There is no doubt that secondaries is a buyers’ market right now. There is a deluge of dealflow, and discounts are deep. Meanwhile, despite some recovery in the stock markets, programmatic constraints continue to haunt many LPs.
“Public market volatility has created the denominator effect, which is putting real pressure on LP allocations to private markets,” Jeff Keay, managing director in the global secondaries team at HarbourVest Partners, tells affiliate title Buyouts. “When you combine that overallocation with the fact that the IPO window is essentially shut and M&A activity is significantly down, that creates a real liquidity challenge.”
“Investors are synthetically overallocated to alternatives because material write-downs in private equity have been limited,” adds Andrew Gulotta, head of private capital solutions at Harris Williams. “We aren’t necessarily seeing any panicked selling, but LPs are placing a premium on liquidity.”
The discounts that investors are being forced to swallow in the LP-led market are substantial, however. According to Gerald Cooper, a partner at Campbell Lutyens, average pricing in the buyout market sits between 80 and 85 cents on the dollar as of the second quarter. Many institutions have therefore sought to circumnavigate the denominator effect by increasing allocations to the asset class as a short-term fix.
However, where the allocation pressure is more acute or there is less flexibility to ease programmatic tensions, investors are faced with a decision, says Keay. “Do they pull back and stop new fund commitments altogether, absorbing the costs that come with that, which may be longer term but are still significant? Or is it more appealing to take the near-term pain that comes with divesting at a discount?
“Different institutions will arrive at different conclusions. It may depend on how averse they are to the near-term volatility that comes with selling at a discount. It may depend on how individuals at those institutions are compensated or the conviction they have in the importance of even pacing.”
Where institutions are arriving at the decision to sell, they are taking steps to optimise the pricing available. First, they are focusing on their highest-quality assets. “Sellers are being advised not to use this environment as an opportunity to offload less attractive portfolios. That is where pricing is most punitive,” says Keay. “Instead, they are focusing on their highest quality sponsors and funds with strong underlying portfolios. They are also steering away from riskier segments, be that venture capital or emerging markets.”
In addition, investors are taking a mosaic approach to potential sales to minimise the discount they face. “In this environment, where there has been a lot of uncertainty in terms of macro risk, buyers have gravitated towards GPs that they know well and assets they are familiar with,” explains Cooper. “That has resulted in us breaking up portfolios, [and] selling them to multiple buyers to ensure that the assets are attracting the highest bid from the buyers who know those assets the best.”
Deferred considerations are also being employed to help bridge the bid-ask spread and make selling a more palatable option for investors. “Deferrals are often preferred by sellers sensitive to discounts, especially when solving an allocation issue as opposed to a liquidity issue,” says Ross Hamilton, managing director at Partners Group. “Increasing interest rates raise the cost of fund financing lines, making deferred consideration more interesting for buyers too.”
The role of the GP
GPs have a role to play in helping ease LP liquidity issues, of course. Certainly, they are motivated to do so, given current paralysis in the primary fundraising market. “The number of new funds seeking primary capital continues to expand at a time when many LPs are grappling with how they can continue to make new primary commitments while already overallocated to the asset class,” says Scott Beckelman, global co-head of the private capital advisory at Jefferies.
“We aren’t necessarily seeing any panicked selling, but LPs are placing a premium on liquidity”
One option available to the GP is a tender offer, or tender offer plus staple. Carlyle, for example, ran a process that allowed investors in older financial services funds to cash out of their interests while bringing in money for the firm’s next flagship pool in 2022. These deals remain relatively rare, however.
“Several GPs have contemplated tender processes, but only a few have transacted,” says Hamilton. “Not all of those that went ahead achieved the desired outcome. Staple transactions work well towards the end of a fundraising as the new vehicle approaches its target size but are less effective where there is a large gap to close.”
The other role that the GP can play in helping deliver much-needed liquidity to LPs in a barren exit environment is through the structuring of a continuation vehicle. “We have had a number of conversations with GPs who have told us their LPs are proactively asking them to tap the secondaries market through a continuation fund transaction in order to create liquidity,” says Cooper. “Continuation funds can accelerate distributions and relieve some of that pressure on allocations, enabling LPs to recycle capital into new investments.”
On the up
What LPs really want, however, is for discounts in the LP-led secondaries market to become significantly less pronounced. But how feasible is this?
According to Gulotta, many secondaries funds were ahead of investment pace heading into 2022, but a slowdown that has lasted almost 12 months means pressure to deploy may increase in the second half of 2023.
Cooper adds that discounts will narrow as more new secondaries funds are raised. “Secondaries funds that had trouble raising capital last year are now having a great deal more success. As this dry powder comes into the market, competitive tension will increase. Coupled with greater visibility in the macro outlook, pricing should get closer to 90 percent of NAV by Q4.”
Beckelman, meanwhile, says that pricing is already improving. “We have recently seen a rebound in pricing and market demand for high-quality buyout-focused portfolios, and believe this offers sellers one of the best windows to access the market that we’ve seen in over a year.
“Uncertainty regarding Q4 NAV valuation changes is now behind us, and concerns regarding write-downs have largely been proven to be unfounded amidst good operating performance and stable valuations.”
“Things are definitely coming together out there,” agrees David Perdue, partner in the strategic advisory group at PJT Partners. “Execution matters more than it has in recent years. You have to pick your spots and you have to do the diligence ahead of time. But I do believe that the pricing floor is getting higher.
“With every quarter that goes by, there is a little more macro visibility and a continued roll forward of quarterly performance in the underlying portfolios… That is going to have a positive effect on allowing transactions to clear more smoothly in the marketplace.”