Preferred by specialists

The growth of preferred equity is an exciting market development. Are traditional secondaries players likely to get in on the action?

As the secondaries market grows, so does the array of options available to general partners seeking to benefit from liquidity from existing funds.

One option garnering interest is preferred equity, which allows GPs and LPs to raise capital against an existing fund by sharing upcoming distributions with the provider while retaining a stake in its assets.

A handful of firms, such as London-based 17Capital and Toronto’s Whitehorse Liquidity Partners, have established businesses to specialise in preferred equity. 17Capital was approaching a final close on its fourth fund above €900 million in February, while Whitehorse is raising its first fund, having secured a large cheque from the Alaska Permanent Fund Corporation.

Preferred equity providers address a gap in the market between debt providers and secondaries buyers. Sellers take on preferred equity – a tranche that sits between debt and equity in the capital structure – instead of selling stakes in their portfolios. In this way they retain exposure to any potential upside, which would be lost in a secondaries sale, and don’t require credit support from limited partners as they would with debt.

The strategy is no longer the preserve of the specialists. Canada Pension Plan Investment Board offers preferred equity to GPs and Secondaries Investor has learned that at least three large secondaries buyers have provided liquidity solutions based on preferred equity. All three buyers agreed, however, that it is a tool only seldom called on.

One large buyer said it was approached by a fund manager looking to do a preferred equity recap of its fund, and that the transaction ultimately didn’t add up for either party. “We spent a lot of time with them on that situation, but it was very expensive,” he said. “They ended up going with more traditional leverage.”

Another buyer said that while it doesn’t typically go into a transaction with the intention of providing preferred equity, “it’s one of the tools we have at our disposal, if that’s our best chance to secure a transaction”.

Preferred equity is an expensive option for a GP; it can cost around 10 percent of the capital raised, said one of the buyers, as well as a portion of the upside, compared with a plain debt facility which could be as low as 3 percent.

One secondaries advisor noted that the challenge with preferred equity is that it doesn’t necessarily fit the risk return profile of most secondaries funds, which are typically looking for IRRs in mid-teens.

“The question is around pricing on those transactions and whether it is an appropriate fit for a traditional secondaries fund,” said one buyer. “Maybe it’s not the secondaries fund that has the right cost of capital for that, but it’s somewhere else where it can fit.”

That somewhere else could be a dedicated fund, such as those run by 17Capital and Whitehorse.

It is still early days for the preferred equity market; it remains to be seen how it will develop and what growth will be sustained by GP and LP demand. “The groups that have focused on it thus far have generated good returns and continue to grow,” said the advisor. “The question is how much more that market grows.”

What are your thoughts on market dislocation for secondaries? Email us at marine.c@peimedia.com