Secondaries special: at the cutting edge

Secondaries investors have been expanding their horizons lately.

“We have people with M&A experience, legal experience, portfolio company operational experience [and] complex secondaries experience,” a managing director at a top 15 secondaries house told Private Equity International. “You’ve seen a massive upgrade in the skills sets of all teams.”

Looking at the range of deal types and structures that have proliferated in the secondaries market in recent years, it’s clear personnel is not the only thing that’s become more diverse.

It’s difficult to say which is the tail and which is the dog. Has a booming secondaries market attracted a broader range of people, who are employing their own experiences to drive greater innovation? Or has the need for secondaries firms to stand out in an increasingly competitive market caused them to think more creatively about what they do and who they employ to do it? Either way, the fundamental definition of private equity secondaries has changed and continues to change at a rapid pace.

Take single-asset restructurings, which seem anathema to the principle of diversification that the LP stake-sale market was founded on. These deals are typically employed in situations where one asset in a portfolio requires extra time or capital to reach maximum value and not all limited partners want to stick around. The asset is removed from the fund and placed in a separate, shorter duration vehicle managed by the same GP but backed by fresh capital. Given the diminished size of the new vehicle and shorter return profile, the terms are typically a 1 percent management fee and 10 percent carried interest, or something similar, as opposed to the usual two-and-20.

These deals have exploded in popularity over the past 18 months. According to research by advisor Campbell Lutyens, the average secondaries buyer made between three and four of these highly concentrated bets in 2017. Brand-name managers such as PAI Partners, TDR Capital and Lime Rock Partners are among those to have carried out single-asset restructurings in the past few months.

There are several reasons for the increase in popularity. For a start, the average price of buyout funds trading on the secondaries market hit 98 percent of net asset value at the end of the first half of 2018, according to data from secondaries advisor Greenhill. This was driven by the proliferation of leverage. Those that don’t want to pay a hefty premium have to look away from conventional portfolio acquisitions to more complex or concentrated deals. And if a GP thinks there is eventual upside in that remaining asset, it makes sense to hold on to it.

At the same time, it’s no coincidence that many early adopters were buyers with broad co-investment or direct investment capabilities, such as Goldman Sachs, which realised the benefits of bringing to the secondaries market a more granular, M&A-like approach to due diligence.

Patrick Knechtli, head of secondaries at Aberdeen Standard, describes the process, which would probably seem very strange to the earliest secondaries players: “You will do your own independent analysis, you’ll meet with the management of the underlying company and in some cases the secondary buyer engages external advisors [and] management consultants, who will do work on the company and the market it is operating in.”

Bridging the gap

Much innovation in the market has come in the form of end-of-life solutions. Tender offers or GP-led restructurings give older funds more runway to maximise their remaining investments with the help of a new, more enthusiastic backer. But there are a growing number of ways in which a GP can extend the life of a fund without having to do a full process.

One such way is through bridge funds: short-duration vehicles for managers that have run out of money, are long in the tooth with their current fund and might not have much success raising their next one – at least not yet. It may be that they still need to convince investors of their track record, have lost key personnel or the macro environment has resulted in a slower-than-expected exit pace.

Instead of carrying out a process on the fund to secure a stapled commitment for a successor, the GP seeks a stapled commitment to a ‘bridge’ vehicle with a two- or three-year life span. They roll the remaining assets into the new vehicle, offer existing LPs the chance to exit and bring in new investors that can provide the capital to develop the assets. Like other types of GP-led processes, these deals give existing LPs the chance to cash out while GPs can continue with fresh capital and, with any luck, a more willing partner. But they also benefit the secondaries buyer.

One difficulty for secondaries buyers in committing to a staple is that their secondaries funds are not usually geared towards making 10-year commitments. “They want to mitigate the J-curve and have a three- to five-year horizon, so putting money into a 10-year blind pool is a difficult ask,” says Yaron Zafir, head of secondaries at advisor Rede Partners. “Sometimes secondaries investors will say ‘let’s make this from a primary pool’, but then you get into questions of conflict of interest, particularly if it involves a different group of LPs. Because this is shorter duration, it’s actually quite easy for secondaries investors to provide this type of solution.”

Single-asset restructuring

A number of brand-name single-asset restructurings have been mooted or closed in the past year. In July, TDR Capital carried out a process on its €2.1 billion, 2007-vintage third fund, hoping to give more life to the last remaining asset. It lifted UK-headquartered Stonegate Pubs from the fund into a new vehicle backed by secondaries buyers, one of which was Landmark Partners, as sister publication Secondaries Investor revealed.

PAI Partners has been exploring a similar process, seeking to transfer the last asset in its €2.69 billion, 2005-vintage fourth fund into a continuation vehicle backed by a syndicate of secondaries buyers. Malmo, Sweden-headquartered chemicals maker Perstorp was valued at SKr9.2 billion ($1 billion; €873 million) at the time of acquisition in 2005. The deal was being sized up by investors at press time, with Landmark Partners again closely linked.     

The preferred option

Along with greater creativity on the equity side, the past few years have seen preferred equity – a quasi-debt instrument – vie for a place at the table.

Though the idea has been around since the mid-2000s, it has gained prominence recently with a few outstanding fundraises. In May 2017, 17Capital closed its fourth fund on €1.2 billion, surpassing its €800 million target after just six months in market. In July, Whitehorse Liquidity Partners, which has only been around since 2015, hit $975 million on the way to a $1 billion hard-cap on its second fund.

Portfolio holders can take on preferred equity instead of selling stakes in their portfolios, keeping exposure to any potential upside while benefiting from liquidity. For example, if a GP wants to provide liquidity to its LPs, it could transfer its fund’s assets to a new vehicle owned by itself and a preferred equity provider. The preferred equity firm injects liquidity into the vehicle, which is then distributed out to the LPs in exchange for future preferential cashflows from the portfolio.

According to research by Evercore, there was $2.4 billion of preferred equity transaction volume in the first half of 2018, compared with $3 billion for the whole of 2017. Given the tendency for the second half to be more active than the first, it is likely to be a record year for the strategy. Already, however, variations are springing up.

One such example is fund unitranche lending. Like preferred equity, a fund unitranche loan is part senior debt and part equity and can be used when a fund wants to provide some liquidity to LPs while continuing to make investments or hold an asset longer. It is also increasingly being used by GPs to fund day-to-day business, build out new strategies or help tide themselves over during a process of succession.

Such loans can go into the hundreds of millions of dollars but typically represent lower risk and lower return than a preferred equity investment. Fund unitranche returns tend to be in the 7-10 percent bracket, versus 10-15 percent for preferred equity.

“It’s ultimately a structured lend to a fund or a portfolio of assets,” says Matt Hansford, UK funds head at Investec, which offers the product. “In a secondaries sale, LPs are getting 100 percent out [of liquidity]; preferred equity may be 50-70 percent… This is an alternative where it’s going to be less risk, therefore less money out needed than a preferred equity deal.”

Liquidity options

Things like preferred equity create liquidity in much the same way as a secondaries sale, but should it come under the banner of secondary private equity? To many GPs, the answers is yes. Increasingly, secondaries GPs are setting themselves up as providers of liquidity solutions at every stage in the life of a fund, from taking an equity stake in a management company to providing capital to help funds take advantage of deals before they’ve reached first close on a fund.

DWS represents an example of this way of thinking. In July 2017, the firm, then known as Deutsche Asset Management, saw its secondaries team spin out to form Glendower Capital. Now, with Credit Suisse’s former global head of secondaries advisory Mark McDonald at the helm, the firm is rebuilding with a strategy that takes its cues from the advisory world.

“On the advisory side, you’d go into a private equity fund and say ‘let’s look at this holistically,’” McDonald says. “What are the issues that you have as a partnership, the issues you are having with your underlying fund or LP base, and can we craft a solution that can be a win for LPs, portfolio companies, the fund and the buyer? We are going with that same mentality [that] only we have capital to pursue things.”

In terms of typical transactions, the firm’s EMEA head Daniel Green tells PEI: “We are looking at a number of situations where GPs are interested in using additional capital to support several portfolio companies and pursue attractive follow-on opportunities – to become market leaders, expand into other geographies or invest in complimentary strategies.”

“These investments may not be possible using the limited amount of follow-on allowed in the fund documents, and our structure is much more flexible,” he adds. “One could call them ‘enhanced’ rather than ‘passive’ secondaries – in that you may be changing the underlying business plans of the portfolio companies to take advantage of opportunities they otherwise could not pursue.”

Ultimately, many innovations in the secondaries market are ways of untethering private equity from the traditional 10-year, five-and-five fund model. Rede’s Zafir believes that while the 10-year model is likely to persist – investors will always want to know how long they are locked in for – the structure could become disconnected from the way portfolio companies are bought and sold. You could buy a company seven years into a fund’s life, hold it five years before transferring it into a short-duration vehicle, then sell it after another two.

It’s all secondaries, but not in the way you know it.

Fund unitranche

Such has been the impact of preferred equity, it’s no surprise to see the development of other similar tools to help investors get liquidity.

In the second quarter of 2018, Investec extended unitranche support to a mid-market European GP that wanted to take advantage of an acquisition with significant upside potential. The fund was in its divestment period, though its schedule of exits – and in turn recycled LP commitments – meant it did not have enough capital to take advantage. The firm took 12-18 months of the hybrid debt support, allowing it to do the deal without diluting the equity of LPs.

In the same quarter, the bank extended a facility to a GP that wanted to up its commitment to a mature co-investment to put more of its own money at stake
but did not have sufficient capital. A loan was extended that would be triggered
by a liquidity event. When it came, within two years of the deal being done, it generated 2x.