Leverage is not new to the secondary market, but it has become more prevalent and consequently LPs should keep an eye on the impact of its usage, says Chason Beggerow, a partner at private equity advisory firm Altius Associates.
The secondary market in 2014 enjoyed another year of record transaction volume. Industry sources expect volume to be in the $30 billion to $35 billion range, representing a record and the fifth consecutive year of growth in the industry.
A variety of factors contributed to the transaction volume including strong public and private markets, regulatory pressures (forcing financial institutions to sell or consider selling), considerable supply of capital for secondary transactions, the increasing trend for portfolio management of private markets portfolios, and strong pricing. The secondary market continues to mature and evolve at a rapid pace as buyers are continually looking at innovative structures and new sources and types of deals (rather than the traditional purchase of fund interests).
One contributor to the growth in volume and strong pricing over the past few years is the increasing use of leverage. Leverage is not new to the secondary market, but it is certainly fair to say that its use has become more prevalent over the past few years as a way to enhance returns. Secondary buyers have historically used leverage in several ways:
- Deferred payments on transactions (where the buyer will pay a portion of the purchase price six to 36 months after close): vendor financing in the form of a deferred payment has been a popular tool to consummate transactions in the current market, particularly in instances where the seller might be selling for strategic or regulatory reasons and doesn’t have an immediate need for cash
- Third party leverage on transactions: there are a growing number of financial institutions that are interested in providing leverage to fund secondary transactions. This increased supply has lowered the cost and improved the availability and terms associated with such leverage
- Fund-level leverage: Secondary funds have historically used fund level leverage to assist with the administration of capital calls and other fund-level working capital issues; however, more recently, this type of financing has become less expensive with better terms, prompting some managers to contemplate expanding its use as a tool to enhance fund level returns.
Proponents of leverage in the secondary market will argue that some of the larger portfolio secondary transactions are highly diversified (by manager, geography, company, and strategy) and are well suited to appropriate levels of leverage. From what Altius has seen to date, the use of leverage by secondary buyers has largely been conservative and has not been applied to more concentrated secondary transactions. Altius is not aware of a situation where leverage has impaired an investment or where a secondary buyer has not been able to service its debt.
The growing use of leverage, however, has occurred during a period of industry tailwinds, increasing public and private equity markets and historically strong distributions over the past few years. As all investors are aware, leverage can enhance returns when asset prices are going up but can also magnify losses when asset prices are going down. The secondary market has yet to endure a down market with an increased use of leverage.
As 2015 unfolds, LPs interested in the secondary market (both by investing in secondary funds as well as accessing the market directly) should keep an eye on the amount of leverage in the secondary industry, and consider:
- Is the growing use of leverage pushing and keeping prices in the secondary market artificially high? A prudent approach to leverage in the secondary market would be to underwrite the transaction on an unleveraged basis and then use leverage conservatively to moderately enhance the returns. However, there is growing anecdotal evidence that the availability of leverage is pushing prices higher and being used more as a tool to allow a buyer to stretch on price to consummate a deal. Certainly, for buyers that have taken this approach there is a chance for disappointment and underperformance if/when the markets turn. Additionally, this impacts secondary buyers that do not use leverage as they are forced to bid higher (and take lower returns) to win a transaction
- What is the impact of leverage on the cashflow patterns of investing in secondary markets? One of the attractions for many (although not all) investors in the secondary market is the expectation for quicker and regular return of cash from a commitment compared to investing in primary funds. If there is leverage that must be paid down, some of the cashflow generated by the underlying assets must be diverted to service and pay down the debt. It is important to keep in mind that the ability of a secondary portfolio transaction to service its debt obligation comes from the distributions within the portfolio (such as through sales, recaps, and dividends). Over the past few years, the industry has had record distributions. Historically, however, the level of distributions has been cyclical and subject to downturns in capital markets and the mergers and acquisitions cycle. For LPs who are primarily interested in strong returns, this may not be an issue, but it is worth watching the distribution patterns of secondary funds
- How does the increase in leverage impact the evaluation of secondary fund managers – both understanding the performance of secondary fund managers and their transactions as well as the risk taken on by the managers? For LPs that access the secondary market through secondary fund managers, understanding a manager’s use of leverage to generate returns and the amount of risk assumed will be critical. In many ways this is no different to comparing buyout managers, some of whom may use leverage more aggressively than others, but this has not been as much of an issue historically in the secondary market
- From a risk standpoint, potential LPs for secondary funds must remember that many of the portfolios being acquired have leverage at the underlying portfolio company level, so applying leverage at the transaction level represents a second layer of debt on the transaction. As mentioned earlier, many of these transactions have not been through periods of stress, so it is difficult to predict exactly how they will react.
Ultimately, the question is, is the increased use of leverage in the market savvy deal-making by buyers and a natural evolution of the industry, or a mechanism for driving up prices and adding risk to portfolios?
Chason Beggerow is a partner on Altius Associates’ global investment team. He focuses on the firm’s secondary limited partnership and co-investment efforts and is based in Richmond, Virginia.