TorreyCove Capital Partners has downgraded its rating for secondaries amid a warning that significant capital overhang means overall pricing and profitability will suffer.
The advisory firm changed its rating for the strategy to “neutral” from “moderate overweight” in its 2017 Private Equity Market Outlook for February. The firm has five ratings ranging from “strong overweight” to “strong underweight”.
“The overall private equity market is showing many signs of frothiness and the secondary market is not immune,” David Fann, the advisory firm’s chief executive, told Secondaries Investor. “Generic secondary transactions are trading at robust prices – however, like most things, there are nuances. We see secondary innovators buying interesting secondary directs and actively driving fund restructurings.”
The trend for GP-originated transactions comprised an estimated 25 percent of deal volume last year and will continue to increase, the outlook noted.
The firm also said the difficult pricing environment and need to put capital to work means the use of leverage will “persist and may intensify” as secondaries funds hunt for private equity-style returns in a challenging pricing environment. Lenders may benefit from providing debt to secondaries deals over other opportunities, according to Fann.
“For debt providers, [backing a secondaries deal] is an interesting risk-return paradigm. For most secondary trades, there isn’t much downside or credit loss,” he said. The historical loss ratios for secondaries have been extremely low, and earning a market-based interest rate with low risk of principal loss is “benign” compared with other lending strategies, he said.
In addition to record amounts of dry powder – as much as $120 billion this year, according to investment bank Evercore – and rising prices for secondaries stakes, the regulatory environment in the US may also shift against secondaries as the anticipated relaxation of financial rules may not provide the same motivation for institutions to divest their private equity interests, the firm noted in its outlook.