According to Bain & Company’s Global Private Equity Report 2020, more than 75 percent of US buyout deals in 2019 had leverage multiples of more than 6x EBITDA, compared with just 25 percent between 2009 and 2011.

The rise of concentrated GP-led restructurings including single-asset processes, combined with the impact of the coronavirus, means this is a potential problem for secondaries funds in a way that was not the case 10 years ago.

How are debt-laden assets experiencing distress likely to affect returns for GP-led transactions? And what can secondaries investors do about this?

The steep drop in Q1 valuations compared with the previous quarter has led to some GP-led deals being valued below cost, several sources told Secondaries Investor. Some deals were done with “toppy leverage levels”, said one London-based buy-side director, on the assumption that if the companies performed as expected, they would be able to refinance.

“If operating performance is impacted, they’re not going to be able to [refinance],” the director added.

Companies have gone bankrupt and will continue to do so as a result of the coronavirus, but not before all options are exhausted. Banks typically do not want to take businesses away from sponsors. According to one debt advisory partner, GPs can negotiate new credit lines, though heightened risk aversion on the part of lenders is making this difficult.

State aid is also proving hard to come by for many PE-backed companies due to difficulties meeting the criteria. Consequently, secondaries funds will have a significant part to play.

“The GFC was a Wall Street-driven liquidity crisis; this is Main Street-driven,” said David Wachter, co-founder of direct secondaries firm W Capital Partners. “Because economic sectors will be impacted very differently, secondary solutions will have to be targeted and asset-specific, not just about leverage and LP liquidity.”

Many GP-led deals may not have sufficient follow-on capital to help assets through a crisis. If more capital is required, secondaries funds will be dependent on having flexible recycling provisions which allow them to direct distributions from elsewhere in the portfolio to service debt or make follow-on investments. Those with weaker provisions than their peers will have their returns “crushed on a relative basis”, said a New York-based managing director at an advisory firm.

The alternative is to raise extra capital from LPs on an ad-hoc basis, which is potentially messy. If a continuation vehicle has 10 LPs, all of them will have to be convinced to put up their share of capital, said one US-based buy-side veteran. What happens if they do not or cannot is not always clear.

“The legal documents aren’t necessarily built to say, ‘if you need capital and certain LPs don’t have it, the rest of you can put up the money and those that can’t get diluted,” the buy-side veteran added. “The syndication of fund restructurings to manage risk created a different kind of risk.”

Preferred opportunity

This situation represents a challenge for secondaries funds and an opportunity in the form of preferred equity, according to Michael Hacker, managing director at AlpInvest Partners, which is one of several large firms to have written preferred equity cheques since the covid-19 crisis began.

Many GPs see it as the quickest, least-conflicted way of injecting capital into fully called funds. Unlike when taking on new debt or doing a GP-led restructuring, it does not require LP approval – though approval is advised.

On the flip side, it tends to be more expensive than NAV-based debt and more difficult to explain to LPs. The lower risk-return profile of preferred equity deals and their limited upside mean they do not fit neatly with the transactions that large secondaries funds typically invest in.

Secondaries funds are exploring ways around this: for example, by extending hybrid preferred equity and debt tranches. The coupon attached to the latter gives comfort to LPs more familiar with the structure of debt financing, and the blended cost is lower than it would be for straight preferred equity.

Last year, Pomona Capital extended a back-levered preferred tranche to London-headquartered Palamon Capital. Borrowing a portion from the bank at a lower interest rate allowed it to lend more cheaply, with the bank being paid via preferential cashflows from Palamon’s portfolio. As more secondaries funds move into issuing preferred equity as a result of covid-19, there could be more similar deals, according to two market sources.

Whether the steady trickle of preferred deals turns into a flood depends largely on the availability of debt financing – preferred is rarely the cheapest option. Yet, the strategy is already playing a role in providing extra capital to portfolio companies and helping secondaries funds put money to work in a market where all-equity deals are, for the moment, thin on the ground.

This is the third part of a series on leverage use in secondaries. Part I looked at fund-level leverage, Part II at transaction-level financing