What is driving LPs to the credit secondaries market?

A record 21 percent of investors plan to commit capital to secondaries funds in private debt over the next 12 months, according to affiliate title Private Debt Investor’s LP Perspectives 2024 Study.

This is the highest proportion in the history of the survey and an increase from the previous year’s 17 percent. These heightened plans to commit capital constitute one metric for the recent growth of the strategy.

“I still think [the growth of credit secondaries as a market] is fairly nascent – there is a lot more room for growth,” says Andrew Bellis, head of private debt at Partners Group. “In general, it is growing in parallel with the way the PE secondaries market grew, with a lag in timing.”

The scale of transactions

Sellers on the secondaries market may have constant cash outflows. Pierpaolo Casamento, who heads private debt secondaries at Tikehau Capital, says: “The more sophisticated investors use secondaries regularly for trading out of positions. It doesn’t mean that they are unhappy or distressed, only that they want to manage their portfolio actively.”

Pierpaolo adds that in 2020 Tikehau looked at between $3 billion and $4 billion of opportunities in private credit secondaries transactions. That number was up to $17 billion last year and is on track to beat that this year. According to Coller Capital, deal value was just $2 billion in 2017.

Perhaps, though, such numbers should be viewed with a caveat. Krishna Skandakumar, private fund and secondaries partner at Goodwin, cautions: “Unlike private equity secondaries, private credit GP-led transactions are often executed without brokers or intermediaries, so the rest of the world doesn’t necessarily know what deal particular parties have struck with one another.

“This means we don’t necessarily have a good handle on the scale of transactions.”

On the debt side, as on the equity side, there are three factors involved in driving firms to the secondaries market: liquidity, valuation and sophistication. In recent years, assets under management for private credit funds have reached at least $1.5 trillion. This has left plenty of investors looking for distributions and, worried about the denominator effect, seeking liquidity across their portfolios.

LPs also sell into the private credit secondaries market because it offers them smaller discounts than for other asset classes. In a recent white paper, Atalaya Capital Management and law firm Proskauer found that “private credit presents better relative value when compared to private equity today”.

Skandakumar agrees. “In private credit secondaries, you’re only looking at a very small discount against the underlying portfolio compared to what you’d see in a private equity analogue,” he says.

Growing experience

Another reason the secondaries market has become more attractive to LP sellers is the increasing sophistication of participants on both sides of the table.

“We’ve gone from a climate in which most participants in a transaction of this sort are doing so for the first time, to one in which there is some experience on each side of the table,” Skandakumar says.

Michael Hacker, global head of portfolio finance at Carlyle Group’s AlpInvest Partners, agrees the sophistication of market participants is increasing.

“Credit secondaries are definitely benefiting from the combination of the broader credit market correction that began in 2022 and the significant evolution in the secondaries market since 2018, driving increasing sophistication among managers and a broader acceptance of these secondary transactions as effective portfolio management tools,” he says.

Although the secondaries market for private credit still, in Hacker’s view, lags “private equity by more than a decade… its faster growth is certainly supported by the trail blazed over the last 10 to 15 years”.

GP leadership and conflicts

Law firm Cleary Gottlieb contends that GP-led secondaries represent the next major growth push for the credit secondaries market. These are transactions in which a sponsor orchestrates the sale of credit assets from a fund or funds that it advises to a continuation vehicle, with new outside investors, generating liquidity for the older investors in the process.

It is worth noting, though, that there are conflicts inherent when the GP takes the leading role. Cleary Gottlieb points out that though the sponsor wants to maximise value for its investors, it does not want to maximise too much value. After all, it wants to leave room for the growth of the underlying assets after the transaction.

Such conflict may show up in tricky negotiations over leverage. According to a Cleary Gottlieb memo, private credit typically has a lower return profile than private equity, and some continuation vehicles may want to use leverage to boost returns. That, though, “may add unexpected complexity to deal execution by introducing the risk that the debt could crowd out equity”, the memo notes.

Another twist in the relationship of LPs and GPs in the context of secondaries transactions is that, as Casamento of Tikehau puts it: “In some instances, LPs decide that they have allocations to too many GPs and they are using secondary trades to consolidate. This, too, is a matter of portfolio management.”

Was the UK’s LDI crisis the credit secondaries’ Lehman?

The UK liability-driven investment crisis in 2022 may have accelerated the secondaries market.

The secondaries market for private equity took off in response to the global financial crisis. Lehman’s bankruptcy filing in September 2008 shook the financial world. The following year saw $9 billion in equity secondaries transactions, according to the Private Capital Research Institute. PCRI says “though the window of opportunity was short, investors discovered that secondaries performed especially well” during the crisis. The amount of transactions was $100 billion by 2021.

Is there an equivalent event on the credit side? In September 2022, after a change of government, the new UK chancellor’s growth plan proposed policies that frightened the markets, sent the pound to an all-time low against the dollar and terrified the liability-driven investment market. The Bank of England intervened successfully on 28 September.

“At this time the market’s growth is mostly LP-driven – the investors in credit funds are looking for liquidity solutions,” Bellis says. “In the UK in particular, the LDI crisis emphasised the need for liquidity for many institutions and may have accelerated this move.”