Why private equity secondaries may soon pick up

While public equity markets have displayed extreme volatility in the past month, it’s been more difficult to gauge what’s happening in private equity, due to lagged market values and slower transaction times. But if past crises are to provide guidance, we’re likely to see a significant increase in PE secondary market transactions in the months ahead.

Mark Everitt, director of research for BlackRock Alternative Investors, discussed current secondary market dynamics, parallels with the global financial crisis, and potential investment opportunities with Steve Lessar, Co-Head of Secondaries and Liquidity Solutions in BlackRock Private Equity Partners, during our April 1 webcast, Private equity in a changed landscape.

Highlights from their conversation:

What are the main items on your radar in the secondaries space?

This cycle is setting up to be very interesting from a secondary perspective.  We saw how secondaries were well positioned during past dislocations including the Global Financial Crisis. Many of the same dynamics are playing through now, although we are observing important differences.

At present, we are seeing a slowdown in new deals and in some cases portfolio buyers walking away from deals that were close to final. Broken deals are incredibly rare in secondaries, but they are happening now. Everyone in the secondary market is highly focused on March 31^st net asset values, which should start to come into focus around the middle of May. Depending on how managers market their portfolios, we think there could be a significant wave of selling beginning in early summer.

For some LPs, the “denominator effect,” where investors become over-allocated to private equity or private markets because of a decline in the value of their public portfolios, has already kicked in. Other LPs will choose to rebalance their illiquid portfolios, and others still will look to change their investment strategies. But if the past is any guide, there will be an increase in selling activity in the medium term, as well as a shift toward more motivated sellers who must sell PE for liquidity or asset allocation reasons.

What are you seeing in terms of pricing?

When the crisis hit, discounts widened materially almost overnight: portfolios that would have traded at low-single-digit discounts, now likely would not transact unless the discount is 25% or more.

It will be interesting to see how long discounts stay at these levels. One factor will be those March 31^st and upcoming June 30^th net asset values. Another will be supply and demand. We operate in a market that was in balance between supply and demand pre-Covid: secondary managers had approximately US$100 billion in uninvested capital, roughly in line with the almost US$90 billion that traded last year. So, to the extent there is an uptick in supply and demand stays consistent near-term, it could allow lower pricing and higher discounts to persist.

It is also important to note that secondary capital provides liquidity to general partners as well as to limited partners. On the GP side, the deal flow has not slowed, but it has changed, and many managers may need liquidity for their funds.

One illustrative example of the type of dialogue we’re engaged in is a PE manager that has a handful of companies left in a more mature fund with total NAV of around half a billion dollars. Half the companies need equity capital urgently—some to pay down debt and some to go on offense and consolidate smaller competitors. This presents an opportunity to engage with managers such as this about preferred equity investments

In a situation like this where GPs want to move quickly—but they can’t easily tap credit markets for multiple portfolio companies, and they can’t go to their LPs because the fund is fully called—secondary capital can be an excellent and constructive solution. 

What similarities and what differences do you see in the secondaries market now versus during the global financial crisis?

The financial crisis was a great example of how secondary capital is well positioned to potentially generate strong returns during market dislocations, and we see here a couple of important similarities to the current environment.

One is the return of the denominator effect that we just mentioned.  We also believe that discounts will behave similarly: after widening significantly, they will slowly narrow back to historical averages. For context, pricing declined from par in 2006 - 2007 to discounts sometimes north of 50% in late 2008 and 2009. Capital that was deployed at the trough in 2009 was rewarded with 30+% gross IRRs in certain cases, according to data from Greenhill.

Importantly, these returns were driven approximately one-third by discount recapture and two-thirds by company valuations resuming growth as we exited the crisis. This speaks to the importance of purchasing the right portfolios, with quality companies that will be resilient through the cycle.

And there are three very important differences in the secondary market today compared to 2009.  First is that private equity has become a much larger percentage of overall portfolios, so for LPs that need liquidity, those larger allocations could lead to significant transaction volumes.

Second is the fact that many more industries are being severely impacted in this crisis, which makes valuation more difficult. Buyers who can form a “house view” quickly on the near-, medium- and long-term effect of this crisis and how it will impact different PE sectors may have an advantage. 

Third is general partner participation. Ten years ago, managers of PE funds were largely not involved in the secondary market, except to approve the buyer as an acceptable replacement LP. Today, managers actively work with the secondary market to generate liquidity solutions for their investors and themselves. Manager-led or GP-led secondaries make up more than one-third of the market and will continue to grow.  Stretched companies and over-levered fund structures will likely provide significant opportunities for secondary investors to partner with GPs on interesting transactions.

Where are you seeing opportunities in secondaries?

There are a few places. We keep a “buy list” of high-quality funds—often where we have been invested from day one—that rarely trade. In this environment, proactively reaching out to LPs with a ready price is much more likely to be effective.

We’re also seeing opportunities in co-investment portfolios. Given the scale of our co-investment franchise, we have an excellent idea of who our fellow co-investors are and strong points of view on their portfolios. If any of them are seeking liquidity, we are likely a good buyer.

I’ll also mention a potential concern, which is the use of fund-level credit facilities. It is not a pitfall per se, but it is a factor to consider.  As the prominence of credit facilities has grown, many GPs have delayed capital calls by purchasing assets using a subscription-based credit facility. As the investment periods end, GPs must make large calls from LPs to pay off the facilities. As asset prices fall on investments completed pre-crisis and liquidity management becomes more of an issue, the combination of outsized capital calls and overvalued assets may exacerbate liquidity issues. This complexity is something to be mindful of, but it may create attractive investment opportunities for experienced secondary managers.