Tail-end secondaries, stakes from funds that have reached or exceeded the end of their planned lives, have traditionally been the preserve of a few, distinct firms.
At the top end, managers such as Blackstone’s Strategic Partners hoover up thousands of stakes, often of seemingly insignificant value. At the other extreme are firms like Hollyport Capital, a small, highly specialised name seeking out value in the darkest corners.
In recent years, more and more firms have joined the party, propelled by huge amounts of dry powder needing somewhere to go and the fact that funds from the early- mid-2000s are coming to the end of their lives with considerable unrealised net asset value. Coller Capital posits there is $313 billion left in funds from vintage years 1999-2006.
NAV growth of a tail-end fund is inherently limited. However, due to their advanced age, they are returning capital rapidly, so the buyer has less time to wait for upside – provided the remaining assets are decent, of course. Another attractive feature is that tail-ends have traditionally sold at a considerable discount to NAV, at 30 percent or more.
Tail-ends have in some ways been a victim of their own increasing popularity. While there are a lot of assets in he market, competition has driven prices up. According to advisor Greenhill Cogent, the average high bid for funds at least 10 years old was 86 percent of NAV in the first half of 2017 – a discount on funds raised in the past five years, which averaged 98 percent, but hardly a bargain.
The result is that buyers are seeing less of a natural increase in value as their tail-end assets distribute. Many are stuck with a choice: accept a lower return profile or drive a return using leverage.
The hybrid theory
Returns can still be achieved without leverage: neither Strategic Partners nor Hollyport use asset-backed debt at the deal level, Secondaries Investor understands. But it can be an effective tool when used properly.
In some ways tail-ends are good candidates for leverage. They tend to be sold in large, diverse portfolios with many granular positions, so the risk is not heavily concentrated in one pocket. They often generate cashflow, so lenders can see exactly how the loan will be repaid.
At the same time, due to the often scrappy nature of tail-end portfolios, deciphering the true quality of the assets is a time-consuming process, made more difficult by the fact that many contain shreds of venture capital, debt and other riskier assets that are hard to price.
Some tail-end funds have little chance of meeting carry, so the GP might not be incentivised to maximise the value of what’s left. The opposite is equally problematic. A fund’s big-ticket deals are sometimes back-loaded, which can leave a secondaries buyer with an unwelcome surprise.
“Sometimes [GPs] are holding onto a small number of very valuable deals, hoping they can get them to the point where they will generate carry for the whole fund,” says Richard Hope, managing director fund investment team Europe at Hamilton Lane. “So you can see big investments that are skewed in quite a significant way towards that. When we are looking at a tail-end we are thinking, am I all of a sudden going to take a hit for the catch-up carry for the whole fund and how does that affect me?”
For this reason, lenders will often offer a hybrid facility, allowing them to lend at a loan-to-value ratio above what the assets merit at face value. An example of this would be to include a clause that gives limited recourse to another source of funding, such as undrawn commitments or guarantees from another, larger vehicle.
Let’s say, for example, that a bank lends $50 million to a special purpose vehicle set up by a secondaries fund to buy a $100 million portfolio of tail-end stakes. This LTV is too high given the quality of assets, yet the portfolio has 25 percent of undrawn commitments that the buyer is confident won’t be called due to the advanced age of the underlying funds. A bank can lend against that in addition to the assets in the portfolio. If, in a worst-case scenario, the undrawn commitments are called, the secondaries fund can step in to provide the funding.
“These hybrid structures can be a lot more flexible,” says Gregg Kantor, head of fund finance, US, at Investec. “We can allow a lot more cash to go to the owners of the portfolios rather than sweeping it to repay the loan, we can be more flexible on things like amortisation – features like that which really help the borrowers plan their finances over the coming year. We see the market going a little bit more in this direction over the course of the next couple of years.”
There are always downsides associated with leverage. Some of the larger portfolios are so difficult and time-consuming to delve into that a buyer might make loose assumptions based on things like vintage, not on the actual exit-potential of the underlying companies. The impact of a bad investment will only be worsened by leverage.
Widespread or excessive use of leverage can push up prices, adding to the problem that buyers were trying to get around in the first place. According to one regular tail-end buyer, less sophisticated investors armed with leverage can distort bid prices to the point where the prices of good and bad tail-end assets diverge.
Still, unless return expectations moderate considerably, applying leverage will be a popular, generally effective way of extracting value from tail-end assets.