There is no doubt that it is a secondaries buyers’ market right now. There is a deluge of dealflow and discounts are deep. Institutional investors are battling liquidity challenges as calls to commit to new funds continue to outstrip distributions. Meanwhile, despite some recovery in the stock markets in the wake of the regional banking crisis, programmatic constraints continue to haunt many LPs.
“Public market volatility has created the denominator effect which is putting real pressure on LP allocations to private markets,” says Jeff Keay, managing director in the global secondaries team at HarbourVest. “When you combine that overallocation with the fact that the IPO window is essentially shut and M&A activity is significantly down, that creates a real liquidity challenge and a lack of capacity to commit to funds currently being raised by managers deemed as core, thereby creating pressure to sell in the secondaries market.”
“Investors are synthetically overallocated to alternatives because material write-downs in private equity have been limited,” adds Andrew Gulotta, partner at Sixpoint Partners. “It helps that the S&P is above 4,000 right now and some stability has returned after the collapses of Silicon Valley Bank and Credit Suisse. We aren’t necessarily seeing any panicked selling. But LPs are placing a premium on liquidity.”
The discounts that investors are being forced to swallow in the LP-led market are substantial, however. According to Gerald Cooper, partner at Campbell Lutyens, average pricing in the buyout market currently sits between 80 and 85 cents on the dollar. Many institutions have therefore sought to circumnavigate the denominator effect by increasing allocations to the asset class as a short-term fix. “US pension funds and endowments have probably shown the most proclivity to increase allocations,” says Cooper.
Where the allocation pressure is more acute or there is less flexibility to ease programmatic tensions, investors are faced with a decision.
“Do they pull back and stop new fund commitments altogether, absorbing the costs that come with that, which may be longer term but are still significant? Or is it more appealing to take the near-term pain that comes with divesting at a discount?” ponders Keay.
“Different institutions will arrive at different conclusions. It may depend on how averse they are to the near-term volatility that comes with selling at a discount. It may depend on how individuals at those institutions are compensated or the conviction they have in the importance of even pacing.”
Where institutions are arriving at the decision to sell, they are nonetheless taking steps to optimize the pricing available. First, they are focusing on their highest quality assets. “Sellers are being advised not to use this environment as an opportunity to offload less attractive portfolios. That is where pricing is most punitive,” says Keay. “Instead, they are focusing on their highest quality sponsors and funds with strong underlying portfolios. They are also steering away from riskier segments, be that venture capital or emerging markets.”
In addition, investors are taking a mosaic approach to potential sales to minimize the discount they face. “In this environment, where there has been a lot of uncertainty in terms of macro risk, buyers have gravitated towards GPs that they know well and assets they are familiar with,” explains Cooper. “That has resulted in us breaking up portfolios, selling them to multiple buyers to ensure that the assets are attracting the highest bid from the buyers who know those assets the best.”
“In an environment where discounts are wide, deferrals can be a win-win tool for both buyers and sellers”
Gulotta adds: “Whilst LPs are placing a premium on liquidity, they are still willing to fish for pricing and then are opting to execute mosaic transactions in which they sell a portion of what they originally brought to market.”
David Perdue, partner in the strategic advisory group at PJT Partners, agrees. “Portfolio sales are common in the marketplace. For major institutions looking for programmatic liquidity, it makes sense to have a diversified book on offer.”
Deferred considerations are also being employed to help bridge the bid-askspread and to make selling a more palatable option for investors. “Deferrals are often preferred by sellers sensitive to discounts, especially when solving an allocation issue as opposed to a liquidity issue,” says Ross Hamilton, managing director at Partners Group. “Increasing interest rates raise the cost of fund financing lines making deferred consideration more interesting for buyers too.”
“In an environment where discounts are wide, deferrals can be a win-win tool for both buyers and sellers,” agrees Keay. “Buyers are able to enhance their rate of return, whilst sellers are able to extract a higher price relative to NAV because they are being paid over time. Deferrals alone won’t solve the bid-ask spread completely but they can contribute to narrowing that spread and providing just enough grease to allow the transaction to come to fruition.”
The role of the GP
GPs have a role to play in helping ease LP liquidity issues, of course. Certainly, they are motivated to do so, given current paralysis in the primary fundraising market. “The number of new funds seeking primary capital continues to expand at a time when many LPs are grappling with how they can continue to make new primary commitments while already overallocated to the asset class,” says Scott Beckelman, global head of private capital advisory at Jefferies.
One option available to the GP is a tender offer, or tender offer plus staple. Carlyle, for example, ran a process that allowed investors in older financial services funds to cash out of their interests while bringing in money for the firm’s next flagship pool in 2022.
“The number of new funds seeking primary capital continues to expand at a time when many LPs are grappling with how they can continue to make new primary commitments”
These deals remain relatively rare, however. “Several GPs have contemplated tender processes, but only a few have transacted,” says Hamilton. “Not all of those that went ahead achieved the desired outcome. Staple transactions work well towards the end of a fundraising as the new vehicle approaches its target size but are less effective where there is a large gap to close.”
The other role that the GP can play in helping deliver much needed liquidity to LPs in a barren exit environment is, of course, the structuring of a continuation vehicle.
“We have had a number of conversations with GPs who have told us their LPs are proactively asking them to tap the secondaries market through a continuation fund transaction in order to create liquidity,” says Cooper. “Continuation funds can accelerate distributions and relieve some of that pressure on allocations, enabling LPs to recycle capital into new investments.”
Cooper adds that when a GP becomes a stakeholder in a transaction rather than merely facilitating that transaction, the outcome is likely to be improved for the seller. “The diligence the buyer can conduct is going to be deeper and the price that can be generated in the liquidity exercise is going to be higher,” he says. “Furthermore, because continuation funds are typically built around trophy assets that have already performed well, LPs are often able to crystalize north of three times MOIC. In an environment where LPs are already short on allocation, these deals enable them to not only take advantage of attractive returns but also accelerate the distribution of cash in a market where traditional exits are thin on the ground.”
Indeed, LP rollover in continuation funds is currently limited. Gulotta says the average seller uptake in Sixpoint’s continuation vehicle deals in 2022 was between 92 and 93 percent.
Keay, however, is circumspect about the ability of continuation vehicles to really move the needle when it comes to the scale of liquidity challenges that some institutions are facing. “GP-leds are helpful, of course. They are creating liquidity options for LPs. But I don’t think that any institutional investor that is heavily overallocated right now is going to be able to find their way out of that situation simply by waiting for GP-led deals to be brought to them. They represent a mitigating factor in what is otherwise a low liquidity environment, given that the IPO market is anemic and M&A activity is down, but they are not a silver bullet.”
Closing the gap
What institutions really want, of course, is for discounts in the LP-led secondaries market to become significantly less pronounced. But how feasible is this?
According to Gulotta, many secondary funds were ahead of investment pace heading into 2022, but a slowdown that has lasted almost 12 months means pressure to deploy may increase in the second half of 2023. The tough fundraising market will keep some secondary funds at below-average pace through the balance of the year as they preserve dry powder, he also notes.
Cooper adds that discounts will narrow as more new secondaries funds are raised. “Secondaries funds that had trouble raising capital last year are now having a great deal more success. As this dry powder comes into the market, competitive tension will increase. Coupled with greater visibility in the macro-outlook, pricing should get closer to 90 percent of NAV by Q4 this year.”
Beckelman, meanwhile, says that pricing is already improving. “We have recently seen a rebound in pricing and market demand for high quality buyout-focused portfolios and believe this offers sellers one of the best windows to access the market that we’ve seen in over a year. Uncertainty regarding Q4 NAV valuation changes is now behind us and concerns regarding write downs have largely been proven to be unfounded amidst good operating performance and stable valuations,” he says.
“Broader equity markets have been improved and there is consensus that the pace of future rate hikes is moderating. All of these positive indicators come at a time when many of the largest secondaries buyers have had remarkable success fundraising in a very challenging and competitive primary fundraising market. This mirrors green shoots we are seeing across M&A and debt and equity capital markets and supports our view of continued long-term growth of the secondaries market.”
“Things are definitely coming together out there,” agrees Perdue. “Execution matters more than it has in recent years. You have to pick your spots and you have to do the diligence ahead of time. But I do believe that the pricing floor is getting higher. With every quarter that goes by, there is a little more macro visibility and a continued roll forward of quarterly performance in the underlying portfolios. As a result, there appears to be a firmer tone to pricing and the bid ask spread is narrowing. That is going to have a positive effect on allowing transactions to clear more smoothly in the marketplace.”
In addition to the secondaries market, investors have the option of taking financing out against the underlying NAV of some of their private markets’ exposure.
By doing so, they can access liquidity without accepting the deep discounts on offer and without forgoing any future upside.
“NAV loans, securitizations and preferred equity financings have exploded in popularity and this is one of the fastest growing areas of our market,” says Jefferies’ Scott Beckelman. “In times of volatility, these solutions become particularly popular with LPs that don’t want to realize a loss on a sale.”
“Larger institutions are becoming more creative in terms of using the balance sheet they have for corporate finance purposes,” agrees Perdue. “This is no longer just a sale-or-nothing market. There are a whole host of tools in the toolkit that can be used to raise liquidity and if you want to maintain upside those structures can have a lot of appeal.”
However, high interest rates are making the NAV-based financing route an expensive proposition for LPs. “Ninety-day SOFR is above 4.50 percent. Add 400 to 500bps for a less diversified portfolio, and you are looking at close to 10 percent borrowing costs,” says Gulotta. “For that reason, while we have seen an uptick in NAV loans, it has been more on the GP-led side, often at double-digit rates. We have not seen an explosion in LPs taking out NAV loans, given where interest rates are today.”
Hamilton agrees: “Investors may consider NAV finance for near-term liquidity, but with valuations coming down and interest rates going up, this option makes less sense than in recent years.”