All credit due

Leverage is an increasingly common factor in getting large secondaries deals done.

Earlier this week, reports surfaced that Lexington Partners had tapped a $1 billion credit line to help fund its purchase of an €800 million portfolio from the Irish National Pension Reserve Fund.

Specific details remain unclear – and Lexington is unsurprisingly staying mum as to its strategy – but it seems they aren’t alone in using leverage when they feel it suits.

Market insiders say gearing is an increasingly common (and important) factor in large secondaries deals, whether for fund portfolios, direct assets or complex spin-outs.

There are a couple of reasons why, I’m told.

The first is simply that the credit market is back. Banks are “aggressively” lending to secondaries firms after credit had virtually “dried up” for secondaries buyers with the credit crunch in 2008, one London-based advisory firm notes.

Amid the current sellers’ market for secondaries, banks are seeing an opportunity to make large, lucrative and safe loans secured against high-quality secondaries portfolios. That was apparently the case with the Lexington credit line: the Irish pension portfolio was said to include first-rate and diverse fund interests that a consortium of banks were willing to lend against (even if Lexington opted to spend part of the credit line on other assets, I’m told).

So banks are ready and willing – but why do the GPs in these situations bother with credit when they’ve already got billions in equity at their disposal?

It’s all about returns.

As one source explained hypothetically, say a GP purchases a $1 billion portfolio of fund interests, which later returns $2 billion. That would be a 2x return.

Now imagine that same $1 billion deal is done with $500 million in equity from a secondaries fund, with the balance comprising bank debt, the source said. Assuming the same $2 billion return, after paying back the bank’s $500,000, that would mean $1.5 billion gets returned to LPs on the back of a $500 million investment – or 3x. That back-of-envelope calculation doesn’t include interest, fees or other “friction costs”, as the source put it, but demonstrates why leverage can be a powerful tool to enhance returns.

Some firms are even managing to arrange lucrative deals where they defer payment on those loans. We’ve had several people talk to us about one large fund of funds, for example, which apparently did a deal where the loan repayment was deferred for six years. A legal source says this type of arrangement is particularly advantageous for buyers as it allows time for realisations and distributions from the assets to help fund future repayments to lenders.

This isn’t the strategy for everyone though. Smaller buyers aren’t given the same access to debt, for one thing. And even if the buyer is big, if the quality of the underlying assets isn’t considered excellent by banks, the cost of obtaining such capital and loan terms may not be worth it. Also, there are of course always risks involved with taking on debt, should market conditions change etc.

But from all the conversations I’ve been having and market data that has been pouring in, it seems we should expect more secondaries deals to include significant debt financing components. A survey we had from Evercore last week showed 35 percent of sellers came to market last year for regulatory reasons, mainly offering high quality fund interests and direct assets from banks and insurers; more is expected to hit the market in years to come, which will be prime material to secure loans against (and assets that the banks presumably already know well).  Watch this space.