Beating the yield problem: how debt enhances returns in the secondaries market

About 63 percent of investors surveyed by Investec are likely to use third-party debt for a secondaries acquisition in the future, explains global head of fund finance at Investec Simon Hamilton. 

The continuing boom in the global secondaries market is creating strong demand for a niche form of leverage aimed at further boosting the attractive returns prevalent among secondaries investors.

Leveraged finance has traditionally played a small role in secondaries deals but investors are increasingly recognising the benefits of using debt to support acquisitions and actively managing portfolios.

A survey by Investec found that, previously, only a third of respondents had used third-party debt for a secondaries acquisition but, going forward, 63% are more likely to use it.

Drivers of the secondaries market

Growing interest in such products comes amid another surge in secondaries deal activity. At the time of writing this article, global secondaries market transaction volumes had reached an unprecedented $42 billion in 2014, according to advisory firm Cogent Partners, compared with a previous record of $27.5 billion in 2013.

Significantly improved pricing has given vendors of private equity portfolios much greater confidence that they will secure attractive valuations closer to the net asset value (NAV). Cogent said the average pricing across all private equity fund strategies was 91% of NAV in the second half of 2014. The average pricing of buyout funds reduced slightly to 95% of NAV – from a high of 100% in the first half of 2014, which was the first time any strategy in the private equity industry had priced at NAV since the boom in 2007.

This is just one of the key changes in the market. Improved pricing has led to a drop in the number of forced sellers and a rise in the number of vendors using the secondaries market to proactively manage portfolios by streamlining investments and increasingly focusing on preferred GPs.

According to Preqin, the largest users of the secondaries market are private equity fund of fund managers at 14% of potential sellers, public pension funds at 12% and asset managers at 10%.

Meanwhile, this formerly opaque market has become more transparent in years. This is partly due to the growth of specialist intermediaries, such as Toronto-based Setter Capital, which have helped boost transaction volumes by matching sellers with buyers of single assets, portfolios and fund liquidations.

All of these factors have opened up the secondaries market and attracted a broader array of vendors, transforming its image from a market for troubled sellers to a buoyant, healthy corner of alternative investments.

The market fundamentals have led more managers to explore the use of leverage to ensure they generate the best possible returns for their investors and remain competitive. As a result, secondaries managers are using leverage as two main tools: to finance the acquisition of portfolios and to better manage existing portfolios.

Portfolio acquisition finance

Acquisition finance is becoming popular for large diversified portfolios of LP interests, smaller concentrated portfolios of fund interests – including transactions for single fund interests – and bespoke GP restructurings.

In this context, leverage can boost return multiples and IRRs but it can also replace deferred considerations, meaning the vendor can be paid in full at the time of the deal’s completion rather than agreeing to a deferred payment. This gives the seller more comfort and eliminates the need for trickling interest payments over a significant period post-deal.

Buyers using such a facility can differentiate themselves from their competition not only by offering an up-front payment but also by increasing their bidding power.

Portfolio management

Debt can also be used as an important portfolio management tool for asset holders seeking liquidity. Traditionally, investors needing liquidity would exit positions but, by using leverage against a portfolio, large amounts of liquidity can be created for the investor. The returned capital can be used for additional acquisitions for an existing portfolio, to acquire an entirely separate portfolio, finance other fund obligations or to pay a dividend to investors. This option also enables asset holders to protect their potential future upside, which they would sacrifice in the event of a sale.

Furthermore, leverage to enable distributions allows managers to crystallise returns and reduce the amount of capital that must be held for the underlying investments, bolstering multiples and IRRs.

Appropriate leverage

Suitability for leverage must be assessed on a case-by-case basis and it is essential to use a lender with a sophisticated understanding of private equity and the dynamics of this unique asset class.

A lender experienced in private equity will bring a vital depth of knowledge to each situation – secondaries debt finance cannot be treated as a margin call facility. The tailored approach required for each client means borrowers should look to benefit from relationship banking rather than partnering with those who see these facilities as trading lines.

A lender with extensive experience of private equity will evaluate a broad range of factors to assess whether a portfolio can withstand additional leverage:

1. Diversity – a strong understanding of the quality and number of the underlying fund managers, their size, where they are based and whether they are specialist vehicles. This should be accompanied by an evaluation of the managers’ overall track record and individual fund performance, and of the investments’ valuations.

2. Asset valuations – an assessment of the underlying portfolio companies, their Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA), and their relative valuations as multiples of EBITDA.

3. Existing leverage levels – lenders should look at the portfolio’s overall existing debt and the leverage among the individual portfolio companies. The leverage-on-leverage level is key but will depend on the underlying composition of the portfolios. Some assets are more suitable for leverage than others.

4. Expected cash flows – portfolios likely to make distributions in the short-term – within 12 to 18 months – will be among the more suitable candidates for additional leverage.

Borrowers must also bear in mind the flexibility provided by certain LTV ratios, a crucial consideration when preparing for challenging markets. A high LTV from the outset would mean tighter controls on the debt facility whereas a lower LTV would give the borrower more headroom.

Conclusion

The complex nature of secondaries has created a need for sophisticated and flexible leverage structured around clients’ specific needs.

In this burgeoning segment of the market, understanding the vast array of underlying investments found within secondaries portfolios, and the complexities of the capital structures involved, is a key challenge. Finding a lender with deep knowledge of private equity and of the unique characteristics of the secondaries arena is vital.