In the depths of summer, amid a heatwave and ongoing pandemic, private equity mega-shop TPG made a key hire that caught the attention of the market.

The firm tapped Michael Woolhouse, former head of secondaries at Canada Pension Plan Investment Board, to build out a secondaries strategy at the firm.

“As the alternative asset class continues to grow and evolve, and fund lives stretch longer, the ability to create liquidity alternatives has become increasingly important,” Jon Winkelried, TPG co-CEO, said at the time of the appointment.

TPG’s move came shortly after Brookfield Asset Management announced it was launching a real estate secondaries business. Asset management giant BlackRock brought on two Goldman Sachs executives in 2018 to build out a secondaries team. CVC Capital Partners explored building a secondaries group inside the firm. And Stone Point hired former Park Hill Group secondaries advisory chief Jonathan Costello to build a secondaries strategy at the firm.

The move by large multi-strategy managers to build out secondaries capabilities represented a major vote of confidence in the strategy. Secondaries evolved from the early days when an LP was wary of selling a stake in a fund because it could risk the ire of the GP, who didn’t want the stigma of an investor cashing out early.

These days, any idea of there being a stigma attached to secondaries sales is a relic of an older era. The ability to cash out of LP interests in private funds has become a routine part of LPs’ and GPs’ portfolio management. Private equity, long differentiated as an illiquid strategy with an at least 10-year lock-up, is tinkering with its rigid structures to provide more options for limited partners, who increasingly expect liquidity flexibility. It’s this evolving role that is allowing secondaries to grow to record levels. And this year, secondaries will face an intense test as the market gradually recovers from the pandemic downturn.

Buyouts spoke with a dozen participants in the secondaries market, including buyers, sellers and advisors, about the unique position the strategy is in as part of the market recovery. Most market players believe secondaries activity, which essentially stopped in the downturn, save a handful of select and smaller deals, is poised to blow out of the gates this fall.

Driving activity generally will be GP-led deals like fund restructurings, followed later in the year by traditional LP portfolio sales. While volume likely won’t hit the record levels of the past three years, market participants expect to be busy for the rest of 2020.

Mike Bego, Kline Hill Partners

“The fourth quarter is going to be a record quarter that’s going to blow away all previous quarters,” predicts Mike Bego, founder and CEO of secondaries shop Kline Hill Partners.

Near the end of the second quarter, “we started to see a resurgence of GP-led transactions, not the point of approaching pre-covid levels, but an even more meaningful pick-up from what we had seen in March and April,” says Jeff Keay, managing director on the global secondaries team at HarbourVest Partners. “That is continuing today.”

Prepping for a flood

The market is now ready for a flood of activity after Labor Day, numerous sources tell Buyouts. Every buyer has a list of deals that are being prepared and will attempt to go live in September, with much of the early activity focused on GPs finding ways to hold certain assets longer as anticipated exits are pushed off in the market recovery.

Jeffrey Keay, HarbourVest Partners

Interestingly, some buyers started to see deals trickle into the market in June, and by July potential volume was starting to crowd the market, according to Jeff Akers, head of secondaries at Adams Street Partners.

Jeff Akers, Adams Street Partners

“We actually saw more deals in July than we saw in July last year,” Akers says. “We’re looking at a number of attractive LP and GP situations right now.”

A few factors are pushing deals into the market and will drive volume in the fall. First, there is an enormous amount of unspent capital sitting in secondaries funds right now. Estimates of uncalled capital hover around $183 billion, according to advisor Greenhill Cogent in its 2020 first-half secondaries volume report issued in July.

“There’s no shortage of demand on the buyside,” says Nigel Dawn, who leads private markets advisory at Evercore. “The covid period generally led to very good fundraising for secondary funds.”

As well, buyers and sellers are waiting for GPs to issue second-quarter fund performance marks, which are expected to publish this month and in September. Once Q2 marks are out, the market will have a clear sense of how to price assets.

The general feeling is that second-quarter marks will be better than the market anticipated back in the dark days of March and April. That sentiment is being driven in part by the recovery of public markets, which private equity tracks through performance measurements of public market equivalents.

Performance also will depend on exposure to specific industries, so those with heavy investments in hospitality, travel, retail and/or energy will likely fare worse than those invested in places like tech growth or certain areas of healthcare.

“As soon as buyers feel more confident that GP NAVs will be net-neutral on average quarter over quarter, and when they’re less worried about a discount translating to a premium the next quarter because of a significant writedown, we will see a sharp increase in deal activity,” says Philip Tsai, global head of secondary market advisory at UBS.

“It will be difficult to make up over a quarter’s worth of slowdown in deal volume between September and December this year. There could be a frenzy, but there is a limitation on secondary buyer resources,” Tsai says. “Deal flow has picked up and will continue to increase but some of it won’t close until 2021.”

It’s important to note that, with all the capital raised for secondaries, the inventory still outweighs the market’s ability to meet the demand. That’s a good sign for the market, but one that will continue to limit its growth until that demand is met.

Longer holds

Another factor driving demand is the prospect of GPs having to delay exits because of the market crisis. Companies that may have been preparing for sales before the pandemic lowered marks may have to wait until next year, or longer, before valuations recover enough to justify a sale, sources say.

A Dealogic survey that charted data through April showed that exit activity had fallen off by 72 percent from January to April, with IPOs all but disappearing. Around 83 percent of GPs surveyed by Investec in May said they didn’t expect to exit any of their portfolio companies over the next 12 months, according to a Bain & Co. report published in May.

The outlook has brightened considerably since May, but still, the sense in the market is that exit activity is only slowly returning.

This will put pressure on GPs who need to sell companies out of funds that are running up against term limits, or to satisfy LPs anticipating distributions. GP-led restructurings and other types of liquidity solutions appear to be the right strategies to solve this problem.

“We believe this pandemic will result in more GP-led dealflow in the long-term, as delays in portfolio company exits and recent valuation declines witnessed across many sectors should facilitate the need for more fund- and asset-level secondary solutions going forward, either for liquidity reasons or for duration reasons,” says Andy Nick, managing director in Greenhill’s Capital Advisory group.

“For GPs contemplating secondary transactions at the onset of the pandemic, it became difficult to run a process in such an uncertain underwriting environment. Thus, it made sense to hit the pause button until market conditions stabilized,” Nick says. “However, we have recently been seeing these types of transactions come back to market relatively quickly, but perhaps with different funds or portfolio companies than the GPs might have been considering prior to the pandemic.”

GP-led deals are easier from a valuation perspective than traditional LP portfolios, which is why GP-led transactions are the first to hit the market. Such deals only focus on a few assets, sometimes even just one asset, sources said. Contrast that with LP stakes deals, which could include interests in numerous funds holding hundreds of underlying portfolio companies. That’s going to take longer to price.

Single-asset deals, where GPs move one company out of an older fund into a continuation vehicle, have been on the rise for the past couple years. These types of concentrated-asset secondaries are likely to receive even more interest because of the pandemic downturn, sources say.

“If you’re looking to make a bet, it’s easier to make it on a more concentrated portfolio,” says Harold Hope, head of secondaries at Goldman Sachs.

A few GP-led deals closed during the downturn, including one that had been in and out of the market for a few years. Southern Cross, a firm heavily impacted by the currency crisis in Latin America in 2015, managed to restructure its 2010 fourth fund. Intermediate Capital Group led the deal, which included nearly $500 million of remaining net asset value across nine investments, Buyouts previously reported.

One of the biggest deals of the downturn involved Ottawa Avenue Private Capital, which is affiliated with the DeVos family office and is selling a large portfolio of private equity assets that had the potential to total up to $2 billion. HarbourVest Partners led the deal, the final total of which is not clear. That deal was complex and included a layer of preferred equity, as well as a straight LP stakes sale, sources previously told Buyouts.

LP books

Canada Pension Plan Investment Board bookended the downturn with two large portfolio sales, one of the few instances of LP portfolios transacting in the down market.

The pension system completed the sale of a $1 billion-plus portfolio at the beginning of the crisis, with Ardian and Lexington Partners as the buyers. That deal had been agreed pre-covid and was moving toward final close when the pandemic struck.

The system then hit the market with another large portfolio, this one potentially up to $2 billion, around August. The move was interesting as it came out before second-quarter marks were fully released, so pricing the deal could be challenging.

However, sources say the portfolio was made up of high-quality GPs, making valuing the stakes a bit easier. Buyers feel more comfortable paying up for high-performing funds that are likely to emerge from a downturn in strong position.

Pushing out a portfolio earlier than the market might anticipate had the advantage of preempting other processes, getting in front of buyers before the crush of deal activity expected after Labor Day, sources say.

While LP books are not expected back in bulk until the latter part of the year, in the smallest side of the market sellers have been busy, Kline Hill’s Bego says. Kline Hill closed its third fund on $450 million with a $150 overage fund for excess deal flow. Bego says the firm has done more than 20 deals since the markets crashed in March.

“We were fortunate to be in touch with some sellers who were not price sensitive,” Bego says. “Our dealflow was about the same as it always had been.”

The smaller end of the market has an enormous level of supply and not as much competition as for larger deals, according to Joseph Marks, head of secondaries at Capital Dynamics.

Joseph Marks, Capital Dynamics

“Very little of all [the money raised for secondaries] goes into the small end of the secondary market,” Marks says. This dynamic also often leads to buyers joining investor clubs to get deals done, he says.

Capital Dynamics had a strong second quarter for closed deals, which it had been negotiating pre-covid, Marks says. “Most of the transactions we had been already negotiating were outside the auction channel,” he says. “So while in general buyers and sellers alike slammed on the brakes, that doesn’t mean we didn’t continue to watch those portfolios, maintain dialogue with those counter-parties and continued to negotiate terms.”

One thing the market has not yet seen is an influx of truly distressed sellers, those who have to exit private equity to shore up balance sheets or pay down debt. Distress may come more into focus as the market moves through the recovery, sources say, but it has not yet been a major factor driving activity.

For now, the outlook is bright with the expectation of even more blue-chip GPs plotting out ways of dealing with strong companies in older funds. At a moment when the supply of deals is exceeding the market’s capacity to handle it, those firms with dry powder to spend are in a strong position and will have a busy autumn.