As the covid-19 lockdown continues, the private equity secondaries market is in a state of paralysis. Some predict a prolonged suspended animation, others a return to normalcy within months, and still others a long-lasting gold rush of historic proportions. To understand how the secondaries market could “re-open”, it is useful to review the relationship between past economic crises and the asset class.
In many ways, the foundation of the modern secondaries market was laid by the Jimmy Carter administration in the late 1970s. The Monetary Control Act of 1980 was a watershed piece of legislation that removed controls on bank interest rates and repealed federal usury laws. This was followed in 1982 by the Garn-St Germain Depository Institutions Act, a Reagan-era deregulatory bill that further unshackled banks, enabling capital to flow even more freely throughout the US financial system. Over the decades that followed, financial deregulation broadened and deepened – London saw the “Big Bang” of 1986, the US repealed the Glass Steagall Act in 1999 and developing markets restructured to receive inbound capital flows from the developed markets. The result: the world’s capital markets became highly interconnected.
The loosening of capital controls within sectors and across borders has been one of the most important drivers of world economic growth over the past 40 years. While the political debate will rage as to whether flexible capital flows have been appropriately channelled considering labour, climate and other competing policy objectives, there is no denying that the positive impacts – broad-based innovation, unquestionable productivity gains and profound wealth creation, among others – are the direct results of a more malleable regulatory framework.
A more problematic consequence of global capital flows has been asset “bubbles”. These have emerged repeatedly in different jurisdictions over time, resulting in financial crises as wave after wave of capital washed across unprepared economies and ill-equipped regulatory structures. The Latin American debt crisis of 1982 was the first in this series, followed by the US savings and loan crisis of 1988, the junk bond crisis of 1989, the Asian debt crisis of 1997, the dot-com bubble of 2001, the great financial crisis of 2008 and the European debt crisis of 2010. Ultimately, all these crises were resolved by a combination of self-correcting market mechanisms and timely government intervention. Central to the market mechanisms was the emergence of a global secondaries market for illiquid financial assets.
Many of today’s marquee alternative investment franchises were formed in the secondary market crucible of financial crises. Would Goldman’s Whitehall Funds and Morgan Stanley’s MSREF franchise come into existence if not for the S&L crisis? How about Apollo if not for the junk bond crisis and Executive Life? What about Fortress, Oaktree, Lone Star and Avenue if not for the Asian debt crisis? Lexington, Landmark and Coller Capital if not for the dot-com bubble? TSSP and Blackstone Tac Opps without the GFC? These firms were able to differentiate themselves and create lasting track records by courageously investing into the deflating asset bubbles while others were retreating or holding their dry powder.
The “wash-rinse-repeat” cycle of the serial financial crises has been a proving ground for the secondaries market. Having grown out of episodic, turbulent points in financial history, the market has become a durable, vibrant and institutional pillar of the private capital markets, one that is available in “ordinary course” times as well as moments of crisis. The secondaries market today serves as critical ballast to the excesses of freely-flowing global capital.
And now covid-19 presents a new type of challenge. A health crisis – rather than a financial crisis triggered by an asset bubble – is causing immense economic damage at an accelerated pace. This crisis is indeed different, and perhaps we cannot depend upon playbooks from earlier days. So, the question must be asked if the secondaries market will assume the same corrective role it did in earlier crises.
We believe the answer is yes, and that the secondaries market will indeed play an important role in rejuvenating the larger economy. However, we believe that its role will be more flexible, innovative and sophisticated than it has been in past crises where it largely acted as a clearinghouse for mispriced private assets.
The common narrative for post-covid-19 activity seems to be that the secondaries market will see a surge of preferred equity transactions before LP portfolio sales return in force, followed later by GP-led transactions. The thought is that GPs and LPs will execute “pref trades” to meet liquidity-induced demands. This line of thought has echoes to 2009 when similar arguments were put forward that structured transactions would lead to a surge in 2009 secondary volume. This did not happen. In fact, in 2009, we saw a decline in secondary transaction volume of 35-40 percent, making 2009 the only down year in secondary market history.
When the market did pick up in subsequent years, traditional “LP book” transactions drove the market. What is different now is that financial institutions are not in crisis as they were in the GFC. They and other holders of LP interests will not be under regulatory and financial pressure to sell LP books. In addition, holders of LP portfolios understand how quickly pricing can stabilise over several quarters. Therefore, holders will have no appetite for sales at sizable discounts to book value and will wait before resuming “ordinary course” portfolio management.
In contrast to the big LP portfolio fire sales of 2009-2011, we believe the 2020-2022 secondaries market will be led by GP needs. At the time of the GFC, there were some proto-GP transactions in the form of spin-outs and carve-outs; however, GP-led deals had not yet entered into the secondary market tool kit. Coming into the covid-19 crisis, GPs had begun to routinely use the secondaries market to address a variety of strategic and tactical issues. We believe that this trend will continue unabated in the post-crisis environment as secondary investors work closely with GPs to funnel capital to individual companies and funds with capital requirements. Hence, we believe that the best opportunities and performance in the secondaries market post-crisis will go to the best “stock-pickers” and not the best indexers – and this dynamic favours specialist investors with direct underwriting skills and appetite for concentration risk.
In the final analysis, the secondaries investors who will lead in the post-covid-19 environment will be those who are the nimblest and most innovative. They will be the first to turn on the spigot, the fastest to deploy capital and the most creative in structuring deals. They will embrace new capital markets solutions while at the same time demonstrating superior ability to conduct deep-dive fundamental analysis with conviction. They are also likely to be able to invest with dexterity up and down the capital stack, embracing credit and equity opportunities in creative, customised ways.
But none of this should come as a surprise. The secondaries market has matured in the past few decades to become a necessary salve for cycle-inflicted economic wounds. The covid-19 crisis poses a unique set of challenges, but secondary investors are accustomed to investing into complex, fraught and dislocated situations. The market’s ability to foster innovative solutions that are relevant to the specific facts on the ground is an important and reassuring attribute that should provide some hope for an economy slipping into covid-induced chaos.
Jeff Hammer and Paul Sanabria are global co-heads of secondaries at Manulife Investment Management.