Andrew Gulotta, managing director of secondaries advisor Sixpoint Partners, and Adam Tope, secondaries partner at the law firm DLA Piper, share their insights into current market activity, LP and GP liquidity options in a pandemic-impacted market, and what the rest of 2020 may hold for the secondaries market.
How is the secondaries market performing during the covid-19 pandemic?
On the LP side of the market, we saw most 31 March portfolio sales close as expected, though we are aware of several pooled sales that were suspended under MAC clauses in purchase agreements signed before covid-19 hit Europe and the US. Since 31 March, we have seen a few portfolio sales move forward at extremely low prices, namely at 50 percent (or less) of 31 December net asset values, in situations where LPs had a strong need for liquidity. Generally speaking, traditional portfolio sales have all but stopped as valuations of fund interests post-covid-19 have become unclear.
On the GP side, we have seen a few bright spots in the enterprise software and IT infrastructure sectors, as well as providers of “essential services” or businesses in the supply chain of “essential services”. Such portfolio companies would feel little impact from covid-19 or would actually see an uptick. Otherwise, the market for private equity and real estate GP-leds has effectively halted. Market players we have spoken to have all expressed concerns around asset repricing. In addition, the pandemic has caused operational difficulties in basic asset diligence by secondaries buyers.
What options are there for GPs that need additional capital for portfolio companies?
We are seeing most activity on the GP side of the market with NAV-based loans and fund-level preferred equity. Both options can be used to secure fresh capital to support existing portfolio companies, for defensive and/or offensive reasons, or even to provide LP liquidity.
A NAV-based loan is fairly efficient to implement. Debt would be incurred by the fund which is guaranteed by the NAV of the fund. An elegant solution, this debt in our experience is generally flexible on cash vs PIK interest and has few covenants – most notably a quarterly asset coverage test. Before entering into a NAV-based loan, GPs will need to confirm that their fund documentation (including side letters) allows such debt to be incurred. If not, then an amendment to the fund documents can be made to permit this transaction.
In a similar vein, we are also seeing significant deal flow and inquiries into fund-level preferred equity. Preferred equity bears no maturity or covenants, making it more flexible (and more expensive) than a NAV-based loan. GPs would typically need to seek consent to amend the fund documentation to permit the issuance of preferred equity since the preferred equity holder would receive a priority share of distributions from the fund ahead of existing LPs.
Regardless of deal structure, a best practice for these solutions is to negotiate for a co-investment allocation for existing LPs to participate.
What options are there for LPs that need liquidity?
The option to sell a portfolio at fire-sale prices always exists, but we currently see strength in preferred equity recapitalisations of LP portfolios. In our view, this presents an excellent option to create liquidity for LPs in the covid-19 environment. This is particularly appealing to LPs: by creating liquidity, it allows them to meet capital calls from other funds or repay credit facilities on their LP portfolios without selling in an adverse pricing environment.
In short, this structure is a ‘dividend recap’ of sorts. The LP would transfer its interests in a pool of underlying funds to a special-purpose vehicle. The SPV would issue a series of preferred equity interests to a capital provider. The capital provider would have a preferred right to future distributions from the underlying funds on a pre-negotiated basis.
For the LP, the transfer would generally not trigger US tax, would not require the consent of each underlying fund as it is an affiliate transaction, and would not typically implicate US publicly traded partnership concerns that may otherwise limit an LP’s ability to sell an underlying fund interest on a timely basis.
A preferred equity recapitalisation can be implemented quickly from a legal perspective, often quicker than a standard pooled sale. Since preferred equity is not a loan, these transactions typically have no fixed maturity, thus letting LPs ride out covid-19 pricing issues in the market.
What does the rest of 2020 hold for the secondaries market?
We expect that the secondaries market will restart in Q3 or Q4.
On the LP side, we expect to see pooled sales re-engage in Q3 or Q4 once Q1 and Q2 valuations are available. We also expect to see many new creative pricing mechanisms implemented on pooled sales to address potential upside in the value of portfolios once the impact of covid-19 dissipates.
On the GP side, we expect many GPs to soft launch continuation vehicles by the end of Q2 in anticipation of stabilised asset pricing and portfolio company financial performance in the second half of the year. Ironically, single-asset deals may prove easier to execute than multi-asset fund recaps. Our rationale is that a single high performer will rebound to pre-crisis levels faster than a portfolio of three to five companies of varying quality. We believe all of this foretells a wave of late 2020 and early 2021 transactions.
Andrew Gulotta is managing director of Sixpoint Partners focused on GP-led secondaries and direct secondaries. Adam Tope is a fund formation and secondaries partner at law firm DLA Piper.