How covid has changed the secondaries industry
The rise of GP-led secondaries is raising interesting questions about the level of returns limited partners should be expecting. Investec Fund Solutions’ Ian Wiese and Michael Zornitta take stock of the secondaries market, which has been affected dramatically by the events of the last 18 months.
How did Covid impact the secondaries market?
Ian Wiese (IW): We saw a division in fundraising, with larger managers continuing full steam ahead while younger and smaller managers struggled to gain traction. The other major trend was an acceleration in GP-led deals, both single assets and multi-asset portfolios. With so little other deal activity going on, those GP-led deals caught everyone’s attention, from the GP that had never considered that form of liquidity before, to limited partners (LPs) recognising an interesting way to access quality assets.
The advisory market responded, as well. For example, certain investment banks brought in secondaries advisers to help build out a secondaries advisory business. So, there were both short and long-term impacts.
Portfolio acquisitions softened significantly. Is that market now coming back?
Michael Zornitta (MZ): It definitely seems to be. This time last year activity was very slow, but we are witnessing a surge in activity. In some cases, we are seeing multiple bidders come to us with the same portfolio transaction. That hasn’t happened in around 18 months.
IW: Most secondaries funds have deployment guidelines dictating the proportion of capital that can be deployed in concentrated GP-led deals. Because GP-led deal flow has been so strong, they are now being forced to look for diversity. This is leading to increased activity in portfolio transactions. That is having an impact on pricing as well. We are seeing large, diversified portfolios receiving full bids or even premiums, which is a function of held back liquidity returning to the market.
How is the use of financing evolving in the secondaries industry?
IW: There hasn’t been any monumental change, but we are seeing everything from subscription lines to asset-based solutions being more widely used, with an added level of sophistication. Some secondaries funds are even bringing financing specialists into their teams. Meanwhile, LPs have accepted that financing enhances their returns. With pricing at its current levels, both general partners (GPs) and LPs are recognising the importance of financing to maximise returns.
What about the role of the financier in GP-led deals? Is that changing?
IW: Historically, debt has always been something of an afterthought in GP-led deals. What we are now seeing is finance providers getting involved much earlier in the process. That’s important because it means legal documents of the special-purpose vehicle (SPV) can be drafted in such a way that meet the financier's needs. It also helps with the marketing of the transaction to LPs. You can imagine a pension fund with the option of rolling over into a continuation vehicle suddenly having the complexity of leverage thrust on them at the last minute. That can act as a deterrent. But if you bring lenders in early, they can help educate and make everyone comfortable. Historically, the use of financing was predominantly for the benefit of the incoming secondaries investor. That is shifting dramatically with financing being used for the benefit of all investors in a GP-led transaction. By getting the lenders involved earlier, an optimal structure can be implemented that will ultimately obtain the best possible result for everyone involved.
What innovations are you seeing regarding SPV acquisition financing?
MZ: We are seeing a lot of evolution in structures from security to sweep mechanics, which then has a knock-on effect on the overall terms of the transaction. One particular manager we worked with recently was extremely sensitive to internal rate of return (IRR). By considering commitments reserved for unfunded into the portfolio, we were able to provide lower pricing, but also permit delayed sweeps. That then allowed distributions to be sent to LPs earlier in the deal lifecycle, obviously benefiting IRR.
How can an acquisition facility, alongside a subline, boost returns?
MZ: Many portfolio acquisitions involve a significant element of unfunded. While you can obviously have acquisition finance to help boost returns on day one, you can also introduce a form of subscription facility, secured by those undrawn commitments, which can be used to fund any future capital calls. Effectively you have two facilities, one put in place at the start of the fund to assist with the acquisition and then the other that is then drawn down as the underlying portfolio has capital calls.
IW: This could relate to a GP-led continuation vehicle but is equally effective when you are looking at an LP portfolio. What you are effectively trying to do is provide an asset-based solution to the portfolio on day one, while also providing flexibility as and when that portfolio needs follow-on commitments.
How are the competitive dynamics within the secondaries financing ecosystem changing?
IW: The subscription finance market is sizeable, but it needs to be. Due to increases in fund size, it often requires multiple banks or a party that can bring in partners to underwrite large transactions. However, when it comes to the more concentrated or structured transactions, there are still only around half a dozen participants. And, in fact, covid did see the retreat of some providers. Those are now slowly coming back but tending to focus on existing relationships. Larger deal sizes garner a lot of attention, but there is definitely a gap at the smaller end of the market.
And what do firms look for in a finance provider?
IW: Most importantly, execution capability and certainty of deliverability. When a transaction is running at record speed, our clients have to be sure we can get there on time and we can deliver on the terms that we initially indicated.
What does the future hold for the secondaries industry as we continue to emerge out of covid?
MZ: I think we will continue to see a growing acceptance of leverage in the secondaries market from LPs. We are starting to see an increase in usage of financing from managers that have historically shied away from it. I expect this trend to continue.
IW: It is undeniable that the secondaries market is going to grow in size. Just look at the number of new entrants. We have recently seen PGIM acquire Montana Capital Partners, for example, and TPG hiring well-known secondaries participants. Advisers are also positioning themselves to advise on GP-led deals as a fourth liquidity solution alongside secondary buyouts, trade sales and IPOs. I do also think we will see a rebalancing of activity between GP-led deals and LP portfolios. But that is going to raise some interesting questions about returns. Buying the market for a diversified LP stake is very different to taking a view on a single asset transaction. LPs are going to be asking whether a fund with large exposure to more concentrated deals should really be returning the same as a more diversified portfolio. We are in for an exciting ride.
Download the Investec Secondaries Research report 2021