Private equity secondaries: Four things to know now

Jun 30, 2020

Private equity (PE) secondaries offer opportunities throughout the cycle, but as periods of market stress roll on, the market tends to become especially attractive. We last reported on secondaries in early April. Here is an update from Steve Lessar, Co-head of Secondaries and Liquidity Solutions in BlackRock Private Equity Partners, based on his remarks on the recent webcast, The evolving picture in private equity.

1. Supply has begun to increase, impacting pricing.

After a strong start to the year, deal volumes slowed amid the extreme uncertainty of early March. By May, however, our team was seeing a noticeable uptick in supply. Our view is that the market will be moderately busy until late summer, when June 30 valuations become available and could open the gate on pent-up selling. In the fall, excess supply may create a very attractive time to be in the secondary market.

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In the fall, excess supply may create a very attractive time to be in the secondary market.

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We believe there is more supply coming because dislocation is forcing more sellers to come to market seeking liquidity. This comes from several factors: actual need for liquidity, especially in PE portfolios where there are remaining uncalled commitments, or by sellers where they have other funding needs since traditional liquidity has dried up – think certain endowments and foundations

The supply picture obviously impacts pricing. Given the dislocation, we are now seeing opportunities to selectively access quality, diversified private equity at meaningful, deep double-digit discounts to year-end 2019 valuations. For example, we are looking at an LP stake in a fund where the GP marked down the fund 15% to 20% in Q1 and we are pricing at a further discount to that – so all in, a 30%-plus discount. 

While we expect to see many more LP stakes come to market as the year progresses, it is GP solutions—the newer part of the market—that is busier at present. We are in dialogues with several PE managers about how secondary capital can be an efficient and flexible source of funding for their portfolios.

2. Secondaries span a range of risk/return profiles.

There has been a lot of recent focus on a type of GP Solution called secondary preferred equity. That’s because it addresses several of the challenges facing private markets stakeholders: namely, being able to agree on the precise value of an asset or group of assets. Preferred equity is a tool that can be deployed quickly and without needing to agree on specific valuations.

Example: In one GP Solution deal we’ve reviewed, a well-regarded manager recently made a final investment in their prior fund and began investing their next, newly raised fund.  The recently invested Fund has a dozen or so companies and over $1 billion in net asset value (NAV). The portfolio is diversified but does have some exposure to consumer businesses that are negatively impacted by the pandemic. The GP is seeking $200 million to $300 million preferred equity as a portfolio level financing – the secondary investor would provide capital which the manager can direct to different portfolio companies over time, as financing needs evolve. The preferred equity would be senior in the distribution waterfall – it gets paid back before distributions can flow to LPs. Because of the relatively high diversification and low loan-to-value (say 30%), it is likely this investment may price in the low teens IRR.

Second example: In a more traditional deal, an LP in a fund has decided its investment is no longer strategic. With the change in thinking, gaining early liquidity is now the goal.  With the discount and deal profile, we think this could price out to potential returns in the low 20s IRR.

Final example: This is a similar set up to the first example in terms of the manager needing liquidity, but with a smaller fund: only a few companies, about $300 million of NAV and a need for $75 million to $100 million in preferred equity. Because of the more concentrated portfolio, the underlying industries and the smaller size of the investment opportunity, this transaction will likely be underwritten to high 20s to 30%+ IRRs.

These are all secondary transactions, but quite different in terms of where they lie on the risk/reward curve.

3. Dispersion of returns may surge even if managers use the same tactics.

Over the last decade there has been increasing specialization among secondaries managers. Some groups focus exclusively on large diversified portfolios, sometimes using a significant amount of asset leverage to ratchet up returns (and risk). Others focus on single-asset or very concentrated portfolios, while still others are more akin to mezzanine lenders, targeting lower returns in exchange for lower risk.

Given secondaries’ strong historical performance, differentiating among strategies and managers can seem challenging, and perhaps less than critical. But even though dispersion of returns in secondaries has been historically pretty tight, that may be changing for several reasons: 

  • Some secondary managers have chosen to trade quality for price over the last couple of years. How will that play out?
  • Use of leverage may come back to bite.
  • Performance of concentrated strategies vs. more diversified strategies will likely diverge.
  • Vintage year concentration: Some firms deployed entire funds in 18 – 24 months, in vintage years that may not turn out to be the strongest.
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Performance of concentrated strategies vs. more diversified strategies will likely diverge.

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Given the lags inherent to private market performance reporting, it may take a while for this dispersion to come through. But investors can always analyze risk, and in particular: a) how much leverage the manager is using, b) how much diversification the manager is targeting and c) the manager’s approach to risk management.

4. Timing is hard, and diversification is your friend.

Weighing risk is critically important in all investment decisions, and we believe it is too early to say we are past the worst in private markets.

But we also believe it is highly challenging to time the market and especially so for private market strategies. We suggest an approach that is different from trying to allocate at the exact nadir of the market. Rather, if there is a strategy that makes sense, then survey the market and select managers that are best equipped to capitalize on the dislocation. We would suggest one aspect of manager selection that is especially important now is evaluating legacy portfolio issues. Legacy deals that need a lot of restructuring can be a real time sink for those secondary managers burdened by underperforming investments.

The way to know you are not catching a falling knife is to work with a secondary manager committed to diversifying risk. It is a simple concept, but diversification is your friend in this environment. Both by number of portfolio companies as well as by deployment pace – we believe it prudent to allocate to a secondary manager who has capital to invest now (not waiting to turn on the new fund) but also no legacy deals in the portfolio and is committed to diversifying vintage year deployment over the next several years. The secondary opportunity coming out of the global financial crisis was not just a 2009 opportunity—it was a terrific secondary market for several years afterward.

Steve Lessar
Co-head of Secondaries and Liquidity Solutions in the Private Equity Partners business of BlackRock Alternative Investors
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