Secondary buyers get creative as capital floods the market

The private equity secondary market is on track for another record year for deal activity, and it’s so flush with cash that buyers are getting creative to find transactions.

While traditional limited-partner-stake sales continue to lead the market, GP-led liquidity processes are quickly closing the gap.

And buyers are turning even more creative to deploy cash, investing into single- or concentrated-asset deals and even working with the independent-sponsor community to deliver liquidity to early investors.

Nothing seems out of range for secondaries players these days, a sign that the formerly stigmatized market has gone mainstream.

“Any time there’s a portfolio of assets out there, there’s going to be some creative way of providing a liquidity solution,” said Patrick Knechtli, head of secondaries with Aberdeen Standard Investments.

“People are looking for increased complexity as a way of driving better returns. There’s more appetite and sophistication around these things.”

While it varies from study to study, total secondaries volume hit in the range of $50 billion or more last year, volume reports from Credit Suisse, Greenhill Cogent and Evercore show.

GP-led volume represented about 25 percent of overall volume, which closed around $58 billion, Greenhill Cogent said in its full-year 2017 volume report.

GP-led deals came in around $14 billion last year, the firm said. This was an increase in GP-led deals of 55 percent year-over-year.

And fundraising for secondary funds hit record levels last year, alternative-assets-data provider Preqin reports. Secondary funds raised $41.5 billion last year, the biggest haul for the group since 2000, Preqin said.

In this environment, prices are as high as ever. The average price for a PE-fund interest was 96 percent of net asset value, Credit Suisse said, up from 95 percent at the end of 2016. CS pegged total volume at $48 billion in 2017.

Additionally, the highest-quality buyout funds were trading above par, with pricing higher than 110 percent of NAV not uncommon, Credit Suisse said.

Credit Suisse “believes that the $110 billion of buy-side dry powder and the growing number of ‘non-traditional’ institutional investors actively seeking secondary investment opportunities continue to sustain a supply-demand environment that is highly favorable for potential sellers,” the Credit Suisse report says.

So how are secondary GPs navigating this hyperactive environment?

In the largest side of the market, $1 billion-plus deals are becoming more common, though only a handful of firms can operate at that level.

Ardian, one of the biggest GPs in the secondary market, has completed several deals over $2 billion, including one valued at about $2.5 billion, according to Mark Benedetti and Vladimir Colas, co-heads of Ardian’s U.S. operations.

Ardian gets creative with large, complex situations. For example, the firm earlier this year worked with a sovereign-wealth fund on the $2.5 billion transaction, which involved much more than sales of LP interests. The sovereign fund used the secondary sale as the “first step” toward raising a fund with external investors, Benedetti said.

The rationale was that simply bringing a first-time fund to market, even from a group within a large sovereign fund, would come with the challenges of raising a debut pool. Instead, through the secondary process, Ardian bought a chunk of the sovereign fund’s portfolio, syndicating a portion of it out to its own LPs, Benedetti said.

This gave the team from the sovereign fund exposure to Ardian’s LPs, Benedetti said. If the team from the sovereign fund can execute on its strategy and deliver strong returns on the portfolio over the next two or three years, the team can potentially approach those same LPs on raising a fund, Benedetti said.

“That’s a much stronger position to kick off a third-party fund management business,” Benedetti said.

The large side of the secondary market is more active than ever, Colas said. “So far, this year has been the most active we’ve ever been closing new deals and even seeing new deals we didn’t participate in,” Colas said. “We expect it to be a record year for activity.”

These bigger deals also include high-profile GPs trying to deliver liquidity to investors in older funds.

Warburg Pincus completed an innovative strip sale of Asia assets out of its Fund XI last year, and this year TH Lee, Providence Equity and New Enterprise Associates are either pursuing or considering secondary processes.

Independent sponsors

One of the newer trends in the market is secondaries firms working with independent sponsors on delivering liquidity to older investors.

One recent process involved fundless sponsor Argonne Capital Group, which bundled six portfolio companies into a special-purpose vehicle, enabling original investors in the deals to cash out or roll their interests forward.

New investors led by Deutsche Bank spinout Glendower Capital, and including GCM Grosvenor, Hamilton Lane and Strategic Partners, invested about $530 million into the deal.

Argonne used the proceeds for various things like recapitalizing debt on some of the companies and providing growth capital for others.

Firms that operate on a deal-by-deal basis, like Argonne, generally tap a group of select investors to put up capital for each transaction. Independent sponsors can spend years investing deal by deal, building a portfolio and track record that they may eventually use to launch a blind-pool fund.

This type of transaction is a way to provide the sponsor with an exit for its investments and deliver liquidity to original investors, according to a person with knowledge of the deal.

It also enables the independent sponsor to stay in control of the asset and not sell to an external buyer like a PE firm. A PE buyer would either take over the asset completely or buy an interest that would dilute the independent sponsor’s control.

“If the independent sponsor really believes in the value of the company and thinks they can drive value for the next five or six years, there’s no reason they should sell to a PE sponsor,” said Holcombe Green, head of Lazard’s secondaries advisory group, which advised Argonne on the transaction.

“The incoming PE sponsor could have a very different vision for the company.”

Single assets

Another type of deal on the rise in the secondaries market involves a single asset or a few assets. Hellman & Friedman worked on this type of deal earlier this year, seeking to allow investors in its 2007 Fund VI to cash out their interests in a single investment called Kronos Inc, while allowing the firm to hold the investment longer.

It’s not clear if the deal reached final close. Patrick Clifford, a spokesman for Hellman, did not respond to a request for comment.

Under the deal, Hellman would move Kronos, a cloud-based HR-software provider, out of Fund VI into an SPV. Fund VI closed on $8.4 billion in 2007.

Hellman alongside JMI Equity took Kronos private in a $1.8 billion transaction in 2007.

An investor group was lined up to buy out LPs that chose to sell interests in the company. That investor group included Blackstone Group and Hellman’s Fund VIII, a $10.9 billion pool closed in 2014. Blackstone already had a stake in Kronos, which it acquired along with GIC in a $750 million deal in 2014.

The deal needed approval from both funds’ LP committees and two fairness opinions to avoid conflicts involved with the newer fund buying a company from the older fund.

Single-asset deals that involve moving a last remaining portfolio company out of an older fund enable a GP to close the fund and hold a company for longer if necessary. They also enable LPs to reinvest in the asset if they want to stick with the investment, according to Rodney Reid, a managing director at Evercore.

“It’s not uncommon, particularly nowadays, for GPs to contemplate these types of structures, particularly with an asset that has done well and it still has very clear runway for additional value,” Reid said.

Evercore this year worked on a concentrated-asset deal involving oil-and gas-focused PE firm Lime Rock.

The firm is moving assets including a company called Crownrock out of its fourth fund into an SPV, giving Fund IV investors the option to cash out of their exposure to the company or roll their interests forward. Crownrock represents most of the value in Fund IV, sources previously told Buyouts. That deal is approaching final close, a source said.

Concentrated-asset deals are relatively new and are partly a function of secondary buyers raising larger funds, allowing them to cut bigger checks for exposure to single assets, according to Eric Albertson, senior investment director with Aberdeen Standard Investments.

“There wasn’t as much of a market for secondary groups to take on that single line item risk,” Albertson said. “Given how big some secondary firms have become, they can write a bigger check that can absorb from a diversification perspective a single [asset].”

Several such deals of significance are in the market this year. Single-asset deals come with more risk because everything hinges on one investment, said a buyer in the market.

“It ends up being one, two, three assets driving returns rather than 10,” the source said.

Action Item: Check out Greenhill Cogent’s secondary market analysis here: https://bit.ly/2K2Uw6C