Secondaries activity in the pandemic era was dominated by GP-led deals. But the LP portfolio market came back with a vengeance at the tail end of 2021 as investors recalibrated their private equity exposures and fought to keep pace with a frenetic primary fundraising environment.

“Primary teams are struggling to keep up with the volume of re-ups, and given their desire to secure co-investment, it is important that they remain meaningful investors in new vintages,” says Shane Feeney, managing director and global head of secondaries at Northleaf Capital. “We will continue to see large LP-led sales as long as GPs keep coming quickly back to market with larger funds.”

Andrew Gulotta, partner at Sixpoint Partners, agrees. “Institutions are looking to rebalance after a material run-up in unrealized NAV, hoping to accelerate liquidity in the face of record re-up requests from their GPs,” he says.

“We will continue to see large LP-led sales as long as GPs keep coming quickly back to market with
larger funds”
Shane Feeney
Northleaf Capital

Indeed, the start of the year saw several mega secondaries sales, including a $6 billion portfolio of private equity fund stakes owned by the California Public Employees’ Retirement System and a €2 billion portfolio of private equity interests owned by Dutch pension administrator APG. But many sellers have since been forced to press pause as buyers reprice risk.

“Challenges with supply chains, inflation and commodity prices, along with the situation in Ukraine and a tight labor market – all of that means that while dealflow remains strong, advisers and buyers are being significantly more selective,” says Gulotta.

“The question is whether all these deals that have been brought to market will clear on terms that are acceptable to the seller, due to volatility in the market in the face of war in Ukraine and broader macroeconomic uncertainty, with inflation and rises in interest rates,” adds Ben Perl, managing director, at Neuberger Berman.

Kevin Dunwoodie, a partner in Pantheon’s secondaries team, says that geopolitical and macroeconomic uncertainty have actually intensified the motivation to lock in some of the strong returns that have been generated in recent years. But he concedes that many will be unwilling to accept the discounts on offer off Q4 valuations. “The volatility we have seen in the software and tech sectors, in particular, means if sellers were expecting to price at par, that is probably wishful thinking and that widening bid/ask spread may limit volume in the short term.”

Private equity pricing is, of course, closely correlated to public markets, albeit with a lag. “Public markets inform secondaries buyers’ views of sectors and risk at a high level,” explains Gulotta. “Transaction comps are also correlated with public comps. Whether a buyer is evaluating a single asset or a broadly diversified portfolio, any material sell-off in public markets will influence how they value private assets.”

“It is still possible to secure discounts on LP portfolios, particularly where the GP is restrictive on who can buy into the fund”
Kevin Dunwoodie

Indeed, Gulotta says that there has been a price correction of between 10 and 20 percent for diversified LP portfolios. “A portfolio that would have priced at 90 cents off Q3 2021 valuations at the end of last year, is probably pricing in the mid-70s today,” he says. “There has been a bit of a slow down while sellers wait for audited Q4 financials and Q1 2022 numbers. Activity should ramp back up halfway through Q2 and continue into the second half of the year.”

Gerald Cooper, partner at Campbell Lutyens, agrees. “At the moment, both buyers and sellers are waiting for Q1 marks to come out, which will potentially re-set valuations due to the decline in public markets and volatility, particularly in tech stocks,” he says. “Sellers are likely to get better optical pricing in terms of discount to NAV by waiting and, of course, buyers are eager to minimize execution risk. No-one wants to be caught catching a falling knife.”

Special forces

The secondaries industry has experienced meteoric growth, which has inevitably led to greater level of specialization

“There was a record $135 billion of secondaries transacted last year. Most estimates see that doubling or tripling within the next three to five years,” says PJT’s Darren Schluter. “With demand for the asset class so strong, secondaries firms are being forced to differentiate themselves.”

We are already seeing firms choose to specialize in GP-leds, for example, particularly new entrants with a direct investment background. “The big asset managers that have either acquired secondaries platforms or hired individuals to raise capital around are touting their industry expertise, and ability to deep underwrite on GP-led transactions,” says Campbell Lutyens’ Gerald Cooper.

We are also starting to see segmentation by sector and are certainly seeing segmentation by size. “Larger funds are focusing on billion-dollar-plus portfolios, whilst smaller funds pick off individual fund names, or even individual companies,” says Pantheon’s Kevin Dunwoodie. “We are also seeing strategies focus specifically on tail-end funds, and others on the value creation phase and even early secondaries.”

Specialization by asset class is another prominent theme, with interest growing around private credit, in particular. Historically, secondaries buyers have tried to apply equity-like hurdle rates to opportunities that have credit-like returns which has resulted in a wide discount. But we are now seeing more appropriate cost of capital participating in the market, which means attractive solutions for those that want to monetize their credit portfolios.

“We are also seeing new entrants coming in to raise pools of capital focused on infrastructure secondaries. There is no doubt that a lot of capital has gone into the late-stage venture and growth equity space, as well, which should naturally lead to a need to provide liquidity to investors in those areas,” says Cooper. Those markets have also performed extremely well, leaving some LPs overallocated. “They have become victims of their own success,” Cooper explains. “Not a lot of secondaries buyers understand how to underwrite those types of deals and we don’t yet see a huge pipeline of capital coming into to focus specifically on that opportunity. But I have no doubt that it will happen.”

Finding value

But despite a pervasive price sensitivity in the seller community, it is still possible to identify pockets of value. Cooper points to opportunities to transact with individuals and family offices, which may be facing liquidity pressures, although he adds that most institutional sellers are, in fact, flush with cash and are more focused on portfolio management than distressed sales.

Gulotta agrees that transacting with high-net-worth investors and first-time sellers can result in material discounts to fair market value, as these portfolios are often too small for intermediaries to take on. He adds that there is also value to be found among esoteric asset classes such as music royalties, aircraft and litigation finance and timber.

There are other ways to ensure you are playing in a limited buying pool, too. “It is still possible to secure discounts on LP portfolios, particularly where the GP is restrictive on who can buy into the fund,” says Dunwoodie, who extols the virtues of having an active primary investment program. “If you have strong relationships with the GP, they may even steer selling LPs your way, enabling you to secure a proprietary deal. Some GPs are also more conservative in their holding valuations, allowing you to pay closer to value and still generate outsized returns.”

“Whether a buyer is evaluating a single asset or a broadly diversified portfolio, any material sell-off in public markets will influence how they value private assets”
Andrew Gulotta
Sixpoint Partners

Where GP-led sales are concerned, the emphasis is always on ensuring the sponsor obtains fair value for existing investors as they straddle the line between buying and selling. But while you may not be receiving a discount at entry, the quality of companies involved can provide significant upside potential, according to Dunwoodie. “These are the top performing assets in the market which we may not previously have had access to as secondaries buyers, and certainly not in a concentrated manner.”

Gulotta agrees. “Another way to frame the unexploited value conversation is that the secondary market, broadly speaking, has made a fundamental shift toward higher quality assets with more upside potential,” he says. “In such a market, the future growth is driving the return, not the upfront discount.”

Nowhere is an adherence to this philosophy more apparent than in the spate of single asset GP-leds that took place during the early part of the pandemic. “Getting visibility on the performance of those single asset GP-led deals will be critical,” says Darren Schluter, managing director in the secondaries division at PJT Partners. “Our belief is that because of the market’s focus on quality, coupled with comfort around the forward projections of these companies despite the pandemic, these transactions are positioned to perform well.”

“I think the single asset deals completed during covid will prove successful, given that they primarily involved tech and healthcare companies,” agrees Cooper. “These are sectors that were resilient through the pandemic, and even if there is a reset in valuations, the quality of the underlying businesses means operational performance will continue to be strong.”

Gulotta, however, cautions that the risk premium associated with these deals was elevated, so return expectations will also be higher. “Many of those continuation vehicle transactions completed in 2020 and 2021 look good today and are in the money, but the full story remains to be written because most of those ultimate exits are projected for 2024 and 2025.”

It was also possible to secure strong performance with the very small number of LP portfolios that transacted in the initial covid slump. The majority of vendors, meanwhile, having learned lessons from the financial crisis, proved willing to hold fire. “We have seen very strong early returns from deals completed amidst the uncertainty of covid,” says Dunwoodie. “There was an opportunity to take advantage of steep declines in valuations, particularly in Q1 2020 at the height of lockdowns. Although the volume of LP deals was limited and we did see some LPs pull back from sales processes as valuations came down, those deals that did come to market have outperformed significantly.”

A question of structure

The secondaries industry is renowned for its spirit of innovation, continually coming up with new structures and investment types designed to meet the needs of all market participants

In 2022, we are likely to see increased structure around LP portfolio sales, with the seller accepting a larger discount upfront, for example, whilst continuing to receive some share of future upside. “We are also seeing strip sales, and preferred equity deals, where the buyer agrees to receive a contractual preferred return as a way to limit the discount,” says Pantheon’s Kevin Dunwoodie.

Campbell Lutyens’ Gerald Cooper agrees. “Preferred equity became an important tool for creating liquidity through the pandemic. If the macroeconomic environment worsens, we could see a resurgence in those structured deals in order to bridge the bid/ask spread, which widens in times of uncertainty or recession,” he says. “Putting in downside protection would help get deals over the line.”

Sixpoint’s Andrew Gulotta, meanwhile, points to an uptick in strip sales, as well as annex vehicles to support a transformational acquisition for a specific portfolio company. He also believes we will see an increase in stapled secondaries. “The fundraising market is highly competitive, and we expect that managers will use tenders offers to attract primary capital to their new funds,” he says.

Finally, growing appetite from retail investors could help pave the way for further innovation. A number of firms are looking to raise open-ended retail funds, where the emphasis will be on liquidity and IRRs. “This could lead to increased appetite for tail-end portfolios,” says Cooper. “The money multiple may not be all that great, but cash comes back quickly, benefiting the IRR and creating an opportunity to recycle capital.”