On the minds of the Next Gen

Last year, the Next Gen Leaders of Secondaries list, published by affiliate title Secondaries Investor, featured some of the most notable up-and-comers in the secondaries market. Here, four of these experts share their thoughts on the most interesting developments in that space, including the need for GP alignment, transacting amid inflation, supply-chain disruptions and conflict, and what’s to come.

Secondaries took an evolutionary leap forward during the covid era, with a raft of household names joining the asset class; how important is specialization in that context?

Lauren Din: $130 billion-worth of private market transactions closed in 2021, making it the busiest year on record. The growth in the market is attracting several new entrants and to stay competitive, it’s important for buyers to understand their strengths. It’s worth noting that among the largest buyers within secondaries, we haven’t seen a lot of changes. To underwrite large and complicated deals, it is important to have the depth of experience and team size required to lead on large-scale transactions.

Pamela Hanafi: Investing in a single asset is different from evaluating a diversified LP portfolio. GP-led transactions require specialization. It’s crucial to have a team with the skillsets to perform bottom-up underwriting and the sector expertise required to assess a concentrated portfolio. Few firms today have credibility in the market and the capability to lead and set valuation and terms. Specialists are better equipped to establish valuation and therefore are viewed as credible price-setters by sponsors and LPs.

Nadeem Kheraj: Despite its growth, the market is still in its early innings. Our industry is long opportunity, short capital and accordingly it’s not surprising to see new participants emerge to capture the opportunity. In the near term, supply is expected to still outweigh demand as both GPs and LPs continue to become increasingly sophisticated. Longer term as the industry matures, akin to traditional PE, secondary firms will need to differentiate themselves to attract capital, which in turn will lead to specialization.

Spencer Gyory: As new players continue to flow into the market, firms will encounter an increasingly competitive fundraising environment. This is compounded by the significant overlap in track records given the syndicated nature of many large transactions. Secondaries managers will need to communicate a differentiated strategy to efficiently raise capital and build their franchises.

How is the global macroeconomic environment creating new challenges?

LD: We’re now seeing unprecedented macroeconomic factors impacting people’s selling decisions – rising inflation and interest rates, the invasion of Ukraine and sanctions against Russia, withdrawal of liquidity of multiple central banks around the world, amongst others – that may cause some to hit pause, similar to the start of 2020 when the pandemic led to a lot of repricing of risk.

Although if there is a pause in selling, I believe it will be short-lived. Ultimately, these same factors will also change asset allocation, which has shown historically to lead to more selling in the secondary market as there’s a greater need for liquidity.

PH: A GP-led transaction’s value proposition is more attractive during a volatile macro environment. An important driver of dealflow in the GP-led market is the finite time and capital available in traditional PE fund structures. In periods of volatility, sponsors continue to be under pressure to generate liquidity for their existing investors and view the opportunity cost of selling their trophy assets as too high. The GP-led market enables sponsors to deliver liquidity to their existing investors and allows sponsors to continue compounding returns – and avoid selling the company to a competitor to reap the benefits of their hard work.

NK: Inflation, supply-chain disruptions and, with a heavy heart, geopolitical conflict, are creating a tremendous amount of uncertainty. Uncertainty can lead to wider spreads and a lower number of closed transactions. As investors, our job is to dance with the market and get creative to execute on opportunities. That being said, we believe in the fundamentals of diversification and quality. Leaning into high-quality, cycle-tested managers and assets in a diversified manner can substantially mitigate volatility.

SG: Within the single asset space, there is a high degree of focus on where Q1 2022 marks are finalized. The public market sell-off creates challenges for deals that were priced in Q4 2021/early 2022. Despite these headwinds, the current backdrop may lead to more sponsors exploring secondaries given the challenges of public market exits and longer anticipated hold periods. Finding ways to deliver liquidity to LPs is a major strategic priority for sponsors right now – solutions like tenders offers and strip sales can help achieve this objective.

Let’s talk pricing – are there still pockets of unexploited value to be had in the secondaries market? And are private market secondaries tied to the public markets?

LD: Public market volatility and drops in public portfolios can force LPs’ private capital holdings above allocation limits, known as the “denominator effect.” Some LPs will either change their allocation targets or sell their illiquid assets to the secondaries private market.

The decreased value in the public markets has widened pricing expectations between secondaries buyers and sellers. There could be good opportunities for buyers if LPs are motivated to sell as they have no other way to rebalance portfolios.

PH: We are only in the early innings of the growth in the GP-led market, particularly for single-asset deals. While the GP-led transaction explosion has meaningfully increased the supply of opportunities, the dedicated capital raised to go after GP-led transactions is limited despite the fundraising headlines. I expect the supply/demand imbalance will continue to persist, creating an attractive, competitive dynamic for secondaries buyers.

NK: The market has scaled such that selling LPs should feel comfortable that they will receive a fair price on opportunities brought to market. Secondaries performance is correlated with the public markets and as such pricing will move in the same direction as public indices. In terms of unexploited value, secondaries participants have emerged as the innovators within the private equity ecosystem. This creativity has led to new transaction types including continuation fund vehicles, strip sales, tenders, structured transactions, and the list goes on. With that in mind, there is meaningful untapped potential to create value from further innovation.

SG: The buyout/growth equity market continues to represent the vast preponderance of dealflow in the GP-led market. However, other parts of the alternative asset space that have been less active in secondaries historically (infrastructure, real estate, credit) or more out of favor (energy) remain an attractive opportunity set for secondaries investors, given there is less investor competition. Specialist groups or generalist firms that have the right type of capital and diligence capabilities to pursue these opportunities should be well-positioned to put capital to work in attractive ways.

Do you expect to see any new deal types, or a spike in volumes for existing types – tender offers, for example – in 2022?

LD: GP-leds accounted for half of the total transaction volume in 2021. I expect volume to continue increasing this year, with even more sponsor interest in continuation funds.

We also see the credit secondaries market growing as there are still relatively few liquidity options for private credit investors who wish to reshape their portfolios. The conditions in today’s private credit market look like those in the private equity market 20 years ago.

PH: Within the GP-led market, I expect to see significant growth in single-asset and multi-asset transactions coming from middle-market sponsors. Over the past few years, we saw larger buyout sponsors leading the way and dominating the GP-led dealflow. More recently we’ve seen new advisory groups set up or acquired by traditional middle-market investment banks, which will drive additional dealflow.

NK: LPs generally have done well on their private equity books and GPs are coming to market quicker, every two to two-and-a-half years versus roughly four years historically, without generating material DPI. LPs are now overexposed to PE and having to make tough calls on where to dedicate resources and capital.

Due to this dynamic, we expect LPs to sell more and GPs to utilize continuation fund vehicles to generate DPI and LP tenders to round out their fundraises. LPs may also make use of structured transactions which allow them to maintain upside and relationships while achieving partial liquidity to deploy elsewhere.

SG: We expect to see more tender offer and strip sale transactions in 2022 as a result of LP liquidity needs and the velocity of the fundraising market. These transactions create an elegant way for sponsors to deliver a liquidity option or material liquidity event to their LPs. Additionally, we anticipate secondary appetite will be higher for these types of deals in 2022 as investors look to increase diversification in their portfolios to counteract greater single asset deal volume.