Deferred payments, leverage and the use of older record dates to price deals are common techniques that enable buyers to pay more and minimise discounts to net asset value. They are also helping sellers receive a more palatable price for their fund positions. The result is that deal activity hit record levels in 2014.
However, secondaries deal structuring has another benefit as Europe teeters on the brink of another crisis. It allows buyers to get quicker distributions and book higher early returns, to take the heat out of investments in case the market turns.
Investors appear divided on the probability of a Greek exit from the euro and the potential extent of the impact. Share prices remain high, fuelled by high levels of liquidity and underpinned by low oil prices. The Euro Stoxx 50 index, which includes 50 blue-chip stocks across Europe, is up by 10 percent since the start of the year. The increase could soon spell higher valuations for private equity companies, but some investors are bracing for a slump in the future that could wipe billions of dollars off global stock markets and private equity valuations alike.
“You have a lot of deals being done off old record dates, being done using deferred consideration or using leverage to help returns. All that is to lock in money multiple and internal rates of return very quickly and get distributions out,” said Ian Shanks, a senior investment manager at Aberdeen Asset Management. “So if there is a downturn in the market, you have some locked-in returns already.”
Leverage and deferred consideration can work in different directions. Leverage can increase the overall money multiple of an investment but flatten the initial annualised return as cashflows go into debt servicing. But some 25 percent of buyers used third-party financing on individual deals or at fund level, in 2014, and more are considering using it in the future, according to a report from Cogent Partners.
Meanwhile, deferred consideration boosts the initial IRR as buyers need to put less cash in up front, and can start banking distributions before the full payment is made. Together, the two can provide a powerful combination, and are widely used by large secondaries buyers.
Deal structuring can improve investment performance by 25 percent to 30 percent, according to Olivier Decannière, head of the private equity group at Ardian UK. “Our approach is just to use structuring as a booster for performance – not as a way to make performance or win a portfolio,” he said. The vast majority of Ardian’s fund performance comes from carefully picking assets that will deliver strong returns, he added.
The benefits of structuring are not lost on sellers either. In a competitive market, where large portfolios of assets are auctioned, rather than sold quietly behind closed doors, leverage can help buyers pay more. Similarly, deferral of around 30 percent of the payment for up to a year, can turn an offer at an unappealing discount to NAV into a price at nearly par.
Buyer underwriting rates decreased in 2014 and are likely to remain under pressure in 2015 as buyers compete for deals, Cogent said in its report. In other words, secondaries buyers are getting less of the reward from structuring, while sellers are getting more.
There is no secret structuring formula for buyers to reduce their risks, but rather a common sense approach. “Stay cautious; don’t go too high in terms of leverage or structuring,” said Decannière. “As long as you stay disciplined and cautious and you know what you are buying, there shouldn’t be too much danger.”
Reporting by Simon Meads