Investec joined Real Deals alongside a panel of secondaries specialists to discuss key trends at play in the current environment.
Stuart Ingledew - Investec
Sharon Thandi - Investec
Clement Beaudin - Ares Management
Raj Chall - Hamilton Lane
Simon Greenway - Pantheon
Ben Pearce - Campbell Lutyens
Andrew Ward - Hollyport
Nicholas Neveling - Real Deals
What has been driving secondaries transaction volume? How are firms looking at the market?
Raj Chall: If you compare this year to last year, there has been a noticeable uptick in LP deals. LP dealflow started to increase in late 2022 and that has carried on through the course of this year. On the GP-led side, there were a number of GP-led transactions launched in the middle of last year that just weren't getting done, most probably because of the gap between buyer and seller pricing expectations.
We saw some stats around the number of GP-leds that launched but stalled during 2022, and the numbers were quite high.
It does, however, feel like there is some convergence between buyers and sellers on valuations, and we are seeing some GPs come back to market again. There are some pretty big deals back in play and in recent weeks there has been a noticeable pick up in GP-led dealflow. As we move into the final quarter of this year, I would not be surprised to see a further uplift in GP-led activity.
Sharon Thandi: We have seen a meaningful pickup in GP-led transactions since the end of Q2 2023. One interesting theme is that a number of lower midmarket managers are using the secondaries market and GP-led deals for the first time as an avenue for liquidity.
Historically, these managers would have exited through the traditional routes, but with the current soft market, they are exploring new ways to release liquidity ahead of imminent fundraisings.
Another interesting development is that we see managers using newly raised funds to co-invest alongside their continuation fund vehicles. Continuing to invest in their prized assets for a longer period and adding value speaks to the quality of the underlying assets in these GP-led deals. It will be interesting to see how that develops.
Clement Beaudin: We have seen more LP-stakes deals this year, but I agree that we could see the GP-led side start to pick up during the last quarter. Investors are pickier and the quality bar is high, but we do see more GP-led deals progressing after a quiet first half.
A bank of deals has built up through the year, but no one has been rushing. Now that everyone is back from the summer break, and investors on the buyside have had the opportunity to look over how assets have traded through a period of high inflation and high interest rates, there is more visibility on performance and we could see more deals done as a result.
Andrew Ward: As our strategy is focused on legacy private equity assets, we have seen less trading as a result of the denominator effect. Structural issues have been the main driver of LP dealflow for us, whether that be LPs selling to rebalance portfolios or fund-of-funds winding down mature programmes.
On the GP-led side, we have started seeing more and more deals. This uptick has come from smaller midmarket firms and often involves single-asset transactions. Many of these GP-led deals involve high quality assets where reputable GPs haven’t had the distributions they would have expected in a normal market. They are, therefore, exploring which companies in their portfolios could work under continuation fund structures.
We don’t expect deals on the LP side to slow down, but as other panellists have highlighted, we are preparing for more GP-led deals to come through in the final quarter.
Ben Pearce: Buyer demand is particularly influencing the composition of the deals that are getting done. Capital is more scarce and the buy side can afford to be more discerning about where it focuses its attention and capital.
We're seeing a lot of demand/competition for quality LP portfolios, because I think that's what resonates most broadly with prospective investors into secondary funds. For the GP-leds, there is a very different supply-demand dynamic – while there is no shortage of transactions being explored, particularly in a market where traditional exits are constrained, buyers can be more selective and ensure transactions hit their key requirements.
Simon Greenway: If you go back 18 to 24 months, there was strong demand for GP-led deals and, given the macro environment, if buyers could ‘tick four out of the five boxes’ for a transaction, the deal would probably get done. In today’s environment, every single one of those boxes needs to be ticked for concentrated GP-led opportunities. As a result, there has been a clustering of buyer interest around a smaller number of high quality assets. Anything that is slightly quirkier is being screened out relatively early.
I do think secondary buyers will be slightly more willing to look at a broader spectrum of GP-led transactions should the macro-backdrop get better, but at the moment they are proving challenging to get away.
Chall: Pricing in GP-led deals has changed significantly since 2021. Back then, the discussion on pricing focused on whether buyers were going to pay par or even a premium.
Now there is more flexibility on pricing and GPs are focused on getting capital back to LPs, and LPs are mainly focused on overall return. In many cases, if LPs are getting a 2.5x plus return on an asset, they will take it, even if they are selling at a discount to NAV. LPs are eager for liquidity.
Pearce: The current fundraising-driven market narrative isn’t encouraging more discretionary vendors to come to market. We have certainly had conversations with LPs who are saying: “Why would we sell now? All we hear [from the buyers] is that this is a great buyers’ market and that sellers have to swallow deep discounts.” That is clouding the sell side, because LPs fear that the market is worse than it is in reality.
I don’t think the pressure to sell has been as broad or intense as anticipated and we haven’t seen swathes of allocation-constrained LPs rushing to offload fund stakes at any price. The vast majority of LPs exploring sales have had discretion and are only selling at narrower discounts. With headline pricing continuing to improve, we expect the volume of more discretionary vendors looking to undertake active portfolio management to grow, which will support further market growth.
Greenway: A GP-led solution works quite well for LPs that have been waiting on meaningful distributions from their private equity portfolios. LPs may see the liquidity that can be generated by a GP-led as an attractive solution, even if it is at a discount to NAV, given where valuations are across the market. A manager can make a strong case for a GP-led deal that offers LPs an option for liquidity at a valuation that is close to a level that might be available in the wider buyout market at the present time.
Pearce: Given the quality of GP-leds being validated by the market, investors are seeing options on assets where they may have already done a five times return, and in a capital-scarce market locking in that sort of return and taking liquidity is very appealing. When a GP-led election comes along which is a good lock-in, through a well structured process and requiring very little work from them, LPs are taking it – there are very few choosing to roll the dice again.
Stuart Ingledew: Many primary funds are running hard to make distributions before coming to market with new funds, but M&A deals and IPOs are pretty challenging to execute right now, so they are exploring all the options.
GP-led deals are one of those options but we also see growing interest in the financing options available at fund level. As GPs and LPs become more familiar and comfortable with NAV financing, some are using these facilities to accelerate distributions to investors, as well as for growth opportunities in their portfolios.
As GPs and LPs become more familiar and comfortable with NAV financing, some are using these facilities to accelerate distributions to investors, as well as for growth opportunities in their portfolios
Can NAV financing emerge as a credible proxy for a secondaries deal when it comes to providing liquidity?
Ingledew: It comes down to the all-in cost of capital, which we all know is increasing. Using NAV financing to make distributions works if it keeps all-in capital costs low, but it becomes harder to implement if the all-in cost of capital starts to exceed fund hurdle rates.
That said, the NAV financing market is growing substantially and solutions are being put together for GPs. Banks are building out their NAV financing teams and there has been an increasing number of alternative lenders focusing on this part of the fund financing market. Market players are seeing opportunities to provide financing with low margins as higher base rates mean they can still hit their return expectations. We have even seen some secondaries funds come into the NAV financing space recently and put pockets of capital to work in NAV structures. The market is in a really interesting and dynamic place.
I want to move onto fundraising for secondaries strategies. How has fundraising progressed this year, and how has it compared to the primary funds market, which has been very challenging?
Chall: Fundraising is more challenging but this is an interesting environment for secondaries – and investors recognise the opportunity. It is also worth taking a step back and pointing out that when we look at all the secondaries dry powder in the market and add it up, it only equates to something like two years’ worth of secondaries deal activity.
LPs look at that and see a more attractive dynamic compared to other parts of the market. That in itself is a long-term tailwind for secondaries across all economic cycles.
Ward: From the conversations I have had, capital is coming into secondaries funds, but it is taking time and funds are having to stay open for longer. Funds that were closing in about 12 months are now taking between 18 months and 24 months to close.
It will be interesting to see where the balance falls between wrapping up funds and getting back to deals, and extending fundraises in order to hit hard-caps.
Thandi: We have seen the same dynamic playing out on the primary side. Fundraises have been slower and managers have been making smaller closes more frequently to get LPs in as fast as possible. We also see managers extending fundraising timetables to try and hit, or get closer to, hard-cap thresholds.
Ingledew: For primary and secondaries funds that have made first closes, there is also an intense focus on ensuring that the deals going into new funds are of extremely high quality, to help build momentum behind the fundraising process.
To what extent is specialisation now a factor in secondaries fundraises? The market has evolved so rapidly during the last five years, and there are many managers now running very specialised secondaries strategies.
Greenway: We are starting to see a greater level of specialisation within secondaries across both sectors and instruments (e.g. credit or infrastructure), but also within the sub-segments of the more mature private equity secondaries market. Certain large players have been able to scale successfully and are well positioned as buyers of very large LP portfolios (c.$1bn+). That has opened room for other secondary buyers to find niches within the market and develop their own areas of specialisation.
As secondary investors have specialised, LPs in secondary funds have also become more sophisticated in how they view the secondary market as a whole. LPs in secondary funds can now choose between a whole range of strategies, including GP-leds, those concentrated in large/mega buyout, or those who lean more into the midmarket such as ourselves.
On the GP-led side, I believe there is another round of evolution to come. At the moment, most market participants are going after similar types of GP-led opportunities and as such, some GP-led secondary portfolios can look quite similar to each other. Although not imminent, I would expect to see the GP-led market start to develop in a similar direction to the LP market, with managers carving out certain niches and certain types of transactions in an effort to secure a more distinctive dealflow and differentiate their offers to LPs.
Pearce: Asset class expansion is already well validated, with infrastructure secondaries particularly well established. Private credit secondaries have taken time to build momentum off the back of the huge AUM buildup in recent years, but are now enjoying rapid growth both in terms of sell-side volumes and the capital chasing it.
Greenway: It is a good development for the market that we are seeing the level of specialisation that Ben mentioned, as the cost of capital investing in these segments will be more appropriate, as opposed to secondary buyers needing private equity-like returns across the board.
Beaudin: That is true. Historically we would see secondaries funds dabble in credit, by trying to buy pools of credit assets and price them opportunistically to align with the return targets of their main funds, which were targeting buyout returns.
What we see now is the right capital chasing the right opportunities. Secondaries buyers have buckets of capital assigned for private equity, credit, infrastructure and real estate.
It means that sellers are much more comfortable going out in the market with a credit book or an infrastructure book, because they know the assets are going to be sensibly priced. This has been a huge development in driving the diversification of the secondaries markets.
So, am I right to assume that investors are looking for different risk-return dynamics for each distinctive sub-strategy within secondaries? Would you expect a different return from a single-asset deal versus late-stage secondary, versus an LP-stake deal involving a mega manager?
Greenway: Obviously across the different asset classes that's absolutely the case, but even within an asset class there are varying risk-reward dynamics.
If we just take private equity for example, it comes down to diversification. So, if you're buying LP books, in which a transaction can involve hundreds of underlying companies, there is an element of diversification that mitigates against potential risk, but which also reduces the potential alpha. When it comes to more concentrated GP-led deals, you would expect returns that mirror those from traditional buyout firms, although still with the benefits that come with secondaries in the form of asset visibility and continuation of an existing growth plan with a manager that knows the asset, or assets, well.
As an example, for a single-asset continuation fund opportunity, we would not expect to underwrite returns below a 2x MoIC and 20% IRR, whereas on the LP side, depending on the level of concentration, expected returns will be lower than that.
In addition to the return profile, the liquidity profile is also an important consideration, especially in LP portfolios where earlier liquidity forms a key part of the investment strategy.
Pearce: The range of strategies within secondaries has expanded quickly – particularly with the proliferation of GP-leds – and we see that many investors who make allocations to secondaries are still grappling with how to appropriately benchmark returns with the risk taken to generate them.
How do you compare a manager doing concentrated, single-asset deals with an LP-dominant strategy? The focus used to be on to what degree a secondaries manager was using leverage, but now a much more detailed assessment is required to understand what risk a secondary manager is taking to deliver returns, and how to compare and contrast those different options.
Ingledew: Some managers have the flexibility to invest in both GP-led and LP-led deals. Has this flexibility of deployment into the relative value for each strategy helped when it comes to fundraising?
Chall: If you take a step back and ask why LPs go into secondaries, the answer is risk mitigation. They want earlier cashflows back and they want to mitigate the j-curve that you have with primary funds.
When we speak to our LPs – and we're obviously pitching secondaries on a diversified basis – our argument for doing LP and GP-led deals together is that generally LP deals give you earlier cashflows and j-curve mitigation and GP-led deals provide more value appreciation over the longer term. So, you want that combined exposure to LP and GP-led deals.
If you’re only investing in single asset GP-led deals you’re unlikely to achieve the same j-curve mitigation as a more traditional secondary fund that is also buying LP deals.
Beaudin: I'd say the obvious argument for a GP-led-only fund is you're going to invest with the top GPs, and that is where relationships with the big platforms matter because you have access to the top GPs and the best assets. A GP-led play offers the same type of return you would get in a primary buyout fund, but with less risk because the GPs know the assets and have known them for a few years.
What we are seeing on the LP side is growing demand. You have the LPs that want their main secondary exposure to mitigate risk and offer value upside on the backend. A well-rounded secondary fund is very attractive to them.
What we also see is that more and more LPs who have a history with us have visibility on the types of deals that have been done and know which ones they like more or less. They form a view on the risk-adjusted value they are targeting, know what kinds of deals they like, and ask for more exposure to certain types of deals.
A growing number of managers will now have sleeves or side pockets to accommodate investors that want more access to certain types of deals. This focus from the LP was probably not a theme in the secondaries market 5-10 years ago.
Do specialist secondaries strategies demand specialist expertise? Do skillsets differ if you're doing a single-asset secondary versus a big LP-stake portfolio?
Chall: Our approach is that the entire team works on both LP and GP deals.
We apply the same skillset for analysing businesses in both LP and GP-led deals. We also leverage our direct equity team as we often find companies in their portfolio that are complementary to what we are seeing in secondary opportunities.
Yes, you can develop very detailed expertise when it comes to going into the weeds of a GP-led opportunity, but the key question for us always comes down to alignment. At the end of the day, we're not controlling the asset. We want to understand what the GP’s motivations are and make sure that we are aligned with each other.
Ward: Our team covers both LP- and GP-led deals but where we have specialised is through our focus on legacy and tail-end portfolios. This has been the strategy since Hollyport’s inception in 2006. We see it as an underserved part of the market because there is often a lot of work that goes into trying to find remaining value in the assets. Sometimes, there is only a little more value to unlock, but you also find great companies that have just taken longer to hit their stride.
Looking back, what is quite interesting is how the first wave of GP-led deals came out of 10-year-old-plus funds that were not going anywhere. That is how we got into the GP-led side of the market. Now, GP-led deals mainly involve the prized assets in portfolios.
But going back to LP portfolios, the key for us is to look through all of the companies in the portfolio, speak with the managers where we can, and really try to find the companies that have potential, and then come up with a price to take on the risk.
We have briefly touched on the use of leverage in secondaries, and I want to go into that in a bit more detail. Where do we stand when it comes to appetite for leverage on secondaries deals, given rising interest rates and tighter capital markets?
Thandi: There is still quite strong demand for leverage, but it does depend on the rationale and the use case.
Given the constraints on capital, there seems to be more interest in managers using finance to unlock liquidity. That is a shift in the use case that we have noticed, but the financing still has to make sense for the overall dynamics of the transaction.
Traditionally, people have used a lot more leverage on LP-led deals, but more and more we've been asked to look at providing leverage on the GP-led deals as well. That can be to fund the purchase price of a GP-led deal on day one, or it can be a way to optimise leverage in the capital structure if there are low levels of leverage at the company level. That can make sense if you can get a cheaper financing package for the continuation vehicle, where the structuring, underwriting and downside risk assessments are quite different.
Overall, there are several dynamics at play, and we are seeing a mixture of approaches when it comes to using leverage in secondaries.
Ingledew: The GP-led market is still far behind the LP side when it comes to taking on financing. When using leverage for a GP-led deal, the use case must stack up from a buyer's perspective. Where we've provided these solutions, the financing is either used as permanent leverage or as a bridge to a refinancing or an exit.
In all scenarios, buyers want to know how that financing is put to work. They are generally OK if GP-led deals are leveraged, but only if the manager can explain why leverage has been used and what the key purpose is. There is certainly much more scrutiny of leverage and how long it is in the deal structure for, particularly given the cost of capital at the moment. This has driven a noticeable shift in tenors. Historically we've done mainly three- to four-year ‘plus-one, plus-one’-type solutions. Now we are seeing facilities with one-year tenors that are acting as synthetic deferred considerations, in which case the buyers know their money is going to be put to work after one year.
The buyers want to be in a position where the GP has to ask for approval for an extension of a financing facility for another year. There is much more attention on making sure the buyers in GP-led situations have bought into the whole rationale of the financing and how long it's in there for.
Given the constraints on capital, there seems to be more interest in managers using finance to unlock liquidity. That is a shift in the use case that we have noticed, but the financing still has to make sense for the overall dynamics of the transaction
When it comes to the cost of capital and terms for these facilities, has anything shifted?
Ingledew: I'd say margins are broadly in the same ranges that they have been in for some time, but with base rates going up, financing has become more expensive. Base rates that were previously zero are now in the 4% to 5% range. Margins haven’t shifted much. Rising base rates are what have forced the market to recalibrate.
How are secondaries investors using and thinking about leverage as all-in cost capital has moved higher?
Greenway: We've always been at the conservative end of the spectrum in the use of leverage. We have not been the types of investors to blanket leverage on deals in order to juice returns.
We've been very selective leverage users at the LP deal level, and continue to consider it, but we have found that the recent market environment that we have seen during the past 12 to 18 months has been less appropriate for the use of leverage, both in terms of cost but also not introducing an additional layer of risk into transactions.
On the GP-led side, we are quite cautious about the use and scale of leverage. Without wanting to come across as being overly sceptical, we want to avoid its use as a way for GPs to boost their chances of ending up in a higher carry bracket without delivering true ‘asset-level’ performance. If leverage is used in a multi-asset GP-led to bridge to a near-term exit, that can make a lot of sense, but we only want to see it where there is a very clear rationale.
Chall: If you are bridging to a near-term cashflow, it makes sense, but apart from those types of situations, we are cautious about leverage facilities in GP-led deals.
On the LP side, we've never really been a big user of leverage. In a market where rates have gone up substantially and the cost of a facility is more expensive, the margin between what you're underwriting versus the cost of leverage has considerably narrowed. If there's any underperformance in the portfolio, you're going to feel that pretty quickly.
Beaudin: Leverage is a very useful cashflow management tool at fund level. When you have financing in place, rising capital costs can have an impact on the absolute return of a fund, but that can be mitigated by adjusting how much you draw. When you draw down from a debt facility, you compare the benefit of using the facility against the cost of capital from your LPs and make a decision. That hasn't changed. In any environment, you will always consider those parameters when you think about leverage.
To close, I wanted to ask the panel about ESG. As a secondaries manager, how important is it in your investment criteria and to what extent can you actually influence ESG policy across portfolio companies?
Ward: ESG is important to us and we are dedicated to integrating ESG considerations throughout the investment process. We recognise that we can’t march in and dictate how GPs should be managing ESG, especially on the LP stakes side, but we do apply a negative screening process for portfolio companies involved in certain sectors. Additionally, for all GP-led deals, we make it a requirement that the GP has an ESG policy in place.
Greenway: As we tend to invest in GPs that are backed by our primary programme, we are able to leverage the broader platform’s approach to promoting strong ESG practices. With LP secondary trades, it is challenging to make demands that the GP implement certain ESG measures if we are not already invested in the fund. We do however apply negative screens to LP opportunities as well as GP-led ones, and have declined deals on the basis of ESG considerations. I would agree with Andrew that on the GP-led side there is much more scope to drive good ESG practices, especially when you are the lead investor.
Thandi: During the last few years, we have seen a shift in ESG-linked facilities being considered at the fund level in both subscription and NAV financings. While insignificant margin ratchets are a feature, the facilities are designed to ensure KPIs are meaningful and stretching for the managers. We have our internal screening processes as an institution and there have been instances where we have declined deals that haven’t aligned with our firm’s ambitions.
In most cases, GPs and portfolio companies are working hard to implement their ESG journeys and best practices, so there is alignment from all parties and a willingness to drive change.