Secondaries: The sector's dirty little secret

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Mention the words “debt” or “leverage” to any secondaries market participants and it is sure to provoke strong reactions.

“It’s a bit of a dirty little secret,” Gregg Kantor, who structures private equity debt financing deals at Investec, told Private Equity International’s sister title Secondaries Investor. “Debt still seems to have a negative connotation to it and yet it is certainly being considered and thought of by the vast majority of people.”

Almost three-quarters of respondents to a recent survey of secondaries and fund of funds participants conducted by Investec said they were either using or considering debt, a figure unlikely to raise eyebrows. What is surprising is that 87 percent of the same respondents also said it was still possible to remain competitive without it.

While respondents did not specify how they could compete without using leverage, Matt Hansford, who leads debt funding origination and execution at Investec, said there are situations where debt is not appropriate and where deals can still be won. This includes where portfolios are already well levered at the asset level, where a portfolio does not have sufficient diversity or a portfolio’s cashflows are unclear.

Buyers using debt, especially acquisition financing, must be prudent when deciding whether to use the tool to acquire a portfolio, Kantor said.

“The [secondaries] market has become more mature and people are starting to feel more comfortable with it as an asset class,” he said. “As people begin to understand how prices move throughout different cycles and inputs such as the volatility over the first half of this year, people have and will get more comfortable in using debt in a safe and prudent way.”

Investec’s survey also found that over half of respondents think target unlevered returns of secondaries funds should be 18 percent or higher – a figure mainly achievable by using leverage, Kantor said. Over a third of respondents said target internal rates of return should be between 12 percent and 15 percent, with just 4 percent saying targets should be as low as 9 percent.

According to a London-based head of a global fund of funds, all secondaries players use some form of leverage though they may not admit it.

“In my view, everybody lies about leverage,” he said. “Everybody knows that leverage is not good, everybody knows that it’s useful, so people who say it’s not useful are lying.”

Any type of structuring where you don’t pay 100 percent cash at the day of the closing is leverage, he added. “You are leveraging the situation, you are structuring, you are deferring the payment, deferring the capital call, you are using a facility at the fund level,” he said. “There are many words, but it’s all leverage.”