As the secondaries market moves into the latter half of 2022, deal volume is expected to slow amid valuation uncertainty and pricing expectation gaps that are only growing wider between buyers and sellers.
GP-led deals continue to hit the market, while LP portfolio sales have faded. What are the opportunities buyers are finding in the challenging environment, and when might activity pick up again at the levels seen in the early part of the year?
How is the environment of rising rates and inflation impacting the way you do deals? What has changed in this new environment?
As a secondary buyer, we do bottoms-up analysis, we don’t evaluate based on top-line, franchise recognition, brand name, anything like that. As it relates to higher interest rates, if underlying companies have floating rate debt, their debt is getting more expensive. Higher inflation could mean pressure on wages, it could mean pressure on input costs, and so it could mean lower earnings. So all of these things have to be factored in.
It also could mean that your exit multiples come down, so how does that impact the secondary market? It’s going to clearly impact pricing and so if, for example, we factor in lower exit multiples, our price is going to be overall lower. Do sellers agree with that lower price or not? So it really comes down to fundamentals.
Have seller expectations kept up with the changing market?
To some extent there’s still an expectation gap. If you look across private equity, valuations off of 6/30, maybe they’re down somewhere in the range of 4 to 8 percent, maybe 5 to 10 percent. The question for buyers and for sellers, is that enough? Does that reflect the volatility we’ve seen in the market? I would argue it does not and I’d argue there’s still more downward pressure on valuations. I think seller expectations have not kept up. Typically, the valuation picture becomes clearer over a series of quarters, not just one.
As a secondary buyer, if we believe there are write-downs coming, we have to price ahead of those write-downs, it’s going to be reflected in higher discounts. Sellers may not agree with those higher discounts for a period of time but as those funds are then written down, that optical discount decreases.
How have second quarter valuation marks cleared up pricing uncertainty especially in LP portfolio sales?
You think about an LP-led portfolio that has 100 assets, it’s a lot to get your arms around. For broad-based diversified portfolios, it’s a little harder to do and that’s why you see some of that LP-led transaction volume fall.
In a GP-led single asset continuation vehicle, you have one asset with a pretty good level of information and disclosure from the GP because the GP’s leading the deal, so they’re going to give you all open information that they have available. It’s a little bit easier to get a sense of where that company’s heading and if the value is accurate or not, or reflects everything you’re seeing in today’s environment.
When you think about GP-led transactions, these are extremely high-quality, all-star names. Those deals typically trade in the par to low single digit discount range. For an LP portfolio, those can be 10, 20, 30 percent discounts, so obviously there could be a lot of movement and pricing between what a seller expects for a diversified portfolio and what a buyer is willing to pay. That’s why on the LP side there’ll continue to be downward pressure on volumes.
Activity was strong in the first half, but seems to have slowed this summer. What is your outlook for the second half?
You’re correct, things have slowed down, really late spring throughout the summer so far. And you are also correct in that the first half volume executed looked pretty good. But you have to keep in mind that many of those deals executed in the first half began and were priced in 2021. So certainly as this market became a little bit more volatile, secondaries dropped in terms of volume. Why did they drop? It’s pretty simple: the bid-ask spread widened, with buyers asking for higher discounts and sellers, if pricing doesn’t meet their expectations, quickly say no unless they’re motivated sellers.
For the second half of 2022, I’d expect volume to drop even from the first half. If you were to look at total volume expectations for 2022, at the beginning of the year, people were probably expecting between $140 billion and $150 billion of volume. I think that number should be revised down somewhere between $110 billion and $120 billion.
Now, once the valuation picture becomes a little bit more clear in terms of write-downs and where GPs are carrying [asset] values, and what’s happening with interest rates and inflation, I’d expect secondary volume to pick up. But I’m thinking late in 2022, you’ll start to see volumes pick up again for diversified pools.
How are these challenges impacting deals – are you seeing pulled deals?
I haven’t seen a whole lot of deals get pulled, if any. What you’re clearly seeing is that people have postponed bringing their deals to market. People looked and said, ‘I’m going to wait until the macro environment stabilizes and then I’ll bring my portfolio to market and I’ll more than likely get a better price when things stabilize.’
It’s not dissimilar to what we saw in the first half of 2020, when covid took hold. A lot of people that had planned to come out in the first half of 2020 postponed and came out in late 2020, or sometime in 2021.
While deal volume is poised for a slowdown, fundraising continues to be strong. How will that impact the market going forward?
If you look at the amount of dry powder in the secondary market, it’s somewhere between $150 billion and $200 billion. Let’s say it’s $250 billion of buying power. If we see $125 billion of secondary deal volume this year, what that says is, there’s only enough dry powder to meet roughly two years or less of supply.
That statistic is very strong. If you look at the traditional private equity market, it’s probably four to five years of dry powder to meet supply. However, the secondary market has only enough to meet roughly two years or less, so what does that mean? It means there’s a significant amount of opportunity relative to dry powder pursuing secondaries.
Why has there not been more firm formation in secondaries, considering the need for more capital to meet all the supply?
While it’s grown significantly, secondaries is still a niche strategy and there’s a specific skill set involved. When you look at competitive constraints in the secondary markets, one is the skill set to complete secondary transactions. The other is, more importantly, the level of data and relationships you have with these GPs and funds
GPs ultimately have to approve you as a buyer and not everyone will get approved, so it’s hard to start de novo as a secondary buyer, it just is. You don’t have information, you’re competing against groups that have investments in thousands of funds and have lots of data that they can use to price assets and have relationships with the GPs and the fund managers. There’ll be a new entrant to the market here and there but if you look at the leadership in this sector, it really is the same … large players that existed 10 year ago.
Along with a dearth of capital, there’s a talent gap in secondaries, not enough people to meet all the demand. How is Strategic Partners navigating that?
We recruit from colleges and universities and then we train, develop, mentor, sponsor and really focus on creating and enabling the best in this industry.
If you look at Blackstone going back to 2015, as a firm, we recruited from nine different colleges and universities. Today that number is 44. We’ve increased the funnel significantly. By the way, that 44 includes eight HBCUs, Historically Black Colleges and Universities. I attended and graduated from an HBCU, Morehouse College. What we’re doing is widening the funnel, we’re looking everywhere for talent, not just a series of nine schools but 44 schools. We factor in diversity. Diversity is important, you want a more holistic solution when we’re trying to solve problems. We really train right out of undergrad so we’re producing talent and helping to meet a need.
What is the unique skill set necessary for secondaries?
It’s the ability to evaluate companies in a high-volume environment. Think about private equity, venture capital, credit, real estate – usually you’re looking at one asset at a time, you have a series of months to evaluate that asset, put in a bid and try and close. For secondaries, you may be evaluating hundreds or thousands of assets per week, and certainly per month. [What’s vital is the] ability to look at deals and large amounts of data and be able to process that data in a high-volume environment, being able to process information quickly and come up with an answer without complete information. We do our best to get lots of information, but if you’re evaluating thousands of companies for one deal, are you going to be able to go visit every company, meet with every CEO? No, so it is a very specific skill set that’s required to do this correctly.
Syndication risk on large deals has been cited as a concern. How challenging is it to syndicate out a large deal to investors?
It’s on a case-by-case basis, so if it’s an extremely high-quality asset that is resilient, even in an environment like today, there’s going to be a lot of demand. Even if it’s an equity check of let’s say $1 billion, there’ll be more than likely two, three or more secondary buyers that will participate in that transaction. If it’s a deal with questions around its ability to perform in a down economy, yeah that’s going to be more of a challenge to get that money raised, to get that deal closed.
What is the appetite like for multi-asset GP-led deals?
It depends on the buyer. Some buyers will look and say, ‘I just want to assemble the highest quality portfolio and I will do that one company at a time. I will diversify by investing in many single-asset deals but I don’t want a multi-asset deal per se.’
I don’t think buyers are against multi-asset deals, but if you can have your choice of investing in a single asset, very high-quality deal where you can say yes or no to that particular deal and just curate the highest quality portfolio that you can one deal at a time, I don’t think people are afraid of that. From what I’m seeing, people like single assets to the extent those are high-quality single asset deals.
A year ago, GPs were able to command premium terms on continuation funds. Is that still the case, or have term negotiations changed?
Not all deals will have premium carry but keep in mind it is tiered, so if they underperform they get lower than 20 percent carry, and if they outperform, they want to have the ability to make more than the traditional 20 percent carry. Most of these tiered carries start at 10 percent. If you’re in another performance range, you’ll get 20 percent, which is obviously standard carried. Some GPs will look and say ‘well, if I have the opportunity to get 10, if I really outperform can I get 30, or 25? That’s pretty normal but remember, I would say the vast majority of deals don’t have super carry, so they don’t have a deal where the carry exceeds 20 percent. Even in a tiered structure oftentimes they’ll max out at 20 percent.
It really depends on the type of asset, what the GP thinks they can do for the asset, what they’re willing to ask for and what precedent exists, frankly. Some GPs want to have the opportunity to get higher carried interest if they outperform. Some GPs are fine maxing out at 20 percent. It’s on a case-by-case basis, which is why I think this market is so interesting. One size does not fit all.
Lightly edited for clarity.