Navigating the secondaries market
How are LPs and GPs faring amidst changes in the secondaries market since the last downturn?
Much has changed in the secondaries market since the last downturn, so how are the different routes to liquidity bearing up as LPs and GPs seek ways of crystallising returns, freeing up capital and rebalancing portfolios?
The denominator effect may have been largely absent for the time while stock markets continued on an upward trajectory, but it is back as LPs find themselves overweight in private markets relative to their allocation targets. Compounding the situation, the period of exit abundance appears to be over, leaving GPs faced with the conundrum of how to realise investments and distribute capital to their investors.
With liquidity at such a premium today, secondaries investors look set for an interesting 12-24 months, in particular as structuring in secondaries has removed some of the barriers to deals getting done and as GP-led deal technology has advanced rapidly.
We’ve certainly seen some interesting shifts over recent months. In the first half of 2022, LP-led deals increased secondary market share, taking 58% of the US$57 billion market, according to Jefferies H1 2022 Global Secondary Market Review. This was the first time since 2019 that LP-led deal volume outstripped that of its GP-led counterpart. However, much of this activity was started in the first quarter, with many players saying Q2 was quiet. At the same time, GP-led volume shrank (by 17%) for the first time in many years.
But what are we seeing in the market today? And what will come to pass through 2023 for both LP-led and GP-led deals?
LP-led deals
The bid-ask spread slowed the market through 2022... “There was a significant fall in potential deal flow in Q2 and Q3 as potential sellers did not bring their product to market,” says John Carter, Managing Partner of Hollyport Capital. “That’s because they didn’t like the prices. The portfolios that have been coming to market recently will require vendors to be realistic on discounts and I’d ask how many of them will actually sell.”
…and it may take some time to work through“People had been expecting robust deal flow in Q4 2022,” says Cari Lodge, Head of Secondaries at Commonfund Capital. “But some LPs decided to wait until the audited financials come out. Whether that makes a difference is yet to be determined – multiples may have contracted, but continued company growth may have offset that and so NAVs may not drop as much as expected. We are a year into this environment, and we probably have at least a year to go.”
Buyers are proceeding with caution, even though they are in strong position“The bar for quality is higher than it has ever been,” says Sanja Cvetinovic, Managing Director at Northleaf Capital Partners. “There is no pressure to deploy capital because a lot of secondary funds have just raised capital or are still raising. Secondary managers are underwriting to higher returns than a year ago and are spending more time with GPs and going into detail to mitigate risks.”“It comes back to risk and return,” says Carter. “There is more risk, it’s a buyer’s market and therefore we can command a higher return.”
Even largely unfunded positions are coming to market“It is not uncommon for investors to be selling younger funds – perhaps even 2020 and 2021 vintages,” says Lodge. “We have even had a completely unfunded position come to us recently. We have all learned not to miss vintage years and so if investors are over-allocated to private equity, they will look to manage their portfolios to generate liquidity to reinvest and that might mean selling young funds through to tail ends.”
Staples are back, although not always taken up“There are good staples and not-so-good staples,” says Lodge. “If the alignment is correct, they can be a good thing to do; if they are offered by a manager because it can’t raise a fund, that won’t work.”
Portfolios are being split between buyers“Most portfolios today are being broken up as sellers try to line up a number of buyers for funds so they can reach a reserve price for each,” says Cvetinovic. “Brokers are actively doing this to maximise the price. We welcome this because many of the portfolios are quite large and this offers us the opportunity to focus on a fund or single GP family.”
LP sales will pick up through 2023“We haven’t yet seen the true impact of the denominator effect,” says Lodge. “But it is coming. When that happens, LPs may need to sell investments to reduce unfunded commitments and private equity exposure. This may come at a big discount, and this is where structuring will come in – sellers will see a benefit to reducing unfunded commitments and gaining liquidity, but will want to have some potential upside on the discounts that they may need to take.”“More portfolios will come to market as the denominator effect takes its toll and as LPs clean up or manage their portfolios actively,” says Cvetinovic. “At the same time, we anticipate that GP distributions will dry up and some LPs will have to sell in order to recommit to the best managers.”
GP-led deals
GP-led deals are down… “There was a rush to GP-led deals over the past few years as some people jumped into concentrated and single-asset deals who may have lacked awareness on the portfolio construction side,” says Neal Costello, Managing Director, AlpInvest Partners. “There has since been a realisation that they couldn’t continue the pace of GP-led deals with what is a finite amount of capital. That has slowed the market as buyers are being more cautious and selective.”
…but they are not out“The GP-led space has grown rapidly because all market participants have embraced it,” says Laura Shen, Partner and Co-Founder of Headway Capital Partners. “For many secondary buyers, they have been an attractive way to add alpha to portfolios as the supply of LP-led deals tends to wax and wane.”
It is becoming a buyer’s market“Things are moving in secondary buyers’ favour,” says Shen. “GPs’ other exit options are drying up while the universe of investment options for secondary buyers are increasing with many LPs looking to rebalance portfolios and divest private assets. At the same time, some buyers may be overweight in GP-leds after recent years of high activity. Therefore, buyers are being much more selective these days.”“We saw more buyer-friendly terms through 2022,” adds a US-based LP. “There hasn’t been much of a move in NAV terms, although these are not moving upwards as they were before, but we are seeing other more favourable terms and this is keeping deals going.”
There may be a shock on the way“You can make mistakes. In GP-leds, unlike in LP-leds, you can go to zero,” says Costello. “We haven’t seen that yet, but when it does, it will shine the light a bit brighter on what the industry has been investing in for the past couple of years.”
LPs are tending towards liquidity today“In the past, GP-led deals have generally seen around 50% of LPs sell and 50% roll,” says Costello. “Today, it’s up to 100% selling – that’s liquidity-driven and they are taking that over price.”
Changed debt conditions may bring more GP-leds to market“For many companies, the debt package they currently have is an asset,” says André Aubert, Co-Head of Secondaries at LGT Capital Partners. “Yet if they were to undergo a change of control via an exit, they’d need to refinance; they generally don’t need to with a GP-led and this may drive more of these deals.”
GPs will need to tread carefully to keep LPs onside“When LPs are looking for liquidity, it’s not usually by any means necessary,” says a managing director of a US public pension plan. “We’d love to see liquidity or exits, but that does not mean we want to see three GP-leds coming from the same fund. We are trying to tamp down how much this needs to be part of our future – we should be in a sustainable place.”
Geoffrey Geiger, Head of Private Equity Funds and Co-Investments at USS Investment Management, agrees.
“The LP reaction can be one of plain annoyance because it’s a fund, you’ve invested in it, say, seven years ago and it’s meant to sit on the shelf for the LP,” he says. “Then, suddenly, you are being asked to make another investment decision. They are also fraught with conflicts. There is a right way to do these and as LPs, we need to give them proper attention, but there can be a limit to our bandwidth".
