Glendower Capital: The ‘virtuous circle’ driving secondaries

The secondaries market has seen more innovation than almost any other area of private equity over the last decade, leaving investors with some intriguing choices, says Charles Smith, managing partner and CIO of Glendower Capital.

This article is sponsored by Glendower Capital

Charles Smith

Limited partners now have an almost bewildering array of secondary investment options, with new strategies ensuring the secondaries market has become an important tool for managing the private equity lifecycle. While today’s secondaries can help investors achieve more granular and finely tuned private equity exposure than was previously possible, LPs need to understand how the risk-return characteristics and cashflows differ according to strategy.

We caught up with Charles Smith, managing partner and CIO at Glendower Capital, a secondaries firm that earlier this year reached final close on its latest fund at $2.7 billion, to discuss market developments, what they mean for LPs and where secondaries are heading next.

The secondaries market has grown considerably over the past decade. What would you say have been the most important developments?

We’ve seen tremendous growth in the market driven by a virtuous circle in the post-crisis years. In the aftermath of the crisis, we saw an increase in sellers on the secondary market, attracting more buyers. Assets were exchanging hands at rational prices so you got to a stage where buyers and sellers became comfortable with the market and the virtuous circle gained momentum through the 2010 decade.

This helped fuel a proliferation of different deal and strategy types. In addition to straight LP position trades, you now have GP-led deals, single asset deals, preferred equity, early secondaries… and the list keeps growing. The market has evolved so that the problems it can solve and the exposure LPs can achieve have broadened significantly – secondaries have become a flexible source of liquidity to the private  equity world. This development has also been boosted by growth in private markets at the expense of public markets; companies can now stay private for longer, while LPs are still able to achieve the liquidity they may require through accessing the secondary market.

One area that’s seen a lot of activity recently is GP-led secondaries. Why do you think this is?

GP-led deals have been around for a long time, but the current wave dates from around 2013 or 2014. Its development is a rational response to the concept of a typical 10-year fund life for private equity funds. Initially, these deals were structured around portfolios but, as these transactions have become more accepted and mainstream, we’ve recently seen single asset liquidity solutions. The secondary market has become a means for private equity GPs to own assets for longer – firms and their investors are no longer tied to the 10-year life – and that means they can do what’s right for value creation rather than being under pressure to sell earlier than might be optimal. For LPs, the development of the market has led to the emergence of funds that are specifically dedicated to GP-led deals, widening their investment options.

Given the evolution of the market, how can LPs use secondaries within their private equity allocations?

Historically, LPs tended to invest in secondaries for two reasons. The first was when they were just starting to build out their portfolios – secondaries offered a way of deploying capital quickly, achieving both quick returns and instant vintage year diversification. The other was when they were targeting distressed opportunities during market corrections when forced sellers boosted secondaries dealflow.

Things have moved on significantly from there. Today, secondaries can provide an attractive risk-return profile for mature investors, which may also be seeking additional diversification, as well as new investors. Secondaries are not driven just by distressed sellers anymore – we’ve been in a benign environment for some time now. Secondaries funds have proven that they can provide attractive and stable returns across the cycle. That said, they can be an attractive strategy currently as they can also provide a hedge for when the cycle turns, and many believe we are not far from that point.

Can you explain how risk-return and cashflow profiles vary according to some of these strategies?

Let’s start with the more traditional LP portfolio secondaries. Here, you have rapid deployment of capital and rapid return of capital – they are shorter duration strategies and they can provide LPs with instant diversification because they are usually spread across a number of funds and underlying investments. These can offer strong IRRs, mitigate the J-curve and be particularly suitable for investors that are concerned about the reported returns from their investments – they may not want to experience several years of negative returns.

GP-led secondaries, by contrast, are more like primary buyout investments in that cashflows tend to be lumpy and investments are much more concentrated. This type of secondary is more likely to offer stronger multiple returns and sits further out on the risk and duration spectrum. Meanwhile, preferred equity related secondary strategies are more akin to mezzanine with a lower risk, lower return profile.

How should LPs be approaching the market now that they have a broader variety of choices in secondaries?

A first step is to scope the market to understand what’s out there since strategies can vary significantly. Some strategies are designed to deploy large amounts of capital by buying hundreds of LP positions – that’s like the ultimate private equity index and it’s a type of secondary investment that can offer a relatively high level of liquidity.

Yet you can now also target different phases of secondaries investment through tail-end portfolios, or at the other end of the spectrum, early secondaries, which target positions early in a fund’s life, and everything in between. You can also invest according to type of private equity investment, such as buy-out, venture capital and growth capital, and we’re also seeing side cars developed for real asset strategies. Then, there’s preferred equity and debt-like products that offer investors a different point on the risk-return spectrum from more traditional equity strategies.

It’s worth noting, though, that while some of these strategies may look or feel similar, when you peel back the onion, they have very different risk-return and cashflow implications for LPs. LPs need to clearly understand where a particular manager expects to play – what type of cake they’re looking to bake.

What about different forms of leverage – that clearly has an impact on all this, too?

Yes, leverage can be used in different ways by secondaries managers and LPs would be well served to understand how this may impact risk and returns. One area that has received a lot of attention over recent times is the use of subscription lines in the broader private equity market. Secondaries funds were early adopters of this type of credit line because it is perfectly suited to the cashflows inherent in a secondary fund. The holdings are so diversified, secondaries funds have cashflows virtually every day, so it makes sense to use subscription lines so you can accumulate cashflows each quarter and make capital calls in one go to simplify the administrative process.

This has extended over the past few years to more permanent types of finance and into deal structuring, allowing funds to shift both where they play in the risk-return spectrum and the cashflow profile they generate for investors. So, for example, if you have a deal that could be attractive in IRR terms – it is mature with short investment duration – but less so in terms of multiple, you can use leverage as a recycling tool to invest the capital twice to increase the multiple. In this instance, you’re not increasing risk; you’re merely increasing the duration of the investment for your underlying investors. On the other hand, if you have a longer duration asset and you’re looking to boost the IRR through leverage, you are increasing risk, so LPs should potentially be putting that in a different bucket of their portfolio.

To what extent do you think there is an understanding among LPs around of the use of leverage among secondaries managers? And how can they navigate this?

I think there’s still some education work to be done by the industry as, from where we sit, some LPs are clear about this, while others aren’t focusing enough on this yet. Investors need to have a dialogue with fund managers to understand how they will use leverage and the impact this will have on the risk-return profile of their investment portfolios. We certainly see more LPs picking apart this aspect during fundraising processes, but for the benefit of robust and transparent GP-LP relationships, managers really need to be clear with their investors about what they’re doing.

As the market has grown, so has the number of players. How has competition affected returns?

We don’t see returns being under pressure because there is now so much variety in strategy. Indeed, 10-15 years ago, I’d say secondaries deals were all priced the same, but today, there’s much greater sophistication in the understanding of risk and pricing. While there are more players, there are that many more niches to play in and so much more dealflow, so the actual level of competition for deals has largely remained the same and our return targets haven’t changed in the past 15 years. We see secondaries as an absolute return strategy which can achieve attractive returns across the cycle.

In addition, each player will have their own angles on different deals and portfolio construction objectives and so they tend to treat the various types of secondary as you would ingredients to make a cake – the way you blend those ingredients will dictate how the cake turns out. For example, we combine LP position transactions with GP-led secondaries to benefit both from the cashflow profile of LP deals and the strong multiples in GP-led secondaries.

How do you see the market developing over the next few years?

I think we’ll see the market reach $100 billion, or very close to, of annual deal value this year – it was around $75 billion in 2018. More broadly, however, the secondaries market will continue to be the liquidity solution to the private equity world. As private companies increasingly seek to stay private, I can see a point where GPs will own assets for 20 or even 30 years, backed by different groups of investors, as liquidity will be offered through the secondaries market at varying points along the way.

I think we’ll see GPs find a way of baking in liquidity solutions to their funds at, say, year 10, even if they plan to hold some assets for longer. I know some GPs are already thinking about how this might work. Ultimately, that could well mean that they use the secondaries market as a fourth exit route alongside the traditional IPO, trade sales and secondary buy-out. As a result, four-track processes may not be that far away.