With the covid-19 virus spreading around the world, a bear market in public equities that began in March and a global economy on the verge a recession, the secondaries market, like much of the rest of the world – whether financial or otherwise – has come to a halt.
While this new environment spells challenges for the short term and likely a difficult year for secondaries in terms of both pricing and volume, the picture for the medium and long term appears much less grim. Market participants interviewed for this feature at the end of March recognise that the crisis may end up being a mere hiccup in the enduring growth of the secondaries market. They anticipate that the disruption will eventually present opportunities for investors and highlight the relevance of secondaries to private investments in the long run.
For now, activity in secondaries has mostly stalled as it did in the immediate aftermath of the global financial crisis in 2008. While valuations in public equity have fallen quickly and dramatically and markets are highly volatile, there is typically a delay in adjusting funds’ net asset values on the part of GPs. Most investors know valuations of private assets will be down as well, and it is difficult to assess by how much. In turn, this is deterring sellers who fear selling at too much of a discount and buyers who want to avoid catching a falling knife.
“Every market is different, and this certainly has similarities and differences with what we saw during the financial crisis in 2008,” says Tom Kerr, global head of secondaries at Hamilton Lane.
“There’s going to be a pause in transaction activity. The uncertainty and the volatility in the public markets and uncertainty in the private markets is a hindrance. We are already starting to see transaction activity largely halted and we expect that it will remain so for the near term as valuations and expectations reset. That is in line with what we saw in the prior crisis.”
Some deals that were already underway have been renegotiated and closed, but there are very few new transactions coming to market. Transactions in secondaries are priced based on NAVs from previous quarters. Until recently, buyers were still pricing off 30 September valuations and fourth-quarter valuations are only now available, none of which reflect the current choppy waters.
“As a traditional secondaries buyer you need to see the updated valuations before you can start trading again,” says Tjarko Hektor, founder and partner at New 2nd Capital. “Potentially, the full impact is only going to be seen in June 30 valuations that are going to come out some time in late Q3. The earliest you can start seeing significant activity in traditional LP volume is Q4.”
A pause to prepare
With almost everyone working from home and transactions few and far between, secondaries market participants have been focused on preparing for the future, staying in touch with GPs and LPs, and trying to identify the types of transactions that may become more popular or that may struggle in the new environment.
“We would expect that secondaries funds might pause for a few months and certainly pace themselves to really see what the implications of the current situation are going to be,” says Andy Nick, a managing director at investment bank Greenhill.
“There are so many more deal types in secondaries now, which will provide more fuel to deal levels coming out of this crisis”
“But with the global financial crisis as a reminder, they won’t stay inactive for very long because if there are willing sellers pricing at 20 percent or below where prices were six months ago, I believe the buyers are going to determine that those could be pretty good purchases in the medium to long term.”
In times of dislocation, the drop in public equity values and the resulting reduction in pensions’ public portfolios typically creates a denominator effect. The denominator effect may eventually force some LPs to sell private investments to comply with their asset class allocation targets, while others may be prompted to sell because they are liquidity constrained.
Eric Zoller, founder and partner at advisory firm and placement agent Sixpoint Partners, anticipates a potential increase in transactions focused on co-investments as a result of LPs overextending themselves in recent years by building large co-investment programmes to lower fees. As some of these co-investments need more cash to stay afloat, LPs could opt to sell their exposure rather than inject more capital.
Transactions that may take longer to return to market include tail-end portfolios as the pricing of the underlying assets is more dependent on the near-term sale of those assets. This would make pricing more challenging than it would be for a mostly unfunded portfolio or a younger portfolio with companies that have more time to recover.
Generally, large portfolios, which have been popular in recent years thanks to their high diversification, are likely to be out of favour for a while as pricing several hundreds of company stakes in potentially dozens of funds will be that much more difficult in light of the uncertainty.
“Diversified fund portfolios will be particularly hard hit in the short term simply because as a buyer, it’s really difficult to know what’s going on in a portfolio of 300 assets,” says Nik Morandi, a senior principal focused on European secondaries at CPP Investments, Canada’s largest pension plan. “Plus, some of the leverage providers are probably no longer there. The more diversified the portfolio, the harder it is going to be to get your arms around it.”
However, Morandi adds that the market could see funds of funds more active on the sellside. “In theory, they have the ability to be more realistic in terms of valuations,” he says. “They have terms and fund life that they have to manage, unlike some other LPs. It wouldn’t surprise me if we saw funds of funds try to wrap up vehicles and be potentially more tolerant to discounts to NAV, particularly if this helps preserve or ensure carry within these vehicles.”
Some GP-led transactions, which were mostly trading at par or at premiums in recent years, might also be more challenging to complete since pricing would have come down and LPs may be less willing to approve them. However, this won’t be the case for all GP-led transactions.
“I would envision, as the markets start to open up, one of the first types of deal to come back will be the single-asset recap market,” says Zoller. “That was a trend that clearly started before this market downturn, but coming out of this downturn, that solution now becomes all the more important and relevant because the M&A market will take slightly longer to recover. The single-asset recap market will be a nice bridge between the market dislocation and the opening up of the M&A market, perhaps much later in the year, if not the beginning of next [year]. That enhanced tool will now really be demonstrating its utility to the market overall.”
Diversity of deal types
Market participants also expect preferred equity and other types of structured transactions to play a much larger role once activity returns. In preferred equity transactions, an LP receives a cash distribution and at the same time retains exposure to the future upside of an asset after the preferred equity provider has been compensated.
“Preferred equity has long been perceived as a niche product in the market,” says Zoller. “Coming out of this market disruption, you’re going to be seeing a lot more players either raising dedicated funds to that strategy or allocating more capital within their existing strategy to that style of investing.”
“This is going to be a temporary disruption, but the secondaries market is on a longer-term growth trajectory”
New 2nd Capital
The growth of the secondaries market over the last decade has increased the diversity of structures and deal types that are now available during times of market dislocation. “That is another difference from 2009,” says Morandi. “There are so many more deal types in secondaries now, which will provide more fuel to deal levels coming out of this crisis.”
Hamilton Lane’s Kerr concurs. “You have a broader toolkit than in 2008 and 2009,” he says. “The overall size of the secondaries market is much bigger today and everyone is much more familiar with what secondaries are. I think that could prompt a lot of opportunities and a lot of conversations for creating liquidity off the back of what is a market dislocation.”
Amid the current uncertainty and delayed decisions from LPs to sell and GPs to address problem assets, it is likely the volume of secondaries transactions will be down in 2020 compared with the roughly $88 billion transacted in 2019, according to data from Greenhill.
However, as Greenhill’s Nick notes, volumes should recover reasonably quickly and 2021 could see a rebound. In 2009, volumes dropped to $10 billion from $20 billion the previous year, and jumped back to $23 billion in 2010, surpassing pre-crisis levels.
“It’s hard to say how this one plays out but certainly there’s a strong correlation to public markets,” he says. “Our thesis is that buyers will remember the deals they or their competitors did at the depths of the market that turned out very well and will thus remain more active seeking quality assets at reasonable prices this time around.”
Indeed, the vintage years following a market disruption can be some of the best in which to invest. Many secondaries investors are recognising that and are gearing up to remain active. In turn, this could further demonstrate the benefits of secondaries to the broader investment community.
“Investors, be that institutional but also high net worth, will continue to increase their allocation to private investment strategies in their portfolios,” says New 2nd Capital’s Hektor. “This is going to be a temporary disruption, but the secondaries market is on a longer-term growth trajectory. This crisis will only strengthen that.”