The secondaries market has accepted debt as a tool to remain competitive while bidding, so firms are now considering other ways in which they can use leverage.
“We’re seeing more interest in leverage and financing,” said Ram Rao, managing director at Macquarie Capital. “Many firms didn’t want to use leverage two or three years ago, but they are now being outbid. They’re trying to figure out how to be more competitive.”
It’s important to keep in mind that despite leverage becoming much more mainstream in the secondaries world, it’s still a relatively small market.
Leverage in the secondaries market, mainly third-party financing and deferred structures used on a transaction basis, amounts to about $5 billion to $8 billion, or 5 to 10 percent of total secondaries dry powder (capital being committed but not invested and funds currently being raised), according to an industry source who declined to be named.
Market participants believe the role of leverage in secondaries will only grow, and firms are actively curious about how it can help them.
Some of the other areas they are exploring involve using debt for dividend recapitalisations at the secondaries fund level and to curb losses related to currency volatility.
“More and more firms are interested in doing dividend recaps,” said Rao. “They’re trying to improve internal rates of returns and distributions to paid-in capital.”
This method involves a secondaries firm borrowing a certain amount from its lender and then directly returning that capital to its limited partners, who get their distributions faster.
When cash actually starts coming back to a secondaries fund, it can recycle it immediately at the fund level. It’s especially attractive to secondaries firms because cashflow starts coming in earlier than with primary funds where cash takes several years to be returned.
“Dividend recaps are very attractive to secondaries fund investors because cash distributions are received earlier than the need to wait for distributions to come from the underlying funds,” Rao said.
At Investec, Gregg Kantor said he has received several inquiries from secondaries firms trying to hedge currency volatility. Currency volatility is particularly a problem for US-denominated funds with investments in euros, as Secondaries Investor previously reported.
“Managers are worried about coming out of their carry as a result of adverse currency movements,” Kantor said, adding that euro-denominated funds with dollar assets have benefited as a result of the same currency movement.
Natural hedges have not worked as well because some currencies, like the euro, have gone down dramatically this year. But there are several ways secondaries firms can curb currency volatility.
Secondaries funds can use foreign exchange contracts to protect against falling currencies, but typically they need to put up cash as collateral. Instead of calling cash from its LPs or using their own cash, firms now have options. They can get a loan and use that cash as collateral for the trade or collateralise the hedge with undrawn commitments from investors.
Firms can also use their portfolio as collateral. Kantor explained that they use the net asset value of a fund as collateral for the trade and Investec charges a little more than the currency price in that instance because of the added risk.
Another way is to simply borrow in the currency a firm is trying to hedge, typically these days in euros.
“Secondaries buyers are becoming more sophisticated,” said Kantor.