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Landmark on the duration mismatch

The traditional 10-year fund life hasn't changed but GPs want to hold assets for longer. That's where secondaries come in, says the firm's Barry Miller.

This article is sponsored by Landmark Partners and appears in the March GP-led Secondaries Special Report by affiliate title Private Equity International.

What challenges has the traditional private equity fund structure presented to GPs as the asset class has evolved?

Barry Miller

The challenge is that the ideal duration for portfolio companies does not always match the stated duration of funds. The private equity industry has evolved enormously, but one thing that has never really changed is the lifespan of investment vehicles. Funds still typically have a 10-year life, with two one-year extensions, yet the likelihood of a fund being seamlessly invested and divested within 12 years is low. What tends to happen is that there is a macro event, such as covid-19 or the global financial crisis, which extends the optimum holding periods for portfolio companies. At the same time, general partners still need to consider the liquidity needs of their underlying investor base. You need to be able to find a compromise, and that is where we see the secondaries market step in.

How is the secondaries market being used to resolve the mismatch between fund duration and the desire for extended holding periods?

If you go back half a dozen years, single-asset transactions were rare in the secondaries market. The focus was on diversified portfolios of LP stakes and some single LP stakes. In the last two to three years, however, we have seen the GP-led market take off. Deals where the GP is our counterparty have accounted for 25 to 30 percent of the market over the past couple of years and that share is only set to grow, with 2020 being a prime example where GP-led dealflow will likely represent closer to 50 percent of total deal volume. GP-led secondaries transactions provide the GP with an important new outlet for creating value in portfolio companies.

GPs now have a viable option for continuing to own and grow a promising business. If you have a business where you see tremendous opportunities for organic growth or transformational acquisitions, you do not want to sell solely based on the underlying investors’ desire for liquidity. That is where the secondaries market really comes into its own. As long as the GP can give existing investors the option to either participate in the go-forward transaction or take liquidity, it is a win-win.

Covid has created both opportunistic and defensive liquidity needs. Has the secondaries industry been able to step in or has uncertainty over valuations proved prohibitive?

The covid era effectively began in mid-March of 2020 when most people moved to remote working. This meant that when we were looking at Q1 net asset values, those only reflected two weeks of covid impact, which made it very difficult to determine intrinsic value. By the time we reached the end of the second quarter, however, there was a greater understanding of how business performance was going to be affected. In the restaurant or travel business, for example, doors were closed and revenues were decimated. On the other hand, medical supply companies and businesses providing critical IT infrastructure and security saw meaningful performance improvements.

As we moved forward through the second quarter, we saw this miraculous movement in the stock markets, such that even by the end of April, many GPs found some NAVs were up. By the end of June, some NAVs were up by as much as 25 percent. While secondaries transactions initially paused as people tried to get their heads around intrinsic value, activity rebounded in the second half of the year, primarily driven by GP-led deals, and 2020 deal volumes were therefore not the disaster many had expected them to be. As we look ahead into 2021, and it becomes increasingly easier to ascertain what assets are worth, there is real momentum building.

Fund finance has become increasingly sophisticated and is looking to address many of the same late-life liquidity needs as the secondaries market. Is that a source of competition for you?

The short answer is ‘it depends’. In many cases we are doing what we call structured growth equity – or preferred equity. That may compete with the fund finance market, although we are dealing in equity and not debt. As the covid crisis has continued, fund finance providers have become increasingly comfortable with the durability of assets and, as a result, we have seen growth in NAV-based lending. It is a market that will continue to expand because the need is there and because it has been a good business for lenders.

How would you describe LP appetite for GP-led secondaries activity?

LP appetite has grown enormously over the past few years. There was a notion that secondaries investment is all about diversification and that was the primary reason why LPs were investing in this space. However, as our head of quantitative research would say, you can actually ‘over diversify’. You can reach a point where your portfolio becomes so diverse that you negate some of the benefits of diversification and limit alpha production.

What we look to do, therefore, is diversify at a fund level. We do not need to have diversified transactions in order to deliver diversification. Many other secondaries managers have come to that same conclusion and there has been real growth in single-asset and concentrated-asset deals as a result. Indeed, today there is not enough capital in the marketplace to facilitate all the deals that are out there, which is why we are seeing secondaries GPs launching dedicated single-asset funds.

What does the future hold for the GP-led secondaries market?

Transaction volumes will continue to grow. One statistic we monitor is dry powder duration. We look at the available capital in the secondaries market and the pipeline of transaction volume, and then calculate how many years it would take to work through that. That figure has been hovering at between 18 months and two years.

Yet, as the definition of secondaries grows, and when we look at the sheer amount of NAV out there, it is clear the supply of secondaries is set to increase and that dry power duration will shrink to closer to 15 months. That will necessitate raising larger funds and creating more funds. It is a very positive dynamic.

Barry Miller is a partner in Landmark’s private equity group.