Should we worry about leverage?

Some GPs swear by it; some stay away from it, some use it moderately. But whatever your view on leverage, it has become an accepted part of the secondaries market in recent years. Even GPs that don’t use debt as part of their strategy keep a close eye on how competitors apply it, and which innovative structures they employ.

Studies suggest that leverage in the secondaries market is becoming more commonplace. Last year, a quarter of all secondaries transactions featured deferred payment structures – effectively a form of interest-free leverage – according to a recent report by secondaries advisor Evercore.

“There was a bit of a divide a few years ago, between the people who use it and those who didn’t. Nowadays, all players seem to be considering it for the bigger transactions,” says Patrick Knechtli, a partner at SL Capital.

So why is leverage becoming more widespread? “There’s more capital generally and there are more sources of cheap capital, not just amongst banks but in particular among the newer debt providers,” says Stephen Ziff, a partner at Coller Capital. “[Plus] interest rates are low and have been for a long time.”

That’s partly why using leverage has become quite attractive, according to Nicolas Lanel, managing director and head of European private capital advisory at Evercore. “Although margins charged by banks on these facilities are higher than they were pre-crisis, the all-in cost to borrowers is at an all-time low given where base rates stand. And other terms have become vastly more attractive too.”

MANAGING CASH-FLOWS

For instance, one of the most commonly used credit facilities is subscription finance, which helps funds manage their cash flows. Rather than having many capital calls and distributions, a fund can use this facility, which is typically 20 percent of the fund. “When you have a 20-day funding cycle and unpredictable transaction timelines you need to be flexible to fund investments as they close,” says Ziff. The majority of secondaries funds now have subscription finance in place, market sources say.

The other benefit of putting in subscription finance is that it can improve IRRs. “If you buy a portfolio and know there are some short term distributions, funds can use the facility instead of the commitments from investors,” according to Elly Livingstone, a partner at Pantheon. Such a structure can be fully backed by LP commitments. “This means the fund will always reserve the commitments to repay that facility so the risk level is relatively low,” he adds.

There’s also another way of using subscription finance: rather than reserving LP commitments to cover the debt, firms can instead offer a bank recourse to the underlying assets in the fund. For the banks, this is pretty good business, according to SL’s Knechtli. “The bankers spend a lot of time focusing on appropriate diversification and making sure there’s no dependence on any one company, sector or fund to repay the loan. I have never heard of an example where using fund leverage went wrong; banks make sure they are well covered. They usually put in covenants [such] that when money comes back, most or all of that cash is going to pay down the loan.”

This strategy can be risky, however. “You tend not to hear about failures, but that doesn’t mean there haven’t been any,” Ziff points out.

“When net asset value drops or distributions stop flowing, theoretically the bank could – in extreme cases – take the underlying assets, which will affect the GP’s ability to provide returns to LPs,” adds Livingstone. “If the cycle turns and interest rates rise, that [type of] leverage has a different risk profile, particularly if it is used to pay the vendor more for the portfolio.”

Using leverage in this way also changes the distribution profile of your secondaries product, says Christiaan van der Kam, head of secondaries at Unigestion. “Before a fund is able to distribute to LPs, it needs to pay back the loan to the debt provider first. This means you do need to have distributions to be able to do that.”

As well as forms of subscription finance, doing dividend recaps on secondary funds is also becoming a more common feature of the market. “Rather than putting in leverage at the beginning when they acquire a portfolio, they build a diverse fund of LP interests over time and then introduce a moderate amount of leverage to the fund; [this] gives cash back and improves the internal rate of return,” says Simon Hamilton, global head of fund finance at Investec.

DEAL OR NO DEAL?

In addition, debt is of course often applied at deal level, especially at the larger end of the market. Earlier this year, for instance, Lexington Partners reportedly used a $1 billion credit facility when it acquired a portfolio of LP stakes from the Irish National Pension Reserve.

In such large portfolios, an average of 10 percent of the underlying portfolio companies is typically listed, because they have been exited already and are still partially owned by a GP. The problem is that these assets – which are exposed to the stock markets – have a public market return profile. Unless GPs buy at a discount, they will not achieve their target returns on those assets, according to Hamilton. “Especially in today’s market, where valuations are high, this is very difficult – so they typically use leverage to enhance returns.”