Debt special: increased popularity pushes up tail-end prices

Tail-end secondaries – stakes from funds that have reached or exceeded the end of their planned lives – have traditionally been the preserve of a few secondaries specialists. At the top end, managers such as Strategic Partners hoover up thousands of stakes, often quite small ones. At the other extreme are firms like Hollyport Capital, which seeks out value in the smallest niches.

In recent years more and more firms have joined the party, propelled by huge amounts of dry powder and the fact that funds from the early- to mid-2000s are coming to the end of their lives with considerable unrealised net asset value. Coller Capital suggests there is $313 billion left in funds from vintage years 1999-2006.

The NAV growth of a tail-end fund is inherently limited. However, due to their advanced age, they are returning capital rapidly, so the buyer has less time to wait for upside (as long as the remaining assets are decent). Another attractive feature is that tail-ends have traditionally sold at a considerable discount to NAV of 30 percent or more.

Sting in the tail

But tail-ends have become victims of their own increasing popularity. While there are a lot of assets in the market, competition has driven prices up. According to secondaries advisor Greenhill, the average high bid for funds at least 10 years old was 86 percent of NAV in the first half of 2017, less than the average 98 percent on funds raised in the past five years, but hardly a bargain.

Buyers are therefore seeing less of a natural increase in value as their tail-end assets distribute. Many are stuck with a choice: accept a lower return profile or drive a return using leverage. Returns can be achieved without leverage: neither Strategic Partners nor Hollyport use asset-backed debt at deal level, PEI understands. But it can be an effective tool when used properly.

In some ways tail-ends are good candidates for leverage. They tend to be sold in large, diverse portfolios with many granular positions, so the risk is not heavily concentrated in one pocket. They often generate cashflow, so lenders can see exactly how the loan will be repaid.

At the same time, deciphering the true quality of the assets is a time-consuming process, made more difficult by the fact that many contain shreds of venture capital, debt and other riskier assets that are hard to price. Some tail-end funds have little chance of meeting carry, so the GP might not be incentivised to maximise the value of what’s left.

For this reason, lenders will often offer a hybrid facility, allowing them to lend at a loan-to-value ratio above what the assets merit at face value. For example, they might include a clause that gives limited recourse to another source of funding, such as undrawn commitments or guarantees from another, larger vehicle.

Widespread or excessive use of leverage can push up prices, adding to the problem that buyers were trying to get around in the first place. According to one regular tail-end buyer, less sophisticated investors armed with leverage can distort bid prices to the point where the prices of good and bad tail-end assets diverge.

Still, unless return expectations moderate considerably, applying leverage will be a popular, generally effective way of extracting value from tail-end assets.