PJT: Preparing for the next generation of secondaries

The secondaries market universe is growing. ‘To boldly go where no person has gone before,’ participants will be judged on market positioning and applicable returns, say PJT Park Hill managing director Darren Schluter and partner David Perdue.

This article is sponsored by PJT Park Hill

Darren Schluter
Darren Schluter, PJT Park Hill
David Perdue
David Perdue, PJT Park Hill

2020 represented an inflection point in the growth trajectory of the secondaries market. Despite deal volume decreasing 29 percent year-on-year (impacted by the pandemic), the $60 billion of total volume represented the third-largest year since the market’s inception.

There is a shared view among industry insiders that 2020 activity accelerated the evolution of the market by five years in just six months. These six months cemented the fact that the secondaries market represents a critical portfolio management tool for both LP and GP investors. The resilience of the market was proven out.

By design, the market can be flexibly adjusted to achieve a myriad of objectives. Moreover, an influx of new participants is hoping to capitalize on positive market dynamics. These entrants have directly impacted go-forward market volume estimates, increasing them from $100 billion or more over the next two to three years to even larger volumes going forward.

As the market transitions into its next growth phase, the question remains: how do market participants differentiate themselves in a growing market? Longstanding market participants have often touted their transaction and structuring expertise, while new market entrants have focused their efforts on the latest transaction trends which in all likelihood are in the early stages of growth themselves. Each participant will ultimately decide what path to take, and as history has shown, there are multiple paths to success.

Leveraging our decade-plus secondaries advisory experience across multiple cycles, PJT Park Hill identifies several key fundamentals that should be taken under advisement as the market navigates to the next generation. These recommendations are not new, but it is our position that the current market trajectory necessitates their prioritization.

Expand professional skillsets

Market participants should establish ongoing internal education programs to provide differentiated insight on the business side of alternative assets and to refine their direct asset underwriting skillset. A thorough understanding of the long-term strategic objectives of both LP and GPs will be vital to understanding their specific transaction objectives. Augmenting that expertise with deeper insight on the specific accounting, tax and legal considerations will aid in positioning your firm as a preferred counterparty.

To cement this initiative, all market participants (buyers, advisors, consultants, legal counsel, etc) should engage in consistent dialogue with other market professionals focused on sharing best practices. Given our market’s growth, we should continue our proactive education efforts to attract professionals from other markets to address our human capital need.

“2020 activity accelerated the evolution of the market by five years in just six months”

Single-asset GP-led transactions are now an established component of the secondaries market. In 2020, single-asset transactions represented a record $12 billion across 25 mandates. 2021 year-to-date, PJT Park Hill is tracking over 50 single-asset transactions with a combined net asset value of over $34 billion.

Given the expected continued growth in the asset class, firms are augmenting ranks with professionals with direct investment and underwriting experience. One of the key underwriting themes in 2020 was understanding covid-19’s impact on the operating performance of the underlying company and determining realistic go-forward run rate assumptions that were defensible in buyers’ investment committees. Understanding the recovery cycles of business performance post-pandemic is just one of the key tenets that will be necessary for participants to adequately underwrite deal opportunities going forward.

Embrace data and technology

Taking a page from the direct market’s investment focus on software-as-a-service companies delivering mission critical data analysis, secondaries market participants should prioritize the implementation of data analytics tools to inform transaction-execution-focused strategic initiatives and technology adoption. Firms should establish data analytics working groups with standardized procedures to review data on a regular basis.

One example of this type of initiative is the implementation of bespoke market intelligence-focused CRM databases aggregating all pertinent market data obtained from market conversations globally to create differentiated content for the benefit of ongoing transactions. Another is fund and portfolio company tracking. Firms should establish a core list of private equity managers and their most recent fund vintages focusing on their ongoing pricing, tracking fund and underlying portfolio company performance including key operating performance metrics for both on a quarterly basis to inform sourcing and real-time investment decisions. A third example is transaction closing technology, which can streamline deal management administrative tasks for GP-leds (ie, co-ordination of election period management) as well as transaction closings for LP portfolios sales (ie, fund transfer processes). A few technologies currently exist, but we expect meaningful improvements in this arena in the short term.

Focus on the LP market

While there are diverse views on the future growth of LP portfolio sales and their estimated makeup of total market volume, the LP market will continue to be a cornerstone of the industry. A recent McKinsey study found institutional investors continued to increase their allocation to alternatives over the past five years, and despite annual global private equity fundraising decreasing over 20 percent year-on-year from 2019-20, global secondaries market fundraising more than doubled to $87 billion during that same period.

LPs are continuing to increase their exposure to alternatives and demonstrating greater willingness to access the secondaries market as a complementary investment strategy and active portfolio management tool.

Despite the decrease in LP market activity to $27 billion in 2020 from $55 billion in 2019, the existing go-forward deal pipeline far exceeds 2020 levels with a path back to 2019 levels. Key themes driving market supply are large institutions selling down tail-end funds of fund portfolios and $1 billion-plus portfolios focused on diversified asset classes including infrastructure/real assets, credit, and real estate managers. Deal volume for the rest of the year is also expected to incorporate $1 billion-plus high growth portfolio sales consistent with 2018-19 market activity. It is clear that LP portfolio sales will continue to grow in volume and regular interactions with LPs will be vital to forecast their portfolio management activity and provide insight on the GPs within their fund portfolios.

In the fast-growing GP-led market, LPs are increasingly being tasked with taking a more active role in transaction execution. They are not only being asked to opine on transaction feasibility as a member of the LPAC but also to make new investment or roll decisions as part of election processes. The response required for these elections is becoming more demanding as LPs, historically a passive allocator of capital, are being asked not only to address time sensitive transactions with internal constituents, but also to develop internal policies on how to address these investment decisions moving forward. There is an ongoing opportunity to work with LPs to help inform their decisions in these processes.

Leverage insights from other markets

The secondaries market provides creativity to generate case specific solutions and flexibility in transaction structures. That flexibility has been focused on gaining access to mature, performing assets, mitigating the “J-curve” effect inherent in direct investing. Over the past 10 years, the secondaries market has leveraged transaction structures and frameworks from the broader financial services market to execute differentiated transactions.

Going forward, it will be vital for secondaries-focused firms to continue to monitor the greater industry for execution insight. To date, some of the more innovative structures include single-asset transactions, representations and warranty insurance, and collateralized fund obligations.

In single-asset transactions, financial sponsors sell an existing portfolio company into a new fund continuation vehicle capitalized by new and existing investors managed by the same sponsor. Given the single-asset nature, a meaningful amount of the structuring and execution expertise is leveraged from the M&A market. A debate is forming around whether SPACs would provide an optimal exit avenue for these transactions, and it is believed there will likely be a transaction in the medium term.

Representations and warranty insurance is a protection primarily utilized in traditional M&A transactions allowing buyers the opportunity to address any potential breaches of a representation or warranty in a purchase and sale agreement. This product has recently been customized for the GP-led market and more than half of the secondaries market’s largest investors have reportedly utilized the product in transactions closed during the last 12 months.

Collateralized fund obligations are a form of securitization derived from collateralized debt obligations, secured by an underlying portfolio of alternative asset interests. The structure allows for the original holders of the underlying portfolio to generate liquidity to address a myriad of portfolio management objectives

2021 market volume is currently tracking to be another record setting year, in all likelihood surpassing 2019 volume of $80 billion. By the time this article is printed there will likely be an announcement of at least two to three new market entrants. While the market is growing it’s important to note that not all of the recommendations covered here will be applicable to every participant. However, what we’re quite certain about is the need to be able to identify your defensible market position at warp speed.

Expand strategic and geographic expertise

Continued growth in strategy-specific fundraising within the greater primary market represents a valuable opportunity for secondaries market participants. 

Historic growth rates in the primary market point to continued momentum as both LPs and GPs look to actively manage their platforms. Given the favorable timing of the current growth trajectory, market participants should initiate coverage of certain subsectors now to formulate an investment strategy incorporating the benefits and considerations of each opportunity.

One area to watch is Asia. Current market activity is concentrated in GP-led transactions, single-assets in particular. PJT Park Hill is currently tracking at least 12 transactions with an average transaction size close to $1 billion. In terms of possible considerations, investors should take note that there are certain friction costs driven by a function of macro policies for specific countries within the greater Asia region. Liquidity and ability for foreign capital to create a truly liquid secondaries market for assets will continue to be governed on a case-by-case basis.

Another is the venture/growth space. Fundraising in VC/growth has benefited from growing alternatives demand. Last year, the secondaries market closed on over $11 billion of deal volume in the segment. Year-to-date, there is an estimated $14 billion of pertinent deal volume split between live and recently closed transactions. Investors should leverage existing relationships in the sector to triangulate opportunities, identify actionable growth models and ensure proper alignment through structure to maximize transactions in light of increasing valuation multiples.

Finally, credit. Current and forward transaction pipeline on both LP and GP credit transactions coupled with new buyside market entrants will continue to drive growth within this asset class in the near term. Developing an internal investment framework to appropriately underwrite the various credit opportunities and structuring pools of investor capital with an appropriate cost of capital will be vital.