In this first part of their chapter from The Secondaries Market, Robina Barker Bennett and Scott Turner from Lloyds Bank discuss the coming of age of debt in secondaries transactions.
In 2012, when we last wrote about secondaries for PEI, we highlighted the growth in acquisition finance facilities in private equity secondaries transactions. In this follow-up chapter from The Secondaries Market, we discuss the increasing market acceptance and adoption of such facilities and ultimately conclude that acquisition debt is now a core component of portfolio deals undertaken in the global secondaries market for private equity interests.
While the provision of acquisition debt is no longer a niche activity, it remains a highly specialised segment within the global banking market, exacerbated by the fact that the senior debt is supported by a portfolio of private equity investments where, by definition, the underlying assets are illiquid and have no fixed yield or capital redemption profile.
Before the global financial crisis, acquisition debt was used in only a specific segment of the secondaries market and was typically provided only on a non-recourse basis. In the present day, the vast majority of secondaries market investors and general partners are using acquisition debt in a myriad of forms to support their investment activity. As a result, demand for acquisition debt is stronger than ever before.
In today’s highly regulated and increasingly volatile world, where balance sheet capital is a very precious resource and risk mitigation is fundamental, acquisition debt providers can create meaningful and high quality portfolios, which deliver strong absolute and risk- adjusted returns with robust downside protections.
Supply of acquisition debt is therefore also growing, although at a slower relative rate to the secondaries market, which has virtually doubled in recent years in terms of transacted volumes. Appetite in general has increased among acquisition debt providers, but in situations of time pressure and corresponding need for low levels of execution risk secondaries managers typically favour their ‘tried and tested’ banking relationships.
Acquisition debt is used to assist in funding portfolio acquisitions in the secondaries market; deals that may or may not incorporate segments of directly held investments in operating companies/assets (secondaries acquisitions). Specifically, it relates to debt financing provided by banks and other financial institutions, typically on balance sheet, to support secondaries acquisitions and, therefore, excludes securitised structures, which saw historic usage but which have not yet regained traction.
Defining acquisition debt
Acquisition debt is typically single tranche senior secured debt provided to assist in financing a secondaries acquisition, which will include associated deal costs and linked unfunded commitments.
The acquisition debt is supported by a significant first loss equity tranche either directly or indirectly, which in the context of this chapter is typically provided to funds managed by one of the leading specialist players in the secondaries market, and the overall capital structure is ultimately supported by a highly funded, good quality and well diversified private equity portfolio. Deals that are targeted for the application of acquisition debt are well balanced and typically dominated by mature fund investments, which hold underlying investments in a broad range of portfolio companies.
The basic principle is therefore akin to the general LBO market where debt is used, inter alia, to lower the weighted average cost of capital and gear investor equity returns in established cashflowing companies. All things being equal, this should help to increase risk-adjusted equity returns relative to public markets. In the case of secondaries acquisitions, the acquisition debt has exactly the same purpose and effect, although the collateral available for the acquisition debt provider is less volatile and provides stronger downside protection versus a ‘single credit’ LBO. In effect, binary/single credit risk is replaced by diversified/portfolio distribution risk. Focus on cost of capital is more important now than ever before in a world of slow economic growth and historically low interest rates.
The ultimate cashflow profile, which will be received from an asset portfolio targeted for a secondaries acquisition is unknown in so far as the underlying fund commitments could theoretically return a broad range of investor returns, ranging from nil up to 2x money multiple and beyond. In addition, these returns could be delivered over a near term or indeed a protracted long-term time horizon. The broad diversity and late stage of most secondaries portfolios has, to date, exhibited strong and early cashflow to service debt and then provide investors with distributions.
However, the nature of private equity assets augmented by the deep and multifaceted qualitative and quantitative analysis undertaken by acquirers of secondaries portfolios (the secondaries investors) allows a relatively predictable range of outcomes to be modelled.
In essence, the acquirer is analysing the underlying assets in all material aspects, looking at, inter alia, valuation, capital structure, liquidity and market dynamics to support an appropriate investment case and provide an indication of the level of debt capacity. Overlaying this, the maturity profile and quality of the assets targeted in a secondaries acquisition are such that the probability of the pool delivering a positive cashflow profile in the near term is high.
Core benefits and why it is growing in popularity
There are two main benefits to acquisition debt that explain why it is increasingly accepted: capital efficiency and competitive advantage.
In basic terms, the secondaries investor uses acquisition debt to lower the weighted average cost of capital deployed in the acquisition structure, reducing the absolute quantum of equity capital required to underwrite and fund the deal through to ‘maturity’.
Both these components lead to a gearing effect on the equity returns, shifting the potential distribution of cashflows. This gives the potential for higher returns on the invested equity in terms of IRR and money multiple. This potential upside correspondingly increases the risk on the downside. As such, the characteristics of the portfolio being financed are hugely important and the financing structures require true alignment between lenders, managers and ultimate investors. If this mix is right, the increase in downside risk is relatively low in a portfolio being financed by acquisition debt.
The use of appropriate acquisition debt more appropriately matches the sources of capital with the risk profile of the underlying assets and their expected cashflow dynamics, namely to fund the segment of the deal that has debt-like characteristics with a flexible tranche of debt capital.
The cost of acquisition debt has remained relatively stable as a result of the low interest rate environment, although the constituent parts of the economics package have moved dramatically since before the global financial crisis. Specifically, the all-in cost of debt is typically lower in 2016 than it was pre-crisis with margin uplifts having been more than absorbed by the material reductions in prevailing Libors, which are typically used to fund the floating rate acquisition debt.
The secondaries market is now truly global and is growing in terms of size and liquidity year on year. As the underlying private equity markets have grown and matured, limited partners are using the secondaries market as a tool to rebalance their portfolios and unlock liquidity. Deal volumes and transacted values are up and the quality of portfolios coming to market is good. Liquidity from high quality, mature private equity assets has been strong and secondaries investors have large pools of dry powder to deploy.
In addition, the number of players in the market has also increased as investors have seen the benefits of buying mature and diverse private equity assets in portfolio form to deliver stable cash flows and strong downside protection. As a result of these dynamics, the secondaries market has become highly competitive and more liquid, although we note that key secondaries investors remain largely consistent on a global basis.
Competitive advantage is therefore fundamental and the speed and certainty of execution is one element that has enabled ‘best in class’ players to win highly sought after deals by offering a condensed closing timeline to vendors. In this context, the use of debt is crucial, both in terms of bridging initial capital flows from the ultimate investors and in funding the appropriate part of the acquisition. Accordingly, a pre-agreed/committed acquisition debt facility, in one or a combination of the forms noted later in this chapter, is now more than ever a key part of a secondaries investor’s arsenal and augments competitive advantage.
Alongside this, it is well documented that the flight to quality by global LPs is now more prevalent than ever. As a result, secondaries investors compete fiercely for LP dollars on a global basis and against their market peers. LPs compare returns delivered by the best players across the market with much focus on IRR. Therefore, even if one secondaries investor is buying exactly the same assets as another, the one that is using acquisition debt will deliver better relative returns, ceteris paribus.
Deploying capital at an appropriate rate and delivering target returns are therefore core competencies for a secondaries investor. Acquisition debt plays a significant part in both these fundamental aspects: initially in the deployment of capital, by allowing secondaries investors to win the best deals through speed of execution and the ability to pay a higher market price by lowering the cost of capital in the financing structure. It also helps to achieve target returns via the incremental effect of gearing on the investment portfolio.
Acquisition debt financing capability is therefore no longer a niche activity or a ‘nice to have’. It is a fundamental tool for core secondaries market investors.
Robina Barker Bennett is global head of financial sponsors and head of North American financial institutions at Lloyds Bank. She joined the group in 2007 where she was head of the team responsible for the Bank’s relationships with credit funds and expanded her role to cover all financial sponsors in 2010. Scott Turner is a director within Lloyds’ financial sponsors group and has over 17 years direct experience in a number of private equity strategies. He provides funding solutions to a large and diverse client base, the core of which is built around global funds of funds and secondaries managers.
Watch this space for the rest of Barker Bennett and Turner’s chapter, where they discuss forms and fundamentals of acquisition debt.