This article is sponsored by Jefferies
Some commentators have been predicting a downturn for years, but thus far it has failed to materialize. Why does it feel different this time around?
I spoke with a CEO earlier this year who has been in our industry for over 30 years and has seen his share of cycles. He referenced what psychologists refer to as the “genius effect,” where those who outperform by historical standards have a tendency to exaggerate their own abilities and focus less on other factors that contributed to the end result. To state the obvious, when interest rates are low, more investors are incentivized to take risk; not just private equity investors – but pension funds, endowments and foundations and so on – need to generate a certain level of return for their constituents. And as increasing amounts of capital go risk on, asset prices rise and ultimately, as he noted, “everyone feels pretty darn smart.”
Zooming out, inflation has been practically non-existent over the past 20 years. In the face of some very real conflicts, ranging from the dotcom bubble to the global financial crisis to the response to covid-19, central banks have moved interest rates in one direction. At this very moment that trend is obviously reversing, and there are natural questions as to how to best navigate in a new environment. In a market that is no longer on “easy mode,” I have never been more confident in the value we’re able to deliver to our clients. While the best investors will continue to thrive, the stakes are undeniably higher and the need to be fully prepared has never been greater.
How are you seeing the secondaries market Navigating GP-led deals in uncertain markets respond to all this uncertainty in the short-term?
We continue to see substantial demand for high-quality opportunities – both with respect to GP-led transactions and LP portfolios. For GP-led transactions, particularly single asset or more concentrated multi-asset continuation fund transactions involving control stakes, I would say the level of due diligence has increased across the board. Projection cases are more heavily scrutinized and focus on sponsor/management team alignment is a critical factor, as it always has been. We are seeing buyers ask to spend more time with portfolio company management and increase in use of outside consultants to help with deep dives at the asset level in ways we didn’t see several years ago.
At Jefferies, we are fortunate to work in close partnership with our industry and sponsor coverage bankers. I can’t emphasize this enough: when marketing a continuation fund or other sponsor-led transactions in this environment, it’s vital to have an expert view on the business and its positioning and be able to communicate that seamlessly to our buyers who are generally not sector specialists.
If we do end up facing a full-blown downturn, how do you think some of the large, concentrated recently completed deals are likely to fare?
No business is immune to such a downturn, but I would fully expect many of the concentrated sponsor led deals of this past vintage to outperform. The secondaries market is increasingly the preferred route for a sponsors’ “trophy assets,” so we are already starting with a selection of the highest quality companies – leaders in their respective fields, with the strongest management teams, backed by the most successful sponsors with all the potential for growth that that combination brings.
In theory, in our transactions, a lot of the uncertainty around the future trajectory of the business has been removed, because the sponsor has an inside view of the business, healthy dynamic with management and a successful playbook that they just need to continue to execute on. Another point to note is the increased GP/LP alignment that comes with a continuation vehicle transaction, enhancing the sponsor’s incentivization to do well.
And by virtue of the fact that in nearly every case the objective of the transaction is to provide additional time and flexibility, and often additional growth equity, these businesses are equipped with the best possible chance for success regardless of what the economy has to throw at us.
All this said, many secondaries funds of the past vintage are more concentrated than the highly diversified “indexes” of prior cycles, and by a very wide margin. It’s fair to expect a much broader variance in returns and true winners and losers will emerge in a more volatile backdrop.
What changes are you seeing in the makeup of that buyer community?
It is incredibly exciting to see the continued expansion of the secondaries market, and we’re currently seeing a few themes converge at once. The first is a large increase in M&A for secondaries sponsors that have built very successful and valuable franchises over the past couple of decades. The secondaries market is effectively a generation behind the succession planning that we saw in the primary PE market over the past 15 years, and we are seeing leading firms go public or find new platform partners to assist with that transition.
At the same time, global asset managers and many of the largest traditional PE sponsors have realized that secondaries are an incredibly complementary business to their existing platforms, and with the right team in place, can represent true white space in terms of fundraising and AUM potential. It’s no longer a stretch – and in fact it’s very likely – that in just a few years we expect every large PE platform to have real secondaries investment capabilities. The only near-term limiting factor to this market’s growth, frankly, is on the people side of the business – there just isn’t enough talent to go around.
At the other end of the spectrum, we are seeing increased interest from the traditional LP community in backing, and in some cases, leading complex sponsor-led transactions. There are fewer investment committee debates over the nomenclature as to whether single asset continuation fund deals are “secondary” or a “co-investment” as our market is now viewed as a true sustainable avenue to some of the very best private investment opportunities available today.
How do you think a downturn would impact secondaries volume overall?
I think we would expect to see a similar response to what we saw both in 2020 and 2008, which was an initial slowdown in volume as both buyers and sellers hit pause, assessed and took stock of the situation. On the LP side of the market, very few LPs were distressed in 2020, and if there was an urgent need for liquidity, they were able to tap other parts of their portfolios. This afforded them the liberty to wait for NAVs to rebound and market conditions to recover – and when they did, volume quickly resumed to the historical levels we see today. And while there may be fewer outright sales of LP portfolios at distressed prices, we expect financing structures and the like to fill much of that void.
GPs, meanwhile, have proved themselves to be very creative when it comes to embracing what our market can deliver and we’ll see opportunities to help funds and portfolio companies navigate a tougher economic environment. That would mean the return of solutions such as preferred equity and other structures to help provide both defensive and offensive capital to support portfolio companies through a downturn.
This is particularly important at a time where traditional exit routes may be closed or become less appealing. If you are a sponsor with an incredible business and capital markets conditions aren’t favorable for pursuing an IPO, or strategic buyers in your market are less interested or not able to execute, sponsors know the secondaries market is capable of providing creative liquidity and growth capital regardless of the macro backdrop.
Do you also believe that secondaries market fundraising would continue to flourish in a more challenging economic environment?
Absolutely. There has always been a counter-cyclical component to our market, and historically LP appetite for secondaries has increased during market downturns. The definition of “what is a secondary” has also evolved and expanded, and as an LP today you have a menu of different strategies to choose from. At present nearly every platform is growing, and we are seeing the largest funds getting even larger. There are multiple groups raising $10 billion and even $20 billion vehicles. So, the most successful firms are continuing to amass more capital consistent with the growing market opportunity.
How are you seeing GPs approach the secondaries market in preparation for a downturn?
GPs are looking for true strategic advice regarding their very best portfolio companies. Very rarely do we sit down with a sponsor just to talk about a continuation vehicle. Jefferies is pretty unique, in that we are the largest fully integrated private capital advisory group on Wall Street, and I think that bodes well when you look at how sponsors are viewing their options irrespective of market conditions. It is rarely a case of one size fits all. I absolutely expect to see an increase in continuation vehicle deals as traditional exit routes potentially shut down, but GPs are recognizing the importance of seeking holistic advice.
How do you expect the continuation fund market to evolve, irrespective of economic cycles?
We still believe that we are in the very early innings of the continuation fund market. The majority of sponsors today still have never completed a continuation fund transaction – but everyone is in the process of thinking through it and preparing for how these deals could be structured to the benefit of their investors and portfolio companies.
At the same time, our market is also being supported by emerging best practices and regulatory frameworks, such as those driven by ILPA, and the willingness of buyers to keep refining their approach to meet the needs of our clients. One of the most fascinating aspects of this market is its creativity and resiliency, and so I absolutely believe that this is a market that will continue to grow over the long term regardless of economic cycle.