Growth in the secondaries market has traditionally been driven by limited partners selling portfolios of fund interests. However, transactions prompted by general partners are on the rise and becoming a more accepted part of the secondaries universe.
Traditional sales of limited partnership fund interests accounted for about $32 billion last year, or 80 percent of the total secondaries market, according to data from advisory firm Greenhill Cogent. GP-led transactions, which can include secondaries direct transactions, fund restructurings, spin outs, tender offers and recapitalisations, represented the balance.
Industry participants who gathered recently in the New York offices of Debevoise & Plimpton to discuss the secondaries market believe that the GP-led segment of the market presents attractive opportunities and its share will likely expand in the years to come.
The LP fund stake business has become efficient in the last couple of years, with advisors typically running auctions and the bidder with the highest price winning. “That part of the market has been generally expensive,” says Wouter Moerel, a managing director with AlpInvest Partners. “There's been a flight to quality and people are paying for that.”
“There are lower barriers to entry there,” adds Jeff Keay, a managing director with HarbourVest. “Typically in those transactions, the one factor you're negotiating is price, and so it's a more straightforward part of the secondaries business, and the most intermediated.”
There are still ways to produce attractive returns with LP fund interests, but market participants need to have an edge. One way to be able to compete successfully is to use financial engineering, most often in the form of leverage or deferred payments, which allows a buyer to pay in installments. Focusing on very large portfolios and the ability to move fast by having intelligence on funds' valuations also present clear advantages.
“We sit on more than 500 advisory boards and so have deep access to funds we know we like and know well,” says Keay. “Outside of that universe, if we don't have an information advantage or an attractive competitive dynamic, the deal is usually not for us.”
Ardian for its part has made a speciality of focusing on the very large portfolio sales and has been using both leverage and its proprietary database of funds to close transactions. Its database of about 1,200 funds is mined every quarter with regular repricing of the underlying assets in each fund, allowing the firm to find undervalued funds and mispriced assets and then purchase those stakes in the market.
As a result of focusing on the upper end of the market, it is operating in a less competitive environment, says Vladimir Colas, a managing director with the firm, and it is also able to move fast on transactions that could contain about 300 funds and 4,000 companies each. “If you're not already equipped to do that, if you don't already have all these funds in your database, it's difficult to do those deals,” he says.
That the sale of LP fund stakes has become such an efficient market has obvious drawbacks, the main one being higher pricing, but it also presents some clear advantages. In recent years, it has allowed funds of funds and secondaries buyers to sell tail-end portfolios as a way to wind down older funds. Secondaries buyers would typically let funds run the course of their life naturally, but with the average fund taking longer than its originally-agreed terms of 10 years with two extensions to liquidate these days, selling in the secondaries market can be beneficial for logistical as well as liquidity reasons.
“The market is getting to a point where we are likely to see a steady and constant need – for fund of funds managers generally speaking but for others as well – to sell tail-end portfolios as the amount of NAV in 10-plus year-old funds grows,” says Chris Bonfield, a managing director with Greenhill Cogent.
The catalysts for tail-end sales are that funds of funds have finite lives while other LPs have teams of finite size. If they commit to 10 new funds in a given year, every year, and only two funds are liquidating, Bonfield says that it gets to a point where the administrative requirements to monitor the funds, process extension requests, K-1s etc justify a clean-up sale.
Because the assets are quite old and there's limited upside, pricing for tail-end portfolios is generally lower, at about 30 percent of net asset value, compared with close to par for buyout fund stakes.
LP fund stakes will continue to represent the bulk of the secondaries market, the roundtable participants agreed, but for many, the action is in GP-led transactions.
“What we're seeing, in particular in Europe where I'm based, is more complex transactions,” says Kate Ashton, a partner with Debevoise & Plimpton. “There are lots of funds looking for a liquidity solution with the GP; or a sponsor wants to placate a certain group in the investor base; or the sponsor wants to look for investors who can help them in the long term.”
Although more time consuming and involving more parties than portfolio sales, GP-led transactions are quickly gaining steam and offer secondaries buyers the ability to secure higher returns in a less competitive environment.
With GP-led transactions, the goal is not only to acquire a fund stake and become a new LP. It is also about being a long-term partner to the GP and having the possibility to provide primary capital down the road. For a firm like AlpInvest, GP-led transactions present an opportunity to be much more involved with a sponsor. “That's a market we've seen as much more attractive [than LP fund stakes], more rational and with better pricing,” says Moerel.
These transactions are more complex because they involve several parties: all the LPs, the GP and at least one secondaries buyer. Historically, they were associated with GPs unable to raise money in the primary market and had a certain stigma attached to them.
But this is changing. As these transactions have evolved, the quality of the GP and of the underlying assets has continued to increase and it's now common to see GPs having successful fundraising after a secondaries deal.
Perhaps because of the extra concentration and lack of diversification compared with fund stake portfolio sales, GP-led transactions exemplify the fact that the secondaries market very much resembles that of direct investing. The participants all agree that with secondaries in general and GP-led transactions in particular, a good investment opportunity is one with strong assets, down to the underlying portfolio companies, and a quality GP.
“Every secondary is just like a buyout, you make 50 percent of your decision on the assets and 50 percent is on the management team,” says Moerel. “The management team is your GP and the assets are the companies.”
GP-led transactions can take many forms depending on the intent of the GP.
Bonfield explains that GP-led transactions can come from the desire of a GP to jumpstart fundraising, gain additional time and/or capital to support the existing portfolio through a fund restructuring, or more simply create an organised liquidity option for LPs on a fund that is very mature. With direct secondaries and especially spin outs, industry participants say the quality of the GP has typically been higher, because the transaction is less about poor performance and more about regulatory pressure – such as banks have experienced since the introduction of the Dodd-Frank Act.
GP-led restructurings have previously been somewhat frowned upon by LPs, as they presented limited options: either selling their interest or accepting new economic terms. This has changed, with LPs now having the ability to keep initial terms. However, while it's a welcome development for LPs to have a status quo option, it's trickier from a legal standpoint to define how that option will work in practical terms.
“If you're taking some assets and moving them into a new fund, how do you actually replicate the existing terms?” Ashton asks rhetorically.
“That's one of the reasons these transactions are very interesting. A lot depends on where the manager is in the carry and reaching that hurdle and how you're going to put that in the new vehicle.”
As the quality of GPs is increasing and best practices are developing, even Ardian, which initially avoided GP-led restructuring, has completed a couple of such deals in the past few years but only in the form of tender offers, where LPs of a given fund are offered a liquidity option but have no obligation to act on it and can otherwise continue to hold their interest. Secondaries directs and particularly spin-outs of financial institutions are a lot more common for Ardian than restructurings, representing on average 20 percent of any given fund, Colas says.
Spin-outs are generally situations where the GP was captive within a bank or insurance company and didn't need to raise money from outside investors, and for several reasons, the main being regulatory pressure, banks are letting these teams managing quality assets go. Again in such cases, the focus on human capital is key to the transactions.
HarbourVest for its part has been active in secondary directs, buying portfolios of companies from funds or other direct investors. Secondaries directs and other less traditional secondaries represent the majority of transactions within its portfolios, Keay says. Regardless of the transaction type, the quality of the manager is always of importance.
“What's critical to us is ensuring there's proper economic alignment. Specifically, there needs to be a shared view of success between the manager and the investors,” Keay says. “Our ability to be a good partner both in executing the secondaries transaction but also in supporting team over the longer term are some of the factors that can differentiate us as a counterparty beyond price. We love that part of the market and we think there are a lot of inefficiencies in terms of deal dynamics that play in our favour.”
What's in store for secondaries in the next few years?
Some of the roundtable participants, like Moerel, expect that there will be a cyclical economic downturn in the next year or two, albeit not as bad as during the global financial crisis, likely making the LP portfolio market more attractive again as leverage becomes harder to obtain and pricing tends to reduce. Others reckon a private equity household firm will likely undergo a GP-led transaction, further democratising these types of deal.
“To the extent that bigger names, stronger funds are seen starting to use the secondaries market, particularly the GP-led secondaries side, that may open the floodgates,” says Ashton. “Once you have a really top name doing a GP-led transaction… that could lead to even more players coming in and looking for liquidity.” ?
CASE STUDY: WARMING UP TO ENERGY
“Compared to the broader private equity secondaries market, there's more fear and dislocation in the energy space today,” says Jeff Keay.
With the downturn in the energy sector, some limited partners, worried the pain will be long-term, are making moves to exit poor performing funds.
“As a buyer with the expertise and the capital to put to work in that strategy, that's an interesting place to be right now,” he adds.
“You would think people would hold their portfolios right now, but in fact you're seeing quite a lot of paper on the market,” says Vladimir Colas, who adds that there is still a bid/ask spread that means most of these transactions are still in the “ongoing discussion” phase.
Indeed, a few key ingredients still need to be added to the mix for activity in energy secondaries to actually pick up.
The average discount to NAV for energy funds has been hovering between 30 percent and 50 percent since mid-2015, compared with par for some buyout funds, notes Wouter Moerel.
“There's a fundamental gap there, because the underlying assets are very difficult to analyse,” he says.
“Part of it is because NAVs are too high; so a 40 percent discount to the latest NAV is probably more like a 20 percent discount versus the real NAV.”
NAVs from 30 September are still high because the majority of the energy firms have hedges in place that are projected to mostly expire later this year, several of the participants note. Funds are also working through recapitalisation of portfolio company debt. “It will probably mean quite a big drop again in valuations,” Moerel adds.
The participants agreed that actual transaction levels could start significantly increasing towards the second half of 2016 and could very well last for a couple of years.
“To the extent we begin to see oil prices stabilise, by the second half of the year, we expect an uptick in secondaries of energy-focused funds,” says Chris Bonfield.
MEET THE ROUNDTABLE
KATE ASHTON, corporate partner
Based in London, Ashton is a corporate partner focused on private equity, corporate finance, debt and equity offerings. She regularly counsels private equity funds on transactions including fund secondaries acquisitions and recapitalisations.
CHRIS BONFIELD, managing director
At Greenhill Cogent, Bonfield, who is based in Dallas, is responsible for managing all aspects of client engagement and transaction execution. He has nine years of secondary advisory experience and joined the firm in 2007. Bonfield previously worked at Bank of America underwriting and monitoring debt transactions for public and private media and telecommunications clients.
VLADIMIR COLAS, managing director
Based in Ardian's New York office, Colas joined the firm in 2003. He previously worked in Exane's BNP Paribas's sell-side equity research department. Ardian, a firm that makes primary, secondary and direct investments, has about $55 billion of managed or advised assets, including $36 billion in its fund of funds division.
JEFF KEAY, managing director
Based in Boston and working closely with HarbourVest's EMEA and Asia teams, Keay focuses on global secondaries investments. Prior to joining the firm in 1999, Keay spent three years at Ernst & Young where he specialised in venture capital and financial services. He has also worked at the Financial Accounting Standards Board. HarbourVest has more than $40 billion in assets under management.
WOUTER MOEREL, managing director
Moerel leads Alpinvest's secondaries investment team. Before joining the firm in 2005, he worked at the Carlyle Group as a principal responsible for investments in the telecoms and media sector. In his career, he's also worked at JPMorgan and Lehman Brothers. Alpinvest, which invests in primary funds, secondaries and co-investments, has about $42 billion in assets under management as of 31 December.