Secondaries: complex deals to increase

As valuations in the secondary market have risen in recent months, buyers are considering more complex deals and innovative structures to enhance their returns.

With robust pricing and more than $35 billion of dry powder still to invest, one would think the secondary market would be alive and kicking. However, snapping up secondaries is not as straight-forward as it was in 2011 and 2012.

For one thing, there are fewer large portfolio sales by banks than in previous years. The revival of the public markets has meant that some LPs have seen their private equity allocations fall in relative terms (because other assets have risen in value). With distributions up, LPs have less urgency to sell. And with NAVs on the rise, potential sellers are reluctant to offload holdings that could potentially increase in value quarter-on-quarter. 

“The traditional LP secondaries have, in many instances, become somewhat commoditised”, says Andrew Hawkins, founder and chief executive of NewGlobe Capital. “It’s very competitive: people are paying par or close to par for the top assets and the returns are probably not going to be as good as they have been historically.” 
As a result, says Hawkins, “an increasing number of secondaries firms have turned their attention to structured transactions”. 

This view is echoed by Bruno Bertrand-Delfau, co-head of the EMEA private equity practice at Baker & McKenzie. “To maintain high returns, the sophisticated players may focus on complex or structured transactions and avoid participating in the larger auctions that often go at a very high price,” he says. To enhance returns, many players are exploring more innovative deal structures. 

DEFERRED PAYMENTS

Take the New Jersey Division of Investment, for instance. In June, the pension fund agreed to sell $925 million worth of stakes in real estate funds to a partnership that included NorthStar Realty Finance, NorthStar Real Estate Income Trust and funds managed by Goldman Sachs Asset Management (GSAM). 

The sale was structured to include a deferred payment, with an initial sum of $510 million being paid. It was also agreed that New Jersey would receive 15 percent for a three-year period following the closing date of each fund interest. In the fourth year after the closing of each fund interest, distributions would be divided equally between the partnership and the pension fund – and after a four-year period, the buyers would receive all distributions, after paying the final acquisition price. The deal was said to be executed near par – considerably higher than other real estate secondaries deals. 

Deferred payments have become more commonplace as a financing tool to improve the headline price, especially for IRR-challenged situations, according to Philip Tsai, global head of UBS’s secondary advisory group. “The concept is nothing new; it’s just [that] the frequency of usage has increased,” he says. “There’s a growing acceptance of these structures.”

“As pricing has strengthened coming out of the downturn, I think the use of deferred is becoming a bit more prevalent,” agrees Joe Marks, a managing director and head of secondaries in investment management at Capital Dynamics. 

THIRD PARTY LEVERAGE 

Additionally, the usage of third party leverage is becoming more widespread. Leverage largely disappeared from this market in 2009, but it has slowly been coming back towards the levels seen in 2006 and 2007, according to Andrew Sealey, managing partner and chief executive at Campbell Lutyens. “You might see 40 percent leverage, depending on the portfolio. In 2007 it was nearer to 50 percent,” he says. 

Leverage tends to “ebb and flow” depending on how robust the underlying markets are, according to David Atterbury, a partner at HarbourVest. “When there’s good liquidity in the underlying private equity market, people will take a little more leverage against those near-term cash flows. When there aren’t any near term distributions then the leverage in the secondary market goes down a bit.”

Even deferred payments are a form of leverage, says Atterbury. “A deferral from a seller is essentially leverage, as an element of the purchase price is effectively being borrowed for a period of time. So even firms that say they don’t use any leverage probably are.” 

TOTAL RETURN SWAP

As well as using more leverage and deferrals, other types of structured deals are on the rise as the market matures. “We are seeing more structured deals where the seller and the buyer cherry-pick which assets are going to be transferred. Therefore we are seeing more complexity in the drafting of the documentation, with often an involvement of the GP,” says Bertrand-Delfau. 

Further examples include transactions whereby the asset is not transferred. In this structure, called a ‘total return swap’, a buyer and seller agree to pay each other all the cash flows that would have been paid had a straight sale and transfer been completed, says Sealey. But while it arguably avoids some difficulties associated with transferring fund interests, the structure is “quite cumbersome and potentially tax inefficient”, he says. “It can also be more expensive and leave some administrative burden and reputational and counterparty risk with the vendor.”

In some of these “derivative-like transactions”, returns are guaranteed on a portfolio of assets for a counterparty, according to Atterbury. This happens when a financial institution is looking to take risk of the balance sheet and doesn’t need the cash flow, he adds. 

“In these deals, the secondary firm guarantees them a certain level of return from their portfolio, but doesn’t actually buy the assets; they stay with the seller. The owner then keeps the distributions themselves, and once those distributions have come back and paid up to the agreed level of return, then all subsequent distributions will be for the benefit of the buyer,” he says. 

Deals like this can potentially be effective for insurance companies trying to bypass the Solvency II legislation, Atterbury points out. “That changes the profile of the asset. The risk is no longer private equity portfolio risk, but a counterparty credit risk. It’s a clever way of moving the PE risk from the balance sheet.” 

NEEDS MUST

The supply of situations which require some form of restructuring has increased – be they secondary directs, stapled transactions, GP restructurings, risk transfers, recapitalisations or active portfolio management by LPs, according to Mark McDonald, a director for EMEA and Asia at Credit Suisse’s secondaries advisory business – which is also why complex deals are more prevalent. 

Indeed, some deals can only be done by using complex structures, says Lars Thoresen, managing partner at Nordic specialist Verdane Capital. “The creativity and the understanding of the needs of the parties, as well as the introduction of elements like deferred payments or earn-outs often make it possible to complete transactions,” he says. 

Yet while these sophisticated deals – including secondary directs – are becoming more common, they are harder to close, because of the higher execution risk and the need for more intensive diligence, according to Atterbury. “Some of the more complex deals can arguably offer higher returns, but [they] typically come with higher risk”, says Sealey. 

Nevertheless, many believe these complex, sophisticated deal structures are here to stay. “Over the next five years, you will see previously unworkable structures emerge,” says McDonald. 

Necessity is the mother of invention here. As Bertrand-Delfau puts it: “Because traditional secondary transactions will be scarcer, the majority of the market will have to be more imaginative.”