Deal-level leverage ratios have increased in recent years, with loan-to-value proportions rising last year to around 40 to 50 percent, from below 40 percent a year earlier, according to research by Campbell Lutyens.

See all Secondaries Investor’s coverage of covid-19 and its impact.

Transaction leverage in the secondaries market is applied by forming a special purpose vehicle around the portfolio being acquired. The size of the LTV, and the number and stringency of covenant tests, are applied on a case-by-case basis with recourse to the assets. The loan is paid via a cash sweep of distributions. LTV on the loans employed by some of the largest secondaries buyers are often in the 50 to 60 percent range, market sources told Secondaries Investor.

What does the coronavirus-related shutdown mean for the health of these outstanding financings? And how will this in turn affect dealmaking?

Early wobbles

Secondaries Investor is aware of one portfolio, acquired by a mid-sized, US-headquartered secondaries firm, in which the LTV of the debt used in the deal has dropped enough to trigger a covenant. We are also aware of a secondaries fund that has called capital from limited partners in order to de-lever several special purpose vehicles. Second-quarter valuations are expected to be down again, further testing the structure of these deals.

Still, according to most market participants Secondaries Investor spoke to for this series, a full-blown crisis related to transaction-level debt is unlikely. SPV-level leverage tends to be more popular among larger firms, which have been able to take advantage of their reputations and a borrower-friendly market to secure flexible lending conditions. LPs who may be facing an increase in capital calls are still unlikely to default en masse, sources said.

“Usually there is enough cushion, even if NAVs fall 20 percent,” said one senior London-based buyer. “I don’t think you’ll find too many of these structures tripping their covenants. Even in they did, they can just call capital.”

Arid landscape

The deals that are closing amid the coronavirus-induced downturn must contend with a changed environment for deal financing. Secondaries Investor is aware of one large portfolio transaction agreed prior to the onset of covid-19 – which closed as a 100 percent equity trade due to the inability to secure SPV-level finance at the desired cost.

Unlike during the global financial crisis, banks are in good health. No market participants that Secondaries Investor spoke to for this series said they expected mass withdrawals from the SPV lending market. According to Tristram Perkins, co-head of secondaries at Neuberger Berman, a pause on lending by many banks could mean portfolios trade at lower prices, portfolios are dismantled into smaller pieces and a more level playing field emerges.

“Given the scarcity of leverage, given the cost of that leverage, I think those big buyers, the most aggressive pricers of risk, could be side-lined for a period of time,” Perkins said.

Deferrals – where buyers can agree to a higher price in exchange for a portion of the total being paid later – were on the rise prior to this year’s pandemic. According to research by advisory firm Campbell Lutyens, 43 percent of buyers last year used deferrals, compared with 38 percent the prior year. Their use has also become more aggressive, with 55 percent of deferred payment structures extending beyond 12 months last year, compared with 28 percent in 2018.

Many of these deals are done under the assumption that interim distributions will finance part or all of any deferred component – something that is no longer a given in the downturn of 2020. During the deferral period, the value of the portfolio could drop far below the amount the buyer agreed to pay for it. The buyer could have to choose between making more payments on a portfolio that is already underwater or defaulting.

“The counterparty is not a commercial bank with which you can negotiate an extension or do an equity cure,” said Benjamin Revillon, managing partner of Nice-based secondaries firm BEX Capital. “It’s a seller to whom you owe money and who has a pledge over those assets.”

We could now see an increase in the use of deferment mechanisms, according to two sources. With credit tightening, they could be the easiest way to bridge gaps between buyers and sellers.

In the long-run, this crisis could have a notable impact on how LPs choose secondaries funds, said Johanna Lottmann, managing director at PJT Park Hill. Funds that use the most leverage will experience greater volatility, making it clear how they achieve most of their target return.

“LPs should start to dissect track records to see what was returned on a levered and what was returned on an un-levered basis,” Lottmann said.

Part I of this mini-series looks at fund-level leverage. Stay tuned for the next instalment looking at the effect of portfolio company-level leverage on secondaries deal performance.