Northleaf’s Flood on finding inefficiencies in the mid-market

Congratulations on your inclusion in this year’s SI 30 list of biggest secondaries fundraisers. How would you characterise the last year in terms of dealflow? What types of transactions have been keeping you busy?

We are pleased to be on Secondaries Investor’s list and we’re extremely grateful for the support of the investors in our secondary strategy. Over the past 15 years, we have built a one-stop shop for mid-market secondary transactions – which for us means opportunities of less than $100 million in size — with the capability and flexibility to source and execute transactions across the entire spectrum of secondary deal types. From a dealflow perspective, we expect 2019 will be another record year for volume in the overall industry and at Northleaf.

In terms of deal flow, approximately 50 percent of what we see are LP portfolios, leveraging the access and informational advantages generated by our extensive global primary investment platform. We think that this flow will likely strengthen over the next few months as sellers look to close transactions before year-end. The other 50 percent (and growing) comprises more complex deals such as GP-led restructurings and tender offers, fund level preferred financings and direct secondaries. We proactively source these opportunities by leveraging both our primary investment program and the broader Northleaf mid-market investment platform, including our direct investment capabilities across private equity, private credit and infrastructure.

You recently raised $1 billion for mandates with institutional investors such as Canada Pension Plan Investment Board, including $400 million for secondaries. How will this capital be invested?

Our investment strategy and focus will remain the same. A consistent focus on all types of mid-market secondary transactions will enable us to generate the kind of outperformance from our secondaries program that we have produced historically. We are particularly well-positioned to identify value in this part of the market by leveraging the access and informational advantages of our primary investment program, as well as our direct private credit and infrastructure programs – each of which are mid-market focused.

The CPPIB custom mandate is focused on Canadian mid-market private equity opportunities to produce top-quartile investment returns through primary, secondary and direct co-investments that fit the stated portfolio guidelines of the mandate. This custom mandate provides CPPIB with access to the Canadian private equity market and is complementary to CPPIB’s own internal investment strategy.  

How competitive has the secondaries mid-market been over the past 12 months since we last caught up?

It’s always a competitive space, but we continue to demonstrate that market inefficiencies exist – particularly in the mid-market. Our team also tracks industry dry powder as an indicator of whether the industry has too much capital. Despite all of the industry talk about the record levels of dry powder, our analysis indicates that secondary dry powder is within reasonable ranges when placed in the context of secondary deal volume. While dry powder is estimated to be at an all-time high of $91 billion, secondary deal volume in 2018 was estimated at $70 billion. By including near-term fund-raising assumptions of an additional $44 billion and comparing that to record first half 2019 deal volume of $42 billion, which when annualised comes to more than $80 billion, it will take less than two years for 100 percent of current secondary capital to be invested. In this context, Northleaf’s focus on mid-market secondary transactions allows us to prudently invest private equity secondary capital as there are significantly more deals by number with less competition at the smaller end of the market.

We’re in the longest bull-run in history. How is Northleaf preparing for a potential market downturn?

We are certainly aware that we are more than a decade into an expansionary period and believe that it will be tougher in the next five years to deliver the kind of returns we have in the recent past. We are seeing some “late cycle” behaviour from certain competitors – an indication of the need for increased caution in our underwriting. This includes a significant reliance on leverage at the asset and fund level to win transactions, the emergence of single asset continuation funds with limited management team alignment, restructurings led by lower quality management teams and/or with lower quality assets, and high pricing on cyclical and tail end portfolios.

In this environment we are staying disciplined, focusing on high-quality, well-aligned management teams and tilting our portfolio to transactions that feature downside protection across all secondary deal types through our own deal structuring. We are also targeting portfolios with exposure to less cyclical end markets.

Michael Flood is managing director and member of Northleaf’s investment committee. He oversees the origination, evaluation and monitoring of the firm’s private markets investments and leads its private equity investment team. Flood is also involved in Northleaf’s investor relations and business development activities.