Declining secondaries returns push funds towards leverage

Fewer buyers sought IRRs of above 15% last year compared with a year earlier, a survey by advisory firm Cebile Capital has found.

Secondaries buyers are increasingly using leverage to boost returns amid lower return expectations, as pricing and competition begins to shift the market’s traditional dynamics, according to a report by Cebile Capital.

In its Survey of Secondary Market Buyers – 2016 Year in Review and 2017 Outlook, the London-based advisory firm canvassed views from 350 buyer relationships and found the first signs of a movement away from traditional secondaries return expectations.

“The sheer volume of capital raised for secondaries means return compression is there,” Sunaina Sinha, managing partner at Cebile, told Secondaries Investor. “Leverage allows funds to get returns back up to the range they are comfortable with and have promised LPs they will deliver.”

The survey found almost half of firms are now using third-party financing at the fund or deal level, a marked shift on 2015 when less than 20 percent of respondents employed leverage.

Increased use of leverage is in part being driven by declining return expectations. Cebile said 80 percent of respondents sought internal rates of return above 15 percent last year, down from 91 percent of respondents in 2015. As many as 12 percent targeted IRRs in the 13 percent to 15 percent range and 8 percent of respondents were satisfied with less than13 percent IRRs.

No buyers reported return targets of below 13 percent in 2015. The firm noted this was a substantial change  from the previous year, when there was “little evidence of secondaries buyers compromising on returns or using leverage aggressively.”

Fund sizes are also set to increase, with three-quarters of respondents saying they expect their next fundraise to be larger than their current fund, and a third saying their vehicle would be more than 30 percent larger. No respondents expect their future size to shrink.

“People are expecting a cyclical downturn,” Sinha said. “Everything is at or near a high and there will be a cycle turn at some point. But today it still feels like a bull market, so there is pressure to raise larger funds and raise them quickly.”

While the report noted there is “considerable uncertainty around 2017”, the majority of market participants believe deal volume is likely to drop to around $35 billion, $2 billion down from 2016.