This article is sponsored by Evercore.
The months of March through at least June will represent a chapter in the secondaries market like no other. The GFC is perhaps the most apt comparable period, when the market began its foray into the private investment mainstream.
From 2009-19, the secondaries market ballooned from $10 billion of deal volume to a record $80 billion. Fundraising volumes increased dramatically as well, with at least 15 funds raising more than $5 billion since 2015, resulting in nearly $100 billion of dry powder.
At a standstill
Due to the covid-19 pandemic, however, the secondary market is at a standstill. While $42 billion of deals closed in H1 2019, all signs indicate H1 2020 will result in less than $10 billion of activity.
Pending and upcoming sales in the LP-led market, which represented approximately two-thirds of 2019 volume, have been put on hold or delayed until at least Q1 valuations are available and buyers can develop conviction around pricing.
Meanwhile, GP-led transactions, which represented the remaining one-third of 2019 volume, have taken a tentative backseat to GPs’ focus on supporting existing portfolios and identifying opportunities to deploy capital into new deals.
The preferred opportunity
Not everyone in the market is suffering from deal shortage. There is a corner of the market that is busier than it has ever been with pipelines through April 2020 outpacing full-year 2019: the preferred equity market.
The preferred equity market had been growing of late, at around $3.7 billion of volume in 2019. Its recent historical growth is attributable to increased creativity around transaction structures. The current market volatility and dislocation, however, has catapulted preferred equity to the forefront of the conversation in 2020, with an abundance of potential bespoke investment opportunities available and an emergence of new capital providers. Preferred equity’s increase in notoriety should not come as a surprise given its flexibility and broad potential application for both GPs and LPs.
“All signs indicate H1 2020 will result in less than $10 billion of activity”
Opportunities for GPs
GPs’ lifeblood is access to capital. Many are already anticipating capital needs at their portfolio companies, evidenced by widespread revolver draws and an uptick in LPA amendments seeking to enhance recycling and recallable provisions. Nonetheless, the pandemic and shutdown will create numerous portfolio company liquidity challenges, creating opportunities for new investment. Where bank or LP capital is non-existent or comes with onerous covenants, preferred equity can help.
Portfolio company liquidity needs will continue to arise throughout 2020 given the shock to the economy and depressed operating environment—in particular for retail, food, travel and oil & gas. Funds hit hardest will be older vintages without access to uncalled capital. Noteworthy, more than $500 billion of value remains in private equity funds that are 2012 vintage and prior. Where bank capital is not available, preferred equity can step in and provide capital to stabilize portfolio companies. To effectuate this, GPs can consider a capital raise at an individual portfolio company, or at the fund level to increase the collateral pool as a means to free up capital and optimize pricing.
Sponsors are now underwriting delayed exit cases due to a more muted IPO and M&A environment, which, coupled with declining valuations, will weigh on fund performance and decrease the prospects of carried interest. Sponsors can consider preferred equity whole-fund dividend recaps as a fund management tool in order to provide a more balanced cash flow profile to LPs, while preserving portfolio upside that remains from operating in a more normalized environment.
While undoubtedly consumed with actively managing existing portfolios, GPs are also immersed in evaluating new opportunities, including accretive acquisitions. Managers of funds that can no longer call capital, but with opportunities to transform portfolio companies, can also look to preferred equity financing.
Additionally, as many commitments to recent, larger funds have increased in dollar value, a period could exist where GPs have less liquidity to fund their own commitments given anticipation of delayed exits in predecessor funds. The creativity and flexibility of preferred equity investors is probably best demonstrated by a willingness to finance GP balance sheet capital that can be used to create investment capacity and bolster returns.
Opportunities for LPs
Due to increased buyer target returns, reduced leverage and higher financing costs, secondaries pricing is expected to fall from recent highs in 2020. Record dry powder and a more mature market, however, will prevent average prices from approaching the 40-50 percent discount levels of the GFC and challenge the sustainability of increased target returns. In this period, a preferred equity solution offers an interesting alternative to a sale.
Many LPs are contemplating strengthening their cash positions to meet expected liquidity needs. Record recent primary commitments paired with a delay in expected exit timing for portfolios is likely to result in a net capital call environment over the next 18-36 months. While accessing the secondary market via a sale is still viable, a preferred equity alternative could combat lackluster pricing. The potential for upside sharing after a certain minimum return requirement is met for the new preferred equity investor should act as a preventative measure against much of the sellers’ remorse experienced by investors who sold during the GFC.
Notwithstanding the expectation of a prolonged net capital call environment, many LPs are not anticipating their own distress and remain bullish on the potential investment opportunities that could arise due to a covid-19 valuation environment. To create additional firepower, LPs can also consider a preferred equity raise at a lower cost than where they believe capital can be redeployed today. Whether it is co-investments, direct investments, or a re-allocation of proceeds to the public markets for example, if expected returns for near-term opportunities can comfortably exceed the cost of preferred equity, LPs should consider it.
A new inflection point
The covid-19 pandemic has already created some interesting investment opportunities for preferred equity investors. This provides flexibility for both GPs and LPs to accomplish strategic objectives. The sheer number of preferred equity opportunities has already resulted in a widening of underwriting thresholds, however, which in turn has attracted new entrants into a once opaque and less-traveled market.
Dedicated specialists will remain most active, but many traditional secondaries investors are looking at preferred equity as a means to deploy capital. Non-traditional lenders and private debt funds could also seek to become serious players. Much as the GFC marked an inflection point for secondaries, the covid-19 pandemic will likely mark PE’s accession into the mainstream of the secondaries market.
Nigel Dawn is head of Private Capital Advisory at Evercore
Dale Addeo is a managing director at Evercore