Evercore: Are diversified LP portfolios still core to secondaries?

Diversified LP portfolios have historically comprised the bulk of secondaries market dealflow, but not so in 2020, say Evercore senior managing director Nigel Dawn, vice-president Amy Heinemann and associate Richard Cutshall.

Nigel Dawn
Amy Heinemann
Richard Cutshall

 

 

 

 

 

 

 

 

This article is sponsored by Evercore

Diversified LP portfolio sales are often described as the bread and butter of the secondaries market and historically have made up the majority of transaction volume every year. In 2020, unusual market conditions characterized by volatility and uncertainty resulted in a shift towards GP-led transactions. While early signs in 2021 point towards a meaningful uptick in the LP market, both secondaries buyers and LPs have been asking: will the LP market return to normal in 2021?

The Evercore Private Capital Advisory team believes the market is poised for a significant resurgence in 2021 with incredibly favorable dynamics for sellers.

Total secondaries market transaction volume was down in 2020, with the decline in volume particularly pronounced for LP transactions. In 2020, LP deal volume was around $28 billion, compared with LP deal volume of approximately $54 billion in 2019.

This reduction in transaction volume of nearly 50 percent from 2019 to 2020 can be attributed to a period of inactivity in the first half of 2020 due to uncertainty resulting from the global covid-19 pandemic and a cautious return by selling LPs in the second half of 2020.

Supply and demand dynamics

Since the LP secondaries market rebounded in the second half of 2020, the market has been characterized by opportunistic sellers and highly competitive processes due to a supply/demand imbalance. The mismatch in selling volume and buyside demand is driven by several factors.

“The majority of funds sold in 2020 were younger vintage funds”

Unlike market activity in prior market downturns, portfolio sales during the midst of the pandemic were opportunistic. The vast majority of LPs that have brought portfolios to market since the pandemic began have done so to actively manage their portfolio, to free up capital to redeploy in core managers or to generate liquidity to invest in other asset classes or opportunities, rather than selling out of distress. In particular, we have seen LPs more actively seek early liquidity for longer duration interests with limited upside to deploy into opportunities with higher expected returns. While some LPs have re-entered the market to sell portfolios, many others opted to remain on the sidelines.

Some sellers chose to hold onto assets and take short-term performance gains rather than sell, due to expectations of write-ups quarter-over-quarter in Q4 2020 and Q1 2021. Continued write-ups created somewhat of a bid-ask spread due to larger implied roll-forward discounts when evaluating pricing off of subsequent quarters. As write-ups going forward are expected to be more moderate, we expect this dynamic to be less pronounced in upcoming transactions.

On the demand side, interest in diversified LP portfolios is strong as deployment into secondaries funds has been weighted towards GP-led secondaries over the past year. As LP transactions have historically made up the majority of volume in most years, investors in most secondaries funds have the expectation that a meaningful portion of deployment will be in diversified portfolios, creating significant pressure on many secondaries buyers to seek out and invest in more diversified portfolios to rebalance their exposure away from more concentrated, higher risk, GP-led transactions.

Younger, high-quality portfolios

Some of the most competitive processes in 2021 have been for younger, high-quality portfolios. In recent processes involving buyout-focused, younger vintage portfolios, competitive dynamics have driven prices into premium territory. This trend mirrors what was seen in 2020, where many sales processes focused on younger-vintage, high-quality portfolios.

Following Q1 2020 adjustments, funds have been consistently written up quarter after quarter, tracking the public market rally and public comparables. This has created challenging pricing dynamics for older vintage portfolios with less remaining upside, particularly if sellers are sensitive to taking a discount. To avoid taking a discount, many sellers elected to sell select younger vintage funds, as pricing and buyer interest was initially stronger for younger funds with the ability to invest through the cycle and with more remaining upside. As a result, the majority of funds sold in 2020 were younger vintage funds.

This trend has begun to dissipate in 2021, with more mature portfolios coming to market and attracting strong interest. Pricing for mixed quality and mature assets has continued to rebound due to unprecedented competitive dynamics in the LP market and we expect this to continue throughout the year.

Return of the LP market

In early 2021, high levels of dry powder and continued buyer demand for diversified portfolios has contributed to competitive market dynamics for portfolios in the market. LP deal volume was up significantly in the first quarter, though it was driven by several large portfolio sales. As many deals in the market recently have been more sizeable, we expect that there will be significant competition for smaller, sub-$300 million deals that are accessible to a wide range of buyers. Looking towards the remainder of the year, we expect strong buyer demand and favorable dynamics to continue as a result of the following trends:

  • High levels of dry powder and consistent fundraising activity: Secondaries fundraises continued throughout the past year and 2020 ended with approximately $113 billion in dry power, with secondaries groups expecting to raise an additional $72 billion in 2021. Assuming approximately 50 to 55 percent of this is deployed into the LP market, there would be roughly $97 billion in dry powder available for LP deals.
  • Substantial transaction pipeline: With many LPs taking a wait-and-see approach to secondaries transactions in 2020, pent up supply has continued to build. The potential pipeline of portfolios that LPs have actively considered selling in early 2021 is approximately $47 billion, predominantly in younger vintage funds with a weighted average vintage of 2015. The majority of potential deal volume is in North American and European-based funds, with over 80 percent in these geographies. As in prior years, the potential pipeline of deal volume is dominated by buyout, but there could also be significant exposure to direct/co-invest vehicles, venture/growth and secondaries/FoFs, with muted transaction volume in real assets in the near-term.
  • Ability to lock-in returns and rebalance allocations: Generally, Q4 2020 valuations released to date show a substantial increase from Q3 2020, mirroring the strong performance of public market comparables. Many LPs are now looking to the secondaries market for liquidity, as high valuations and strong buyer demand provide them with the ability to crystallize strong returns. As valuations have increased quarter-over-quarter throughout the past year, some LPs are also facing allocation issues. Many have experienced very strong performance in their private equity portfolios over the past 12 months with mixed distribution activity and are bumping up against the upper limits of their allocation targets. This is expected to be one of the key drivers for some sizeable portfolio sales over the next six to 12 months.

While GP-led deals are expected to remain a meaningful part of overall market volume going forward, LP portfolios will continue to be the base upon which secondaries buyers construct balanced, diversified secondaries funds. Given the dynamics surrounding the LP market, 2021 is shaping up to be an attractive time for LP portfolio sales and we anticipate a significant increase in volume over 2020 levels.