Volatility sparks renewed interest in preferred equity

Preferred equity is back on the menu for secondaries buyers in scenes reminiscent of the early days of the pandemic.

Growing numbers of buyers are actively seeking deals that are structured with a profit-sharing component as public market volatility makes it more difficult to price diverse portfolios of assets, according to Gerald Cooper, a partner with Campbell Lutyens.

“We expect 12/31 marks, which are just getting released, to be up 4–5 percent from 9/30,” he said. “Given public market volatility, there’s some uncertainty around where 3/31 marks will land. The buyside is going to be cautious bidding on a 12/31 reference date, which could lead to wider discounts. The way to bridge the gap between bid and ask is through structuring.”

Sentiment among buyers was slightly brighter this week compared with the three weeks prior, Cooper said. How much of this interest turns into deals is largely down to how prolonged the period of uncertainty ends up being.

Preferred equity transactions accounted for 7 percent of total transactions by volume in 2021 and 3 percent by number, Campbell Lutyens noted in its recently published annual survey. The adviser counted $135 billion of total secondaries deal volume last year.

Greater volatility is also causing buyers to pivot towards single-asset deals after a period of prioritising portfolios, Cooper added. This shift is not likely to be as pronounced as it was after the pandemic, particularly among firms in market.

“Most secondary funds don’t want single assets being the highlight of their fundraising discussion. LPs generally invest in secondaries because they want diversification, J-curve mitigation and strong IRRs – you don’t really get all of these with concentrated deals,” according to Cooper.

Campbell Lutyens also anticipates an increase in the number of stapled tender offers during 2022, as GPs help their investors to free up capital to reinvest in new, often larger funds coming back to market.

“A lot of LP fund commitments are driven by the desire for co-investments,” Cooper said. “You want to stay relevant, you want to ensure the relationship remains strong. If the fund is increasing its size by 25 percent, you may have to increase your commitment by 25 percent to maintain your priority in the queue for co-investments.”

The average ratio of secondary to primary capital in stapled tender offers was 2.6 to 1 in 2021, compared with 3.7 to 1 in 2020 and 3.9 to 1 in 2019 and 2018. The higher proportion of primary capital is indicative of the quality of GPs that did tender offers last year, Cooper said.