes some of the higher quality GPs in the market. They can either: have an opportunity to refresh their LP base; set up a continuation fund with a new time horizon to realise the full potential of an asset or group of assets; or create an opportunity to help facilitate fundraising.
How has the competitive landscape changed amid that growth?
Chris Perriello: There’s been a lot of capital raised, but it’s been raised by primarily the same firms that have been around for many years. The number of competitors hasn’t really changed. The biggest driver of competition for us has been the use of leverage by our peers, which has impacted how we think about pricing much more rather than the amount of dry powder.
We have stayed away from using leverage and generally avoided the broader LP portfolio deals that have dominated the market volumes over the past few years. We don’t believe that in these market conditions the risk/reward makes sense to essentially buy the levered index. Fundamentally for us, the key is to create a portfolio with the following characteristics: low volatility/capital preservation and a solid and consistent cash-yielding profile return. If we add leverage to our transactions, we would change both of those characteristics.
We alter the risk profile of the transaction and we change the cashflow profile back to our investors. Adding risk at that level for us doesn’t make sense.
WM: We don’t use a line at the asset level and we don’t use financing at the fund level for transactions. We have a working capital facility at the fund level, but we use that exclusively for capital call management and don’t underwrite deals using this facility as leverage.
Leverage also delays cashflow back to investors. Secondaries investors like AlpInvest, first and foremost, seek to avoid the J-curve and negative cashflow. In a secondaries portfolio, you typically start getting cash back almost immediately as opposed to year five in a typical buyout portfolio. But if you need to give some of that cash back to the bank, you’ve created the same J-curve. The primary purpose of doing secondaries – early cashflow back– is gone. That’s another pitfall of leverage. It can defeat the purpose of secondaries investing.
What has AlpInvest focused on in this environment?
CP: We’ve deployed the same amount of capital on a per annum basis over the past five to eight years even though the market has doubled. Over that period, we have deployed on average between $1.5 billion and $2.25 billion per year. Our focus on quality and selectivity has kept this deployment pace relatively stable despite the overall growth of market volumes. Our unwillingness to veer from our core strategy leads to a more focused approach around a smaller number of transactions per annum, which is typically around 10 to 12 deals closed. Some secondaries investors are doing 50 to 100. We focus on asset and GP diligence as our key risk mitigant rather than on the value of diversification for the sake of diversification.
In the GP-centred market, we’re trying to find unique situations where we can partner with a GP we have conviction in and where we have an asset pool that has a story around value creation. In most cases that also includes providing new capital to realise that plan. In all cases the GP is putting money alongside us and understands we’re going to be partners. The need for us to have all these key elements in each transaction limits the GPs we will partner with. We haven’t done many intermediated tenders – alignment is often challenging in that setting and usually leads to peak pricing. You’re not resetting economics or getting GPs to invest alongside in those cases, which limits our ability to create the alignment we need. We’ve focused on high-quality GP-led restructurings, whole or partial asset sales, and we still invest in stapled transactions with GPs we like.
What has your approach been on the LP side in recent years?
CP: Our niche in the LP portfolio market has always been the same. We focus on buying LP interests in three- to six-year-old funds in high quality GPs we have conviction around and where we have natural alignment. We trade at or around par to net asset value because in most cases we are buying funds that have not been marked up yet and we’re aligned with the GP. We’re staying away from the large portfolios, older assets and lower quality GPs. We don’t believe there’s a price for everything. We haven’t changed our strategy on the LP portfolio side, we just adjusted how much capital we put to work in that segment based on the market conditions.
What could be the worst-case scenario for those secondaries funds in an economic downturn?
WM: If the public markets decrease as they did in 2009 or even generally in line with most recessionary periods, the leveraged funds could likely face issues. The underlying companies will be worth less and the loan-to-value will go up. It may lead to capital calls from the bank, which investors in these secondaries funds must put in, which could further reduce the already low returns available in the diversified LP portfolio market.
Will it lead to default? Probably, but they could be more sporadic because a lot of the documentation is quite borrower-friendly. You may see one or two blow-ups where the secondaries fund can no longer fund the commitment to the underlying fund. That is a crash scenario. What we expect to see is that returns of these funds are going to be severely impacted with significant swings in valuations. You may lose some of your investments.
Right now, everyone who has used leverage has done so in an up market. If the market goes up, leverage is your friend. If the market goes down, leverage will eat into your equity returns. As a result, secondaries funds which use leverage extensively will need to retool and focus again on the base. We’re already beyond the top or somewhere close to the top of the market.