What are the main differences in dynamics between GP-led secondaries involving credit funds, versus buyout funds?
GP-led transactions for credit funds and buyout fund have similar deal mechanics; the processes of engaging investors, facilitating price discovery, tendering for LP interests, executing documentation, and closing deals are virtually the same. Differences arise in the rationale for these transactions. Credit fund managers are increasingly looking to implement GP-led deals for funds with restructured equity positions or “legacy” debt positions. GP-led deals in the debt context are often structured to address positions deemed to be inconsistent with the fund’s original strategy – a major difference with private equity GP-led deals. For credit managers, a GP-led deal can be used to dispose of a cohort of assets in an elegant way or potentially to launch a new strategy with seeded investments.
How can a credit fund benefit from the GP being given more time and capital to manage the portfolio? Is there any upside potential in this asset class, as there is with private equity?
A credit portfolio is dynamic. For example, a direct lending fund starts out with a performing loan portfolio; however, the portfolio never remains in this pristine state. Inevitably some of the names will move to a “watch list” or fall into full-blown “distressed” status. Watch-list and distressed names take time to work out. If a manager is forced to “fire-sale” names at the wrong time, returns can become severely impaired. Buying time to resolve or stabilise a situation is absolutely critical – sometimes this also could require additional investment. Either way these dynamics create a powerful rationale for credit manages to be given more time in certain circumstances.
Another reason that a GP can benefit from having more time is the result of “recycling dynamics.” If the GP has the ability to recycle capital, the fund may be holding a number of positions at end of its stated life. The options on what to do about these positions are limited. LPs greatly dislike attempts by GPs to transfer positions into affiliated funds. The GP could orchestrate a portfolio sale of positions on the secondary market, but the current market may want to purchase these names at a discount – not a great outcome. A GP-led secondary transaction or a simple fund extension, accompanied sometimes by additional capital, can be the best alternative in dealing with this end-of-fund-life situation.
How common is it for a credit fund to hold equity positions and how important is this when it comes to a potential secondaries process?
It is quite common for credit vehicles to hold equity positions, for a variety of reasons.
First, credit managers sometimes actively seek equity positions to augment core credit holdings if they believe in the upside of a specific story and want to enhance the fund’s overall return. Investments can be in the form of convertible preferred shares, common equity shares, or warrants.
Second, credit managers receive equity as the result of restructurings or in return for accommodating borrower requests for leniency in the face of covenant violations or outright distress. For these reasons, as closed-end credit funds age they inevitably take on more equity exposure. In the vast majority of these cases, the credit funds become the “unnatural holders” of equity positions. In a large number of cases, the equity positions are minority holdings. Control is only achieved in cooperation with other credit managers who also became “unnatural holders” through restructuring activity.
What types of buyers are active in credit fund secondaries? What are the returns compared with buyout secondaries?
There is a large universe of different types of investors in the secondaries market for private credit. The universe includes traditional opportunistic debt investors which are focused on direct positions as opposed to LP interests. Traditional private equity secondaries investors are also seeking transactions in the private credit secondary market, but their focus is the inverse of that of the debt investors as they prefer investing in partnerships as opposed to purchasing debt positions directly. Finally, there are a variety of family offices, specialty finance companies, private credit sponsors, sovereign wealth funds, and pension plans that chase deal flow in the private credit secondaries market.
Aside from portfolios of performing securities, direct positions in the private credit secondaries market are driven by the “distressed bid.” Red-blooded opportunistic debt investors price distressed opportunities at a minimum 2x MOIC and >20 percent IRR. The problem is they tend to price everything from modestly stressed to deeply distressed at the same levels. The market lacks a bid for “watch list” securities that would allow more counter-parties to cross trades. We think that this bid naturally falls in the 1.4-1.6x MOIC and 14-16 percent IRR range.
How big is the opportunity for credit fund secondaries and what is recent annual deal volume like?
The private credit secondaries market is enormous, arguably bigger than the $75 billion private equity secondaries market. However, it is much more fragmented than the private equity secondaries market and often less transparent; therefore, its contours are not as easily defined. The private credit secondaries market is driven by sales of whole loans, participations, and other direct exposures to the credit of a particular enterprise. Transactions can be executed through the sale of a single loan or a participation, but flow is more visible through portfolio sales of direct loans or participations.
The private credit secondary market includes sales of performing loans as well as non-performing credits; includes securities from the corporate, real estate and structure credit sectors; and involves banks, insurance companies, specialty finance companies, credit funds, BDCs, REITs and special situation funds, among others. Viewed from this perspective the market is huge, with annual volume well in excess of the private equity secondary market.
Jeff Hammer and Paul Sanabria are managing directors and co-heads of the illiquid financial assets practice at Houlihan Lokey.