The hidden risk in the secondaries market

Buyers are used to dealing with currency or concentration risk, but information asymmetry is trickier to price.

The phenomenal growth of the secondaries market over the past few years has brought a dramatic shift in the types of deals that secondaries firms are investing in. Gone are the days of simply acquiring diversified portfolios of LP stakes. Secondaries firms today face a multitude of investment opportunities, including GP-led fund restructurings, preferred equity transactions, single-asset deals and stapled transactions. The availability of cheap leverage has added fuel to the fire.

Over the past few months we’ve spoken to various market sources about risk for an upcoming deep dive into the topic. Through conversations with participants from Hong Kong to London, New York to São Paulo, we’ve identified certain risk factors that the secondaries market is less well-equipped to deal with, and some from which it might benefit.

Some of these risk factors are obvious. Currency risk is something that most firms engaged in buying diversified portfolios are exposed to. It’s “risk with no return”, as the chief financial officer of one London-based buyer tells us. When as much as half of your portfolio is exposed to non-dollar currencies, says the CFO, currency hedging is a must.

Concentration risk is another obvious one, especially with the increase in single-asset restructurings that has taken place over the past 12 months. Most participants we’ve spoken to claim buyers are mitigating this risk by adjusting down their ticket sizes in such deals. If they typically buy a $500 million portfolio of 10 diversified LP stakes, they’ll only back a single-asset deal to the tune of $50 million, for example.

Others say concentrated bets are no riskier than acquiring diversified portfolios if you know what you’re buying, and that it’s better to have one good asset than 100 bad ones.

But one of the most interesting risks we came across concerns information. In the halcyon days of the plain-vanilla LP market, buyers looking to acquire a stake in a fund would have a nice lunch with the GP, get to know them well, visit their office and go through the portfolio in a couple of hours, asking detailed questions. Today, in the case of a pension plan selling a large portfolio that has attracted 30 to 40 buyers, you’d be lucky if the GP spent an hour with you.

“They’re just not keen to spend time with potential buyers,” says one veteran market participant. “It is quite a time sink for them.”

What this means is that buyers with greater access to information will always be better placed to bid for assets, and this should lead to better pricing for the sellers as well. Are buyers with primary programmes better positioned to bid on and win deals? Does it make sense for a firm to be involved in both the plain-vanilla and complex segments of the market, or should they specialise? And are LPs sufficiently aware of their secondaries managers’ expertise?

We look forward to sharing our findings with you.

Write to the author: or @adamtuyenle