The secondaries market had traditionally been viewed as an area for investors to find mispricing opportunities. Over time, as the market has become ever-more efficient – and sellers more sophisticated – secondaries have evolved to become a tool to manage portfolios, mitigate risk and, among buyers, to facilitate access to managers that would otherwise have been inaccessible.
Like other corners of finance, the covid-19 disruption has chilled secondaries activity. Bid/ask spreads, while tightening slightly since Q1 valuations became available, are still too wide to stimulate a strong rebound in activity.
A silver lining does exist. Secondaries should emerge as a resource for any market. In the wake of the global financial crisis, many viewed them as a niche in which distressed sellers could find liquidity, albeit at a considerable cost. Fast forward a decade, and secondaries are now a mainstream segment of the PE market and often billed as the most attractive entry point for new investors. In addition to the typical LPs, GPs are finding new ways to leverage secondaries as a tool to optimise portfolios, extend investment periods and accommodate LPs with differing objectives.
To be sure, there are notable differences between the covid-19 disruption and the GFC. The biggest is that LPs are generally in a better position than in 2008. For instance, a recent survey from placement agent Monument Group – a strategic partner of Mozaic – documented that while many LPs have “backburnered” new investment programmes and are focusing on re-ups, the distress is not as acute as that which accompanied the GFC. The rebound in the public markets minimised the damage, but the lack of distress speaks more to the fact that seasoned LPs were better prepared.
A separate survey, in which Mozaic polled more than 70 active buyers in the secondaries market, affirmed what many assumed to be true. Participants documented a decrease in dealflow, modifications in underwriting criteria and reservations around certain sectors – think ‘energy’.
Prior to any commitments, buyers are also evaluating downside scenarios more closely. The majority (58 percent) said they were incorporating a higher rate of return into their underwriting, given the increased risk.
Many are now looking to Q2 marks to further trim valuations or instil conviction around the likelihood of a recovery. Given the role of secondaries today, buyers and sellers are motivated to find common ground.
In the past, amid market disruption, one primary driver would fuel dealflow: distressed LPs in need of liquidity or looking to avoid defaulting on unfunded commitments. Today, distress is limited to newer investors in PE, and these investors may not be as diversified across sectors, market-cap exposures or by vintage. Still, cases of distress are the exception and portfolio management has replaced the need for liquidity as the chief catalyst of dealflow.
For instance, many will use the secondaries market to trade out of legacy funds as new offerings come to market. In recognising that 2020-vintage funds will be investing during a period of depressed valuations, LPs are keen to gain exposure to new funds from high-quality GPs over the next 12-18 months.
This is not to say that distressed sellers will not emerge. However, observers anticipate that, post-covid, distressed sales may ‘trickle in’, precipitated by a slowdown in exits over a longer period.
The biggest potential dealflow driver reflects the more recent rush of GP-led deals. Many GPs had already been using secondaries to facilitate creative structures allowing funds to hold assets longer than the traditional three- to four-year holding periods. The disruption should stimulate even more interest from GPs that had not already considered secondaries as a tool to extend holding periods.
Continuation funds orchestrated through special-purpose vehicles can also be a useful tool to provide existing LPs with liquidity options and ease pressure on GPs to exit investments before value-creation initiatives have been realised. Beyond just extending a fund life, SPVs can also bring fresh capital to existing assets.
Another option is preferred equity structures. These transactions allow for more flexibility to realise upside as assets mature, while protecting against downside scenarios. Preferred equity represent another alternative to gain liquidity, while ensuring GPs remain motivated once preferred returns have been met.
Although economic uncertainty has certainly slowed activity, secondary sales and structured transactions offer solutions to solve some unknowns. The wide array of optionality speaks to the level of sophistication in the secondaries market and underscores how these transactions have evolved. The savviest investors in PE can still benefit from an illiquidity discount, while LPs are afforded a level of flexibility that reduces risk, enhances returns and realigns interests even as markets and objectives change.
Solomon Owayda is a founding partner of Mozaic Capital with more than 32 years’ experience of investing and managing institutional private equity investment portfolios. Prior to forming Mozaic Capital, he was a managing director at Siguler Guff
Christine Patrinos is a founding partner of Mozaic Capital with more than 15 years’ experience in private equity investing, portfolio management and transaction structuring. She previously founded a private equity consulting practice advising large institutional clients on secondaries, fund structuring and valuation. She also spent five years with HarbourVest Partners.