This week sister publication Private Equity International published its September deep dive: a look into the hidden risks in the secondaries market based on discussions with more than 26 market participants. Here are some of the key takeaways.
“Currency risk is risk with no return,” says Charles Smith, Glendower Capital’s chief investment officer. A hedging strategy in a must, he adds.
The Brexit referendum proved a boon for dollar-denominated secondaries funds that wanted to buy sterling-based assets, but there have been instances of this volatility working against buyers. A 5 percent discount on net asset value can turn into a 5 percent premium in the period between signing and closing a deal.
The market has moved on from diversified bundles of LP stakes to include more continuation deals with fewer individual assets, so portfolios risk becoming more concentrated.
Secondaries Investor has heard of a recent example in which an LP launched legal action against a GP, claiming it had not properly explained how rolling into a vehicle containing a single asset would impact its concentration limits.
By and large, however, secondaries firms appear to be managing concentration risk through syndication. In 2016, 100 percent of the deals advisor Lazard worked on had just one or two backers; in 2018, this figure was 25 percent as the number of backers on a given deal grew. While not all secondaries funds have minimum asset limits in their LPAs, most that we spoke to keep their per-company exposure in the low single-digits.
Greater efficiency in the secondaries market has driven down returns and encouraged the use of leverage. By value, the proportion of secondaries deals that employed leverage last year was 38 percent, compared with 23 percent in 2017, according to data from Triago.
While a particular credit line might make sense on its own, an underlying portfolio company in a secondaries deal could be impacted by as many as five layers of leverage.
Several banks offer fund-level leverage, transaction-based leverage and an LP credit facility as a one-stop solution. “Given the high price environment we’re in, it’s something an investor needs to be aware of,” warns Cambridge Associates senior director Holger Rossbach.
The secondaries market has benefited from healthy pricing equilibrium and rising transaction volumes. However, this has encouraged some deals to come to market that might not have “industrial rationale”, says Johanna Lottmann, soon to be Park Hill’s European secondaries advisory head.
Deals involving high-quality GPs will get done. But given the point in the cycle, secondaries firms want to back “managers that have proved they are able to navigate challenging economic situations”, says Rede Partners’ Yaron Zafir. Spoiler alert: expect the GP-led failure rate to increase in the short-term.
The conflicts inherent in GP-lead deals are by now well documented and readily managed. In the event of an economic downturn, however, this could be put to the test. When funds’ net asset values drop and LPs who rolled their interests into their GP’s continuation vehicle start to think they should have sold their interests instead, they may try to claw back some of their losses.
“That’s when people will start focusing more on how these deals were done, what was said and what was not said,” says one London-based fund formation partner.
What do you think are the biggest risks in the market right now? Let us know: firstname.lastname@example.org