The secondaries market – an area of private markets that has experienced seven-fold growth since the last financial crisis – has been caught up in the economic ruptures brought on by coronavirus.
Almost three months since the first cases were reported in China, causing price dislocation in the Asian secondaries market, the global secondaries market appears to have effectively ground to a halt.
Travel bans are making company-level due diligence almost impossible, leading to increasing numbers of stalled so-called GP-led processes that involve stakes in companies, as opposed to stakes in funds. At the same time, volatile public markets make it difficult to accurately price assets, causing paralysis that will remain at least until early April when GPs start to finalise their December net asset values.
According to one senior UK-based secondaries buyer, the only comparable situation is the previous global financial crisis.
“Secondaries buyers were saying [during the GFC], we don’t know what this is worth, so let’s pick a number then go lower than that. We don’t know when the exits are coming, so let’s push them out, which pushes out your IRR. Then we layer on top of that an even higher target return because risk/return has gone through the roof. With every assumption you are building in additional caution, which means discounts of 50-70 percent.”
For limited partners used to being able to sell portfolios of their fund interests at 90 percent of their most recent net asset value or more, steep discounts are unlikely to go down well. Several opportunistic sellers have stepped away from the market in hope of a pricing rebound in the second half, two sources said. Sellers who typically insisted on receiving a cash price are increasingly inquiring about structured transactions that employ preferred equity, said one US-based buyer at a mid-sized firm.
There has also been an increase in instances of buyers walking away mid-deal, looking to re-price on the fly or trying to get material adverse change clauses embedded into their pricing agreements, giving them the option to walk away before closing if events occur that impair the assets from being acquired, said one London-headquartered advisor.
Law firm Debevoise & Plimpton noted the limitations of MAC clauses when applied to secondaries transactions. The global nature of the average portfolio makes drafting complicated, and the aggravation they tend to cause makes them potentially damaging in such a relationship-driven market, Debevoise noted. Still, these are not typical circumstances.
“[Normally] you rely on the intermediary to put pressure on the buyer and say, ‘This is going to impact your reputation if you don’t follow through’,” the advisor said. “It’s pretty difficult to put pressure on people in this environment.”
It will be some time before we see the impact that coronavirus-related market volatility has on pricing, sister publication Secondaries Investor reported in early March. Private equity tends to lag public market performance measures, and the secondaries market in turn tracks the primary/directs market.
If public market volatility continues for an extended period of time, it seems likely the result will be deals that will pause and become active once the market settles, according to one US-based buyer.
Discounts to NAV could also increase.
“There’s volatility and more risk than there was historically. That’s going to work its way into pricing,” the buyer said.
The other side of the rainbow
Amid the confusion, every secondaries source PEI spoke to for this report was hopeful that the covid-19 crisis would bring some distressed sellers to the market, either in search of liquidity or as a way of combating the denominator effect; the question is when.
On one hand, the secondaries market is much better known than it was during the last crisis, when it took until late 2010 for big distressed positions to start hitting the market. Today, those with a need to sell know exactly who to call. Still, like a frog in a pan of slowly boiling water, LPs often experience a gap between perception and reality.
“Sellers don’t necessarily internalise the effect [of economic crises] on the valuation of their portfolios immediately,” said one buyer, whose first experience of investing in private equity during a crisis was Black Monday in 1987.
“After the public market goes down, there is a lag between when the private market valuation starts reflecting that. On the way up, the public market may go up a little faster. You have to be careful of when you start doing the buying and what you buy.”