Leverage in secondaries: crossing into the mainstream

Whether for acquiring portfolios, ensuring the efficient use of investor equity, or for returning value to investors, secondaries participants are increasingly viewing debt as part of their strategic mix, explains Simon Hamilton, head of Investec Fund Finance.

With dry powder estimated to be between $50 billion and $60 billion, the growth of the secondaries sector has been significant since the financial crisis. While funds are raising more capital, they are also becoming more comfortable using leverage, which is further increasing the amount of capital in the market.

Investec’s own research suggests that the use of third-party debt, while already an established feature, looks set to expand radically as the market develops. Of the market participants at Investec conferences in the US and Europe,  only 25 percent have used debt, 75 percent expected to do so, and less than a third said it is possible to remain competitive without leverage.

There are three clear trends regarding the use of debt in the secondaries market:

1. Acquisition finance at the outset of buying portfolios
2. Ensuring the maximum amount of capital raised is being deployed
3. Recapitalising existing portfolios

The first trend on acquisition finance has become increasingly prevalent. While historically the market was dominated by shorter-term capital call lines against investor commitments and deferred consideration, third-party acquisition financing is an increasingly common feature and one that is well-understood by investors and their advisers. The shift toward using acquisition finance is not only a desire to enhance internal rates of return but also the money multiple, which funds are seeing as important to differentiate themselves at their next fundraising.

The second trend on maximising equity deployment involves funds’ increasing use of leverage from third-party lenders to ensure that all the capital raised is invested into assets rather than held aside to meet undrawn commitments, which may or may not be serviced from distributions. It is costly to commit capital and investors want to see a return on every pound/dollar/euro they put in to a fund. Third-party debt can be a cost-effective means of provisioning for timing mismatches between drawdowns and distributions and any unexpected costs, leaving investors’ capital free for deployment in the market.

The third trend, evident from Investec’s own research, was that dividend recaps are an easier form of financing as leverage is applied to an existing portfolio. It is an area that Investec has seen developing over the last two or three years and, as a flexible tool for managing a secondaries portfolio, one that bears examining in detail for secondary funds, fund of funds and the wider limited partner community.

Why do dividend recaps?

Recaps are a means of both delivering value by boosting IRR and also maximising investment capability. Done at the right time, they can help LPs as a recap returns capital at a relatively low cost of finance, allowing LPs to redeploy that cash into other investments and opportunities. The benefits also extend to GPs by helping them reach the performance hurdle sooner than they would otherwise.

Recaps are a valuable alternative to selling assets for those who want to extract value from their portfolios without losing the upside in carefully selected positions, which still provide opportunities for growth. For more mature and lower geared portfolios, applying a dividend recap can help to create an optimal capital structure for the portfolio.

The process of doing a debt-funded recap also has the advantages of familiarity and timing, both in terms of the portfolio being an existing portfolio and therefore well understood, and in terms of the opportunity to dictate the speed at which the facility is put in place.

Changing perceptions

Some 45 percent of market participants have considered dividend recaps, Investec surveys found. The historical perception was that dividend recaps only benefited GPs, but many people now are comfortable with dividend recaps as a way to release capital and provide an optimal capital structure for the fund, as well as enhancing returns.

If the principles behind recaps and the process of obtaining leverage are familiar, other aspects are not. It is true that leverage for this purpose isn’t appropriate for all portfolios but it is more accessible than many GPs believe. A misconception is that it is only applicable for very well-diversified portfolios, but trends in the market show that not to be the case. Specialist lenders such as Investec, with a deep understanding of the underlying asset class, will also consider more concentrated portfolios such as secondary direct portfolios. The size of a portfolio or fund doesn’t solely determine the appropriateness of leverage, factors such as the asset and counterparty quality and existing leverage on the underlying portfolio are also important drivers.

There is also flexibility around the advance rate required.  By taking additional hybrid credit-enhancing features such as supplementary asset pools or LP commitments security, higher levels of leverage could be supported. There is no right answer and each management team must decide what works for them. Some GPs currently limit their use to sub-portfolios rather than entire funds to ring-fence the risk. For others, it’s an option at the overall level but not for individual transactions. Generally speaking, when considering leverage, flexibility around covenants and structure is equally as important as pricing and quantum.

Is it right?

When clients are assessing portfolios, they consider what is acceptable to both the client and the bank. Leveraging a portfolio is no different to buying a portfolio, the drivers include quality of cash flows and portfolio diversification. However, when evaluating if leverage is suitable, one of the critical follow-on steps is to assess the leverage on leverage effect to ensure the fund is geared appropriately for the assets.

Clients who have used leverage multiple times before have found that the constructive dialogue with the experienced lender coupled with the joint assessment of leverage appropriateness, has also helped them internally in their decision making. In some cases, a portfolio is simply not suitable for leverage.

Thankfully, understanding of the implications of taking on leverage is improving. As with any credit provision, the use of leverage must be appropriate and the right risk management procedures must be in place. These encompass two key areas: understanding the suitability of portfolios for further debt and their ability to negotiate “market speedbumps”; and selecting the right partner as lender.

Investec Fund Finance is a specialist finance provider focused on lending to funds and fund management teams.

Disclaimer: The opinions and views expressed are for information purposes only and are subject to change without notice. They should not be viewed as independent research, recommendations or investment advice of any nature.