May 7, 2020
Private equity secondaries activity has cooled as buyers and sellers await clarity around valuations, but opportunities are expected to arise out of the uncertainty caused by the coronavirus pandemic.
Limited partners and their general partners are digesting market changes and expect to have a clearer idea of their options once second-quarter valuations are available.
“We get very excited about the opportunity set that will come around as a result of this,” a partner at a U.S. firm with a focus on secondaries who wished to remain anonymous, said.
Mark Maruszewski, StepStone Group LP’s co-head of secondaries, said that for the time being, the market is readjusting. “Pricing has backed up 20 to 30 points, so all those deals that were launched with the expectation that they would get very strong pricing, that’s all out the window now.”
Forced sellers, such as those whose alternative asset allocation has grown too big due to the fall in public markets, known as the denominator effect, or those with cash flow issues are coming to market with “a more realistic understanding of pricing expectations” and those deals will get done, Maruszewski added.
Even so, LPs are unlikely to be pushed into fire sales. Following the global financial crisis, when the denominator effect was keenly felt, some investors introduced flexibility in their asset allocations to avoid forced selling, the anonymous secondaries partner said. But the degree of flexibility will vary between LPs.
And Gerald Cooper, head of Campbell Lutyens & Co. Inc.’s secondary advisory practice in North America, does not think any investors will be willing to sell positions at distressed prices to correct the denominator effect. “We haven’t picked up on any LPs that are in distress, at least of scale.” LPs are likely to wait and see if they can “work through the system,” and selling will begin once the market has stabilized and discounts are narrower than they are today, he said.
Considering the options
Although activity has stalled, discussions continue. The opportunities available are diverse and abundant,
StepStone’s Maruszewski said.
Managers are considering creative ways to build their capital base to defend their portfolio companies, including possible strip sales, fund recapitalization and preferred deals on existing partnerships, “all the things that they can think of to come up with the necessary capital to continue to protect the portfolio of companies and preserve asset value long-term for their original limited partners,” Maruszewski said.
There are also conversations around preferred capital securities, when a secondaries GP provides capital to some portfolio companies that may be struggling, which is backed by the entire remaining fund portfolio as collateral.
These deals, which are bespoke, are typically structured with an interest rate that is paid in kind. Once the secondary firm’s principal and interest are paid off, they may have a small slice of equity, which is intended to help get them to their target return, Campbell Lutyens’ Cooper said.
Preferred equity is an option for funds whose portfolio companies face acute liquidity problems. Traditional financing markets may not be “open to provide capital” to them, and while they may be able to tap into government help, they will not be able to do so quickly, the anonymous secondaries partner said.
It is more expensive than traditional financing, but can be more conservative, Cooper said. “The preferred equity doesn’t have covenants, it doesn’t have a maturity. The only obligation is that it’s repaid, and so it doesn’t show up on the balance sheet as debt,” he said, adding that if assets truly have upside, “then it could be quite effective as a leverage tool for the existing common equity holders.”
Down the line, longer exit horizons may make GP-led secondaries, where managers take the lead on buying and selling fund commitments, and continuation vehicles more attractive. The secondaries market is more sophisticated than it was during the financial crisis, so GPs are “more aware of the various solutions and tools that they have to create optionality for LPs,” Cooper said.
Funds to follow
Increased opportunities to invest could also lead to more future capital commitments for managers.
The amount of private equity secondaries dry powder available to deploy sat at $96.4 billion as of April 29, up from $87.7 billion at the end of last year, according to Preqin. That compares with $23.4 billion as at December 2008.
LPs get “very, very excited” about secondary private equity ahead of, going into, and through a downturn, the anonymous secondaries partner said. This is because liquidity becomes incredibly valuable, and the provider of that liquidity stands to earn a premium return.
The secondaries market has performed well, and from a cash flow perspective, deployment to secondaries should be a way to help balance an LP portfolio as these funds theoretically distribute cash and return capital quicker than primary funds, Cooper said.
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