When New York-based VCFA Group raised the first secondaries fund in the early 1980s, the idea was simple: acquire interests in private equity funds on a secondary basis and provide liquidity to limited partners in a highly illiquid asset class.

In the three-and-a-half decades since, the secondaries market has grown from a cottage industry to one impossible to ignore. In the last decade, annual deal volume – measured by the purchase price plus the unfunded commitments a buyer agrees to take on – has grown more than sevenfold. Last year’s estimate was $74 billion, according to advisor Greenhill, and some predict total deal value will eclipse $105 billion this year.

Investor appetite for the strategy remains strong. Almost 50 percent of limited partners intend to participate in the secondaries market this year, either as buyers or sellers or both, according to Private Equity International’s LP Perspectives Survey 2019. Half of LPs surveyed also plan to commit capital to secondaries funds this year, adding to the roughly $125 billion in dry powder available for the strategy, including leverage.

With the market’s phenomenal growth has come a dramatic shift in the types of deals secondaries firms are investing in. Gone are the days of simply acquiring diversified portfolios of LP stakes. Secondaries firms today face a multitude of investment opportunities, including GP-led fund restructurings, preferred equity transactions, single-asset deals and stapled transactions, and the availability of cheap leverage has added fuel to the fire.

“You’re starting to see some of the same issues emerge in the secondaries market that you see on occasion in the buyout market – some may be using financial engineering as a focus and put greater precedence on that versus underwriting assets in detail,” says Mark McDonald, global head of private equity at DWS.

As processes become more efficient and auction timeframes narrow, there is a risk that some secondaries managers won’t be resourced enough or have the time or relationships to conduct the level of scrutiny and diligence they once did, he adds.

It wasn’t until after 2013 that fund restructurings really took off with multiple, higher profile deals involving firms such as Motion Equity Partners and Diamond Castle Holdings prime examples. “Now we’re six years in and there’s a fund recapitalisation twice a month,” says Jon Costello, head of Park Hill’s secondaries advisory group.

Secondaries market sources have a common concern: the characteristics of today’s market – high leverage levels in the form of acquisition financing, coupled with new and riskier deal types – have not been tested in a down market or financial crisis.

“Everything goes well as long as the companies are doing well and the cashflows are developing well, but it’s going to be a problem in the case of a downturn,” says Philippe Roesch, managing partner at private equity advisor RIAM Alternative Investments, which invests in secondaries both directly and via funds.

Roesch says one of the first questions he asks a secondaries fund manager when performing due diligence on a fund is whether they use leverage and, if so, whether they use it at the fund or deal level; what criteria is used to determine whether to use leverage; who their debt issuer is and the covenants and conditions they expect the issuer to give.

He is “very concerned” about how highly levered portfolios will perform in a prolonged downturn.

“One has to be cautious and not rule out the fact it might happen,” he adds.

Many of the risk factors facing the secondaries market are issues buyout and growth managers also face. Yet, through conversations with more than 26 market participants for this article from all corners of the market, it appears there are certain risk factors the secondaries market is less well-equipped to deal with – as well as some from which it can benefit.

Macro wobbles

One of these is coping with macroeconomic volatility and political uncertainty. Unlike buyout managers who control the assets they buy and when they exit, a secondaries fund provides replacement capital to LPs who want liquidity and, as such, acts as a passive investor.

Does this mean secondaries funds are at the mercy of the GPs they invest in when there is a macro wobble? Yes and no, says Thomas Liaudet, a partner at advisory firm Campbell Lutyens.

“When you buy an interest in a fund, all you receive is the fund’s latest report, a presentation from the manager’s AGM and relevant legal documentation about the fund. You’re not going to get much more on the underlying assets,” he says.

In a buyout or co-investment situation, you get much more asset level information as well as opportunities to due diligence the assets, he adds.

Others point out that per billion of assets under management, secondaries funds have lower resourcing capabilities than buyout funds.

“Say you’ve got four weeks to price a portfolio of 30 LP interests in 25 GPs, how much diligence are you doing in that four-week period to understand the cashflow dynamics of those GPs?” asks one buyside source. “I would say very little.”

What balances this out is that the traditional or so-called “plain vanilla” part of the market involves acquiring diversified portfolios of LP interests, so the risk is spread across multiple assets. “You ultimately need less due diligence than you would if the deal was very concentrated in one asset or than if you were going to be on its board,” Liaudet says.

One such macro wobble came in June 2016 when the UK voted to leave the EU. In this case, the wobble was a blessing in disguise for dollar-denominated secondaries funds looking to acquire stakes in sterling-denominated funds. DWS’s McDonald says he was aware of at least one sizeable transaction in which the buyer was able to increase its bid while taking a further discount in dollars due to the currency swing caused by the referendum.

Of course, swings can cut both ways: an agreement to acquire a portfolio at a 5 percent discount to net asset value based on the most recent quarterly valuation date can turn into a 5 percent premium on paper if there are large swings between signing and closing – up to six months in some cases.

With the rise of political and currency volatility, the arbitrage opportunity that secondaries buyers have taken advantage of in recent years has the potential to go in reverse. “Transactions are being underwritten today at higher underlying multiples and with more leverage – but things could quite quickly turn tomorrow and that’s where some could face a double whammy,” McDonald says.

Currency hedging tools allow secondaries funds to lessen the impact of wild forex swings. PEI asked the 10 largest secondaries firms what forms of hedging they employ. All but two declined to comment on record. HarbourVest Partners says it uses various tools to mitigate forex risk that are highly tailored to specific investments, whereas LGT Capital Partners says it models currency fluctuations at entry and prices a given deal accordingly without using hedging products.

Glendower Capital, a London-headquartered secondaries firm, says around half of its dollar-denominated portfolio is exposed to other currencies. As such, the firm uses a systematic programme of NAV-based currency hedges in the form of forward contracts which are adjusted every quarter. For Charles Smith, the firm’s chief investment officer, this is a no-brainer.

“Currency risk is risk with no return,” Smith says. Taking on political or other types of risk can be priced to generate outsized returns, but currency is a zero-sum game as you can’t expect to generate a higher return than someone who’s based in that currency just because you’re based in a different one. Hedging forex risk is particularly important for mid-to-large sized secondaries funds as they typically buy big diversified portfolios and inevitably end up with global currency exposure, Smith says.

A tale of two markets

Not all secondaries strategies deliver the same returns. Buyers engaged in the plain vanilla part of the market typically underwrite to a 1.5x and mid-teen internal rate of return. French giant Ardian, the market’s biggest buyer, is targeting a net multiple of 1.6x and a net IRR of 16 percent for its latest ASF VIII fund, according to University of Houston System’s board of regents meeting last year.

Firms focusing on GP-led processes, on the other hand, typically target 1.8-2x returns and close to a 20 percent IRR. The two markets mean investors looking to commit to secondaries funds should be aware of a manager’s skillset.

There are significant risks taken by any buyer that approaches plain vanilla and GP-led secondaries with the same investment teams, due diligence process and underwriting criteria, as the profile of these types of transactions couldn’t be further apart, says Ricardo Lombardi, managing director at ICG Strategic Equity.

“Most secondaries firms now want to do GP-led deals as a natural evolution to their business model, but as the secondary market grows in complexity, our view is that specialisation will become a key competitive advantage, I would even say a necessity.”

As the types of deals secondaries funds invest in continue to proliferate and managers are tempted to jump on the latest trend bandwagon, GP-LP alignment will become even more important. LPs aren’t in the dark about this: in January, Oregon Public Employees Retirement Fund warned the “aggressive” behaviour of some secondaries market participants was leading to a breakdown in GP-LP alignment. It noted it was increasingly seeing innovative but complex and conflict-riddled transaction proposals and that while such developments have a place in a maturing private equity industry, “the aggressive pace of innovation may suggest that secondary buyers have more appetite for deals than the current market can satisfy”.

Alaska Permanent Fund Corporation is one investor that has taken a drastic measure. In June, head of alternative investments Stephen Moseley told PEI the US sovereign wealth fund would never back a traditional secondaries fund, nor is it a keen buyer of fund stakes.

“I view being on the buyside of a secondaries transaction as an interesting tactic to build exposure versus just making primary commitments, but the cash-on-cash returns aren’t typically very high and it’s an incredibly competitive market,” Moseley said.

Risks in concentration

Being highly exposed to a limited number of assets can bring unnecessary risk. Nowhere is this more acute than in single-asset fund restructurings which bring exposure to a single company in a particular sector and market. How can secondaries funds maintain diversification in a market defined by increasingly concentrated deals?

For David Atterbury, managing director at HarbourVest, any single asset could only make up a “tiny” percentage of one of its Dover Street secondaries funds. A high-concentration deal would have to demonstrate characteristics typical of a secondaries deal: a path to early cashflow and a relatively short holding period. The firm also favours deals structured with some form of downside protection, such as a preferred equity component, to reduce risk.

“We’ve questioned the asset profile of some of these transactions that have come across our desk with five-year holds,” he says.

Switzerland-based Partners Group focuses mainly on portfolios of LP stakes, only considering GP-led deals with managers it knows well. It strictly limits its per-company exposure to the low single digits and while it doesn’t rule out highly concentrated deals, it wouldn’t lead but take a small slice as a member of a syndicate.

According to managing director Benno Lüchinger, the firm’s peers with larger risk appetites are generally taking a responsible approach to concentration risk. The increasing prevalence of syndicates on large, concentrated GP-led deals is testament to this. In 2016, 100 percent of the deals advisor Lazard worked on had either one or two backers; in 2018, this figure fell to 25 percent. If an LP finds itself overexposed to similar assets through more than one secondaries fund, it can diversify its holdings by investing in another secondaries fund with a differentiated strategy.

Neither HarbourVest nor LGT have minimum asset limits in the LPAs of their secondaries funds, spokesmen for the firms confirmed to PEI. In LGT’s case, the firm avoids concentration by making as many as 80 deals from its flagship funds and no single company can account for more than 15 percent of the fund’s value, according to André Aubert, the firm’s head of private equity secondaries.

None of the limited partners PEI spoke to for this article said they systematically consider the concentration risk of their secondaries portfolios. For LPs that do want to know more, there are some considerations, says Holger Rossbach, senior investment director at Cambridge Associates.

“Would you only do buyout? Would you consider venture? Would you put these deals directly in to the fund vehicle or leverage them up? Does the performance come from appreciation of the assets or from buying at a discount? What role does leverage play at fund level?” he says. “There is a willingness by fund managers to provide this information but it doesn’t come as a given.”

Still, diversification for diversification’s sake can be a misguided approach when constructing a secondaries portfolio.

“Diversification is not a panacea for risk,” says ICG’s Lombardi. Better to have one high-quality asset than 100 mediocre ones, he adds.

Layers of leverage

Greater efficiency in the secondaries market has made it more challenging for funds to achieve the same levels of historical returns. One tool to help boost returns is leverage, which has grown in recent years. By value, the proportion of secondaries deals that employed leverage last year was 38 percent, compared with 23 percent in 2017, according to data from advisor Triago. The amount being used in a given deal averaged 52 percent, passing the halfway point for the first time.

While there tends to be a sound rationale behind individual applications of leverage both at the deal or fund level, each loan or credit line is part of a complex network with a portfolio company at its centre. How these components interact with each other, particularly during an economic downturn, remains untested.

Kishore Kansal, managing partner of intermediary PEFOX, gives the following example: an investee company’s earnings lower such that it is unable to meet its debt repayments. This impacts the company’s direct lenders and reduces the value of the unrealised equity. This then hits the likely cash flowing to a secondaries buyer, which may have employed leverage itself in the deal on the basis of anticipated future distributions.

A portfolio company can be impacted by as many as five layers of leverage. The company itself will have been acquired using leverage by a buyout fund, which in turn employs a capital call facility. A secondaries fund might employ fund-level leverage, additional transaction-based leverage and have its own LP credit facility. The result is a complex picture of intertwined leverage lines and as yet untested risk factors.

Cambridge Associates’ Rossbach says several banks offer such triple-layer leverage products as a “one-stop solution”, something secondaries funds have been taking advantage of over the last three years.

“Given the high price environment we’re in, it’s something an investor needs to be aware of,” he warns.

Rising tide

The growth of the secondaries market appears to be unstoppable. As of March, 87 percent of secondaries buyers reported their deal pipelines were as strong or stronger than the year before, according to data from UBS. There is clearly room for more growth.

LP appetite for the strategy does not appear to be slowing down either. While capital raised in final closes during the first half of the year booked a 72 percent year-on-year drop to $5.3 billion, according to PEI data, a flurry of mega-fund closes are just around the corner. As of late July the top 10 secondaries funds in market were seeking a combined $63.85 billion, a figure almost 30 percent larger than the figure being sought by the top 10 private debt funds – a strategy often compared with secondaries because of its recent growth.

Faced with a plethora of choices and dynamics that remain untested in the event of a market correction, investors looking for secondaries exposure will do well to exercise caution in manager selection.

“Risk is out there on every deal, be it a buyout or a secondaries deal, and you need to consider how you mitigate those risks,” says Richard Hope, a managing director at Hamilton Lane. LPs are sophisticated when it comes to investing in secondaries funds but extra due diligence can never hurt, he adds.

“I would definitely encourage the LP world to make sure they know what they’re buying.”