The time value of money concept assumes that $1 today is worth more than $1 tomorrow. But what if the choice was between $1 today or $1.03 in six months’ time?
That’s a conundrum playing out in some parts of the LP secondaries market. Speaking on the firm’s half-yearly interim results call on Tuesday, Partners Group chief executive David Layton said his firm has been using deferred consideration mechanisms to delay closings on this year to boost the internal rate of return on a transaction.
“We’ll shake hands on a transaction but push the closing time frame out several quarters,” Layton said. “In a market that is rebounding and increasing in value, that can be a way to enhance returns.”
For any readers unaware of how deferred considerations – also known as vendor financing – work, this is where a seller of a portfolio agrees to accept part of the cash for a sale upon signing and the remainder upon closing at a later date. This can be several months in the future, and the payments can be split into more than just two instalments. Such an agreement can allow the buyer to pay a higher price as they are able to split their payments over time. In today’s environment, a deferred consideration of up to six months can result in a narrower discount to net asset value of as much as 2 or 3 percentage points.
For the seller, it benefits from an overall higher price; for the buyer, it can boost the IRR on the deal due to capital being invested at a later date. The buyer can also benefit from the portfolio rising in value as its discount will appear larger by the time the transaction closes.
Deferrals have become a more widely adopted tool in recent years, with 53 percent of buyers using them in the first half of this year, up from 50 percent last year and 36 percent in 2021, according to research by Campbell Lutyens. Time to final payment appears to ebb and flow, with roughly half of such agreements being beyond 18 months last year (there were no average deferral periods of that length in 2021), according to Campbell Lutyens’ report. Deferral periods shortened in the first half of this year, with almost 90 percent being less than 12 months – a sign that LPs are a little more focused on liquidity than they were last year.
Why the increasing use of deferrals is continuing into 2023 appears to be a reflection of at least two dynamics. LPs are selling because of overallocation issues and not necessarily because they need liquidity, and so are willing to forgo cash today for a higher price down the line, says a managing director at a global firm active in secondaries. The higher cost of borrowing has also made vendor financing a particularly attractive alternative to third-party debt, market sources say.
For the seller, splitting the received payments is sometimes about more than just receiving a higher dollar figure overall, it’s also sometimes psychological: a discount that starts with the number ‘2’ may be psychologically harder to stomach than one that begins with a ‘1’ – even if that means being paid 18 months down the line.
“Sometimes it’s about getting into the right ZIP code in terms of range,” the MD says, who adds that he has seen more deferred considerations in recent months compared with this time last year.
As the mix of overallocation issues and the higher cost of borrowing continues to play out in private markets in unexpected ways, expect the ‘buy now pay later’ trend to remain.
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