The first half of 2011 was the most active six-month period to date for the private equity secondary market, in volume terms. For the biggest deals – portfolios over half a billion dollars in size – increased competition is leading to very low discounts, and this has encouraged the use of some kind of structural element to boost returns.
Supply has been boosted by banks looking to divest their alternative assets to comply with forthcoming regulation like the Dodd-Frank Act in the US and Solvency II/ Basel III in Europe, as well as more active portfolio management by investors; while the amount of dry powder accumulated by secondary managers (estimated to be in excess of $30 billion) indicates a strong level of demand. At the lower end of the scale, where the market is less efficient, attractive returns can still be generated.
But at the upper end – portfolio transactions above $50 million, usually sold via competitive auction processes – greater competition and transparency is putting pressure on discounts, which have narrowed to single-digit figures. This pushes IRR expectations well below the oft-touted 20 percent mark. As a result, securitisations have moved up the agenda of many experienced institutional investors.
After a period of little activity in this area, there are indications that these securitisations are once again becoming a serious alternative to straight secondary sales – which is good news, since the potential return is often substantially higher for both portfolio sponsors and investors.
HOW THEY WORK
Figure 1 shows an outline of a securitisation in which a portfolio of private equity assets is moved to a special purpose vehicle and refinanced through the issuance of various classes of notes. The financial structure usually consists of an equity tranche, a mezzanine tranche and one or more debt tranches, which can be rated.
In the last decade, a dozen of these transactions were closed and proved to be very resilient during the financial turmoil of 2008/09. The first ever public securitisation backed by a private equity portfolio was Prime Edge, closed in 2001. This was followed by Pine Street, a $1 billion transaction that AIG completed in 2002 in order to reduce its regulatory capital and open commitments. Thereafter SVG created its three Diamond vehicles: two were public securitisations with rated bonds, and one was a private transaction with debt provided by a single bank (Diamond III). One of the last transactions before the financial crisis was Astrea, a $800 million deal; here, the private equity portfolio was financed with two senior bond tranches, which received a rating of AAA and AA. Both ratings were retained through the financial crisis. (For more details on these deals, see PEI Media’s 2008 book ‘The Private Equity Secondaries Market‘ – available to buy at www.peimedia.com/books.)
While the availability and terms of debt made new securitisations unattractive in the last few years, both parameters have bounced back in 2011. The loan-to-value ratio has increased substantially, while debt spreads have come down and are now more in line with the risk profile of the investment. Despite the recent turmoil in the equity and debt markets, securitisations of well-diversified and mature portfolios of good private equity managers are still expected to get attractive financing, as pension funds and insurance companies seek attractive yields backed by real assets.
THE UPSIDE FOR SPONSORS
Structures like these have various benefits for portfolio sponsors. The most obvious is the partial monetisation of the portfolio’s current value – via an early non-recourse cash payment – when it is transferred into the special purpose vehicle. This cash payment is financed by selling part of the newly issued notes to third parties.
At the same time, the upside can be partially retained, depending on the share of equity and junior securities sold to new investors. This is one of the main advantages of a deal like this compared to a straight secondary sale, especially for high-quality portfolios. Here, sponsors do not want to give up the entire upside of their well-diversified portfolios, because much of the value is expected to materialise over the next years through increased exit activity. In addition, the sponsor can maintain its existing GP relationships, keep know-how in-house, and continue to gain valuable information from its ongoing involvement with the portfolio.
Equally, many sponsors are considering structured transactions as a means to reduce their risk-weighted capital, in order to comply with regulations like Solvency II and Basel II / III. The rating and tradability of notes lead to a lower risk weighting for private equity investments – and as such, reduces the risk capital the sponsor is required to hold.
Finally, this kind of structure can help to mitigate the funding risk investors usually have with private equity investments, given the uncertain timing and size of capital calls. In a securitisation, open commitments can be covered via different financing solutions, such as liquidity facilities or variable funding notes – especially useful for the kind of extreme scenarios we saw in 2008/09.
The scenario above, for a financial institution, was calculated using Montana’s proprietary models and was based on the most up-to-date market conditions, including loan-to-value ratios and interest rate spreads.“In this situation, the risk-weighted assets of portfolio sponsors are reduced by more than 50 percent, open commitments for the sponsor decrease by 68 percent and the sponsor can extract an up-front cash payment of up to 48 percent of NAV. The flipside – the price paid for getting these benefits – is that the upside potential of the portfolio is 17 percent lower than it would have been had the portfolio remained on the sponsor’s balance sheet. However, that still leaves the sponsor with more of an upside than a straight secondary sale even at net asset value, since in that case the return upside would be totally lost for the parts of the fund sold.
The four main elements shown in Figure 2 can be adjusted to the objectives of the sponsor and the actual market conditions. For example, if the sponsor’s main objective is to decrease risk-weighted capital further, this can be achieved by selling more of the upside. Hence, these kind of structures can be used to calibrate the trade-off between how much risk to take and how much upside to keep. It also involves a trade-off between liquidity at closing of the transaction, and possible cash requirements during the lifetime of the product. Each sponsor’s requirements are likely to be different – so each structure needs to be customized according to their specific requirements.
It’s also worth bearing in mind that these structures have a big advantage for investors on the financing side: the possibility to pick a tranche according to their risk appetite. This can range from highly investment-grade-rated bonds to an equity tranche that captures the upside of the portfolio. The most senior notes, which offer a regular, pre-defined interest payment, opens up the investment to institutions that could not normally invest in private equity. In contrast, equity and junior securities offer the benefit of a substantially increased expected return. Given the aforementioned increase in competition at the larger end of the secondary market, structured transactions can be used to generate returns that would otherwise be hard to achieve in this market segment.
CHALLENGES AND OPPORTUNITIES
The main challenges for these securitisations are setting up the structure, analysing the underlying assets, carefully weighing risk and return aspects, organizing the rating process for the debt tranches and putting sophisticated risk models in place. This is where it’s useful to seek out providers with prior experience, since the last financial crisis demonstrated the importance of robust structures with – for example – sufficient risk buffers and prudently-structured distribution waterfalls.
Of course, they won’t work for everyone. Some sponsors will still prefer a straight secondary sale, particularly if they’re cash-constrained – in this instance, they might want to focus on the maximisation of their short-term benefits while being prepared to forgo the long-term upside of the portfolio. Another possibility is that the portfolio is not big enough to make a structure like this work. Or it may be that the investor doesn’t have access to providers with the requisite experience, since these transactions are more complex than straight secondary sales (although they can also be more customized to the needs of the client).
Nonetheless, structured transactions have clearly been regaining ground in recent months. They might not be suitable for every investor in private equity, but in the right circumstances, they offer a number of benefits compared to straight secondary sales. Portfolio sponsors benefit from reduced risk-weighted assets, a better risk profile and a retained share in the upside of such a portfolio – which can ultimately lead to higher performance than a straight secondary sale. Meanwhile investors on the debt side get rated debt exposure to a diversified pool of private equity assets with regular interest payments, while equity investors benefit from very attractive returns on their tranche.
All of which suggests that structured transactions will become a more familiar solution in private equity again – particularly since existing structures have demonstrated their ability to withstand adverse market conditions and deliver attractive risk-adjusted returns for both portfolio sponsors and investors.
Christian Diller and Marco Wulff are partners and founders of Montana Capital Partners, a firm that provides liquidity solutions and asset management services in private equity for institutional investors.