The use of leverage in the secondaries market has helped drive pricing and deal volumes to record highs, but not all investors use the same type of leverage, explains Sunaina Sinha, founder of Cebile Capital.
Not all secondaries investors are able to use leverage, though many use creative structuring to add an element of leverage to their deals, and the select few are able to use almost all types of credit lines, structuring and deal-specific leverage available on the market. It is important to understand the common types of leverage available in the secondaries market today to structure the most effective transaction for buyers and sellers alike.
One of the most common ways of embedding leverage in a deal is through a deferred payment structure, whereby the buyer pays the seller a portion of the transaction proceeds at closing and the rest at a later date or at staggered intervals. The deferral is effectively vendor financing. The buyer owns the assets straight away, including any distributions from the interests. This type of deal represents a leveraged transaction in that you can pay a portion of the proceeds upfront but get a greater exposure to the interests than that amount. Some buyers estimate that they can improve pricing by 3 to 4 percent by deferring half the payment for 12 months.
Most of the major banks provide leverage to secondaries funds for specific deals. These deals, almost always, need to be well-diversified buyout portfolios. Lenders will usually analyse diversification at a company level. The typical range of the debt is LIBOR + 4 percent up to LIBOR + 8 percent. Lenders usually fund deals of 30 percent to 50 percent loan-to-value with a term of two to four years but can stretch up to six years for a portfolio of younger funds.
Earn-out or share-of-proceed structures
For deals in which there is a mismatch in pricing expectations between a seller and a buyer, earn-out structures are particularly useful in structuring a deal that provides embedded leverage for the buyer and aligning incentives for the seller. In a typical earn-out structure, the buyer pays a portion of the total net asset value of the portfolio upfront (for example 30 percent to 50 percent) and commits to taking on the future unfunded commitments. The buyer gets 100 percent of the cashflows until they achieve a multiple of the cash invested (for example 1.5x to 2x). Thereafter, the seller gets the majority or all of the cash flow.
This type of deal provides a good opportunity for buyers to put a portion of a deal’s value to work while availing themselves of the intrinsic value of the entire portfolio in order to meet a minimum investment hurdle. It also enables sellers to continue to share in the upside of the portfolio whilst receiving some liquidity to recycle elsewhere in their portfolio.
Capital call facilities
Some of the more sophisticated and larger secondaries funds are able to arrange capital call facilities on a fund level basis via banks. This type of credit facility enables them to employ leverage in any of the transactions of their choosing without having to apply to lenders on a deal-by-deal basis. This enables them to have a price and speed advantage over the rest of the market. They are also able to manage their credit obligations against their entire, diversified secondaries portfolio. The largest secondaries buyers have a number of such credit facilities in place. It comes as no surprise that lenders require purchased portfolios to comprise largely of flow-name buyout interests and diversified portfolio transactions to minimise concentration risks.
Dividend recapitalisations are a type of leveraged recapitalisation, which are typically used when LPs of fund of funds wish to realise value from their holdings but may not want or be able to sell their interest outright. In such a deal, the GP of the fund of funds would contribute the fund interests to a special purpose vehicle and a bank would loan 25 percent to 40 percent loan-to-value to the vehicle. Such a loan would be paid back to the fund of funds GP to accelerate distributions back to the LPs.
In an alternate structure, a secondaries buyer that is uncomfortable with employing leverage can also enter into a deferred payment agreement with the bank, where the deferred amount will be treated as debt.
The secondaries market continues to evolve, creating structures that enable buyers to push the envelope on pricing and execution to meet sellers’ expectations and win deals over the competition. As with any structured transaction, a good advisor will be able to steer sellers and buyers to reach a zone of possible agreement that will enable a deal to be completed with speed and efficiency.
Sunaina Sinha is founder and managing partner of Cebile Capital, a London-based secondary advisor and placement agent.