This article is sponsored by Evercore
With total transaction volume topping $66 billion, 2021 was another record year for the LP secondaries market. The year benefited from a combination of supportive factors:
- LPs being overallocated to the asset class following record performance post-covid, in what was coined a “numerator effect” situation;
- An unprecedented wave of re-ups with LPs citing that successful, core GPs are fundraising faster and with larger fund sizes;
- Substantial dry powder from dedicated secondaries funds, with these groups sitting on over $100 billion (excluding leverage and recycling);
- Overallocation to GP-led deals and in particular single-assets, increasing appetite for diversifi ed transaction profiles; and
- Supportive exit environment and public markets valuation levels.
As a result, LPs’ willingness to rebalance alternative portfolios was particularly high. While disposing of non-core and/or tail-end positions in prior years was often considered a sound portfolio management tool, it was a necessity for many LPs in 2021 if they wanted to commit their full allocation to re-ups and to identified new relationships. On the demand side, secondaries buyers were very eager to close on diversified LP portfolios to meet their yearly target allocation in a market with no shortage of single- and multi-asset GP-led opportunities.
A strong start
2022 started strong, but underlying market conditions for each strategy and geography may be changing. The themes of 2021 continued into the early days of 2022. A number of large LP portfolios were in the market off September 30, 2021 reference dates and benefiting from a strong Q4 2021, particularly in the US. What tends to be a quieter quarter for the LP secondaries market showed no signs of slowing down.
Today, the first three of the above listed factors remain strong drivers of the supply of LP interests, however there are now a number of new considerations for sellers due to widespread economic uncertainty largely driven by the sharp drop in public markets (S&P down 14 percent and NASDAQ down more than 20 percent YTD 2022), rising inflation and the war in Ukraine.
First, consider optical vs economic sellers. It is of course easier for LPs to justify a sale when the price for noncore or tail-end funds is at or above the most recent NAV levels. That is particularly achievable when there are strong post-record date events such as rising stock prices, new up-rounds of financing or exits occurring above NAV levels. But the December 31, 2021 reference date being used right now is less supportive. Most trades can no longer clear at or above these NAV levels and sellers need to be economically – and not simply optically – driven in their decision to dispose of funds. It remains unclear as of early May 2022 if the upcoming March 31, 2022 NAVs will provide buyers more comfort.
Next, consider hard-hit late-stage tech valuations. The most impacted sub-strategy within the secondaries market in 2022 is mature, late-stage venture and growth. In 2021, Evercore PCA estimates that venture and growth funds (excluding tail-end funds of vintage 2012 and older) priced at an average 97 percent of record date NAV, with some funds commanding up to double-digit premiums. Early pricing indications in 2022 look significantly lower, although LPs are typically locking in outsized TVPIs for these funds, even when selling at a discount. That said, very recent, oversubscribed venture and growth funds still command strong secondaries pricing as most buyers continue to underwrite the potential for future value appreciation in the underlying companies.
A third consideration is skepticism around emerging markets exposure. With rising global geopolitical instability, we have noticed a shift in pricing for funds based on their underlying portfolio geography. There has been a flight to perceived safety, with buyers often pricing North American and Western European assets the strongest. Private funds with assets in Asia, Latin America, Central/Eastern Europe or Africa have been impacted the most.
Fourth, consider improving market conditions for energy funds. On the back of record oil and commodity prices with inflation on the horizon, energy funds (especially upstream oil & gas funds) seem to be the early winners of 2022. Once considered untouchable by most secondaries buyers, interest and pricing have grown materially. It is worth noting that most active buyers in this subsector are “non-traditional,” such as endowments, foundations, family offices and pension funds. Sellers of such assets typically committed to divest from such funds in a net zero effort and were waiting on the sideline for improving market conditions.
Fifth, consider resilient assets. Recent buyout funds tend to be the value drivers of strong optical pricing in the secondaries market, and 2021/22 are no different. Average pricing for buyout funds vintaged 2013 and newer averaged at 101 percent of reference date in 2021 for Evercore PCA deals. Early indications in 2022 look very similar; however, older buyout funds (fi ve-plus years old) with marked-up portfolios and meaningful public exposure have seen an impact to pricing levels.
There has also been a rise in credit and infrastructure secondaries. Once faced with a wide bid-ask spread due to traditional secondaries buyers’ inability to underwrite to high single-digit returns for such assets, credit and infrastructure funds are now highly sought-after by specialist buyers looking for yielding investment strategies. Given the lower correlation to market volatility for these assets, they could continue to be value drivers in 2022.
Increased sophistication of the LP secondaries market
Beyond traditional cash sales, several tools are emerging to bridge the potential bid-ask spread for LP secondaries:
- Purchase price deferral. A classic mechanism enabling sellers to improve optical pricing by giving buyers the ability to defer some or all of the purchase price payment.
- Preferred equity structures. Once a niche part of the LP secondaries market, these SPV structures have typically become more prevalent in volatile markets, such as the early days of the covid outbreak. A number of large, dedicated secondaries buyers are now able to offer these solutions, providing sellers with an upfront cash payment (typically 50-70 percent of NAV) and the ability to retain part of the future upside after an agreed-upon hurdle for the capital provider.
- NAV loans. Given the inexpensive cost of debt in recent years, a growing number of lenders have entered this space, offering LPs an alternative (partial) liquidity solution.
- Collateralized fund obligations. Brought to market years ago, they are still considered niche securitization vehicles by most market participants. CFOs enable sellers to generate secondaries liquidity through the securitization and rating of part of their LP portfolio.
A supportive market
The secondaries market for LP interests has enjoyed massive growth over the past decade. Supportive market conditions were fueled by a growing number of buyers, dedicated dry powder and increasing sophistication from all participants, particularly leverage providers. Despite newly formed headwinds, the market provides much-needed liquidity in an illiquid asset class. With the strong rise in commitments made by a growing number of LPs worldwide, we expect this market to continue to grow in the foreseeable future.