Private Equity Analyst: Secondary Buyers Use Debt, Complexity to Stretch in Crowded Market
Buyers of secondhand fund stakes are under pressure to think outside of the box as returns become elusive This year, French secondary firm Ardian struck a $2.5 billion deal to invest in the private-equity funds of Mubadala Development Co., in one of its largest ever transactions with a sovereign-wealth fund. Armed with $10.8 billion to buy secondhand private-equity interests, Ardian took a $1.75 billion stake in a portfolio of funds and direct investments of Mubadala. In an unusual twist, Mubadala received a $750 million pledge from Ardian for a new fund it launched, the first time the Abu Dhabi institution accepted money from an outside investor. Ardian lined up financing from two banks, Macquarie Group Ltd. and Natixis SA, said people familiar with the matter. In the end, Ardian beat competitor Lexington Partners. Ardian's $2.5 billion trade is a sign of the times. Secondary investors are experimenting with new deal structures and increasingly turning to debt to boost their spending power. They are seeking to stand out in an environment in which money raised for secondary funds have swelled to a record high, driving up competition and prices. "Investing consistently and at a steady pace—as the market has increasingly become more expensive—has been the mindset of most buyers," said Philip Tsai, who heads the secondary advisory arm of UBS Group AG's private funds unit. Drowning in Dry Powder After a robust fundraising year in 2016 and strong start to 2017, secondary firms now sit on a record-breaking $71 billion that has yet to be invested, according to a report by UBS's private funds group. That pile of dry powder dedicated to secondary deals is ballooning as 48 such funds—the most ever, according to data provider Preqin Ltd.—are being marketed. Capital is particularly concentrated at the large end of the market: UBS projects that the top 16 buyers control more than 85% of dry powder, or $61 billion. However, few market participants expect deal flow to peak this year. More than three quarters of respondents polled by Private Equity Analyst on the secondary market said they don't expect 2017 to be a record year for secondary deal volume, roughly on par with respondents to last year's survey but a steep rise from 32% of respondents in the 2015 survey. Dow Jones & Co. surveyed 33 market participants for its latest study. "It's not as if a light bulb has gone off and everyone is rushing to sell," said Gregg Kantor, of Investec's private-equity fund finance group, which provides debt for secondary trades. "It's going to be a healthy year, but it's not going to be a record year." Many institutional investors, cash rich after rallying markets in early 2017, aren't going to part with stakes unless they get the right price. They will likely retreat if market volatility picks up, and stay at the sidelines if the gap between buyer and seller expectations widens. After deal flow peaked in 2014 and 2015, the secondary investing pace has leveled out, with roughly $30 billion to $40 billion in secondhand stakes expected to trade this year, said industry participants. At the same time, many funds launched between 2006 and 2008, which have long dominated secondary volume, appear to be winding down. Those precrisis funds made up a smaller share of deals marketed in 2016 than the year-earlier period and will likely represent a smaller portion of trading volume this year, according to a report by Greenhill & Co.'s secondary advisory arm Greenhill Cogent. After active trading of these stakes in recent years, there is likely less value left in these funds for buyers to capitalize on. A Pricey Bet Hordes of buyers eager to do deals are driving up the prices of portfolios with household names and funds of more recent vintages, particularly at the large end of the market. Large pools of diversified holdings often trade at par or a premium to net asset value, market participants said. At the same time, stock markets edged up early this year, boosting fund valuations across the board. Secondary buyers who are "passively investing" by buying bundled portfolios face heated competition, said Jeff Akers, who heads secondary investments at Adams Street Partners. "Pricing is at feverish levels." Deal prices started creeping up in parts of the market in the latter half of 2016. The average high bid—the largest offer for a secondhand portfolio—was 95% of NAV in 2016 for buyout pools, a slimmer discount than the previous year, according to Greenhill Cogent. Private funds of all stripes drew average high bids of 89% of NAV in 2016, roughly in line with 90% in the prior year. As in recent years' surveys, a higher percentage of respondents, on average, paid prices that were at par or a premium to the underlying NAV for buyout assets than those that did for venture-capital assets. The higher risks associated with venture capital, along with a wide disparity between the top performers and the mediocre ones, has often made such assets trickier to price than their steady cash flow-generating buyout peers. "For a U.S. or European buyout portfolio with good names, there seems to be no pricing ceiling," said Michael Pilson, a managing director in the secondary advisory unit of Eaton Partners. "It will be hand-to-hand combat for those transactions." Buyers are expected to bid more aggressively now, lifting—or at the very least, supporting—pricing levels over the next year. Many are using debt to boost their spending power and juice returns. "There is a lot more money chasing deals than previously," said Mr. Kantor of Investec. "How do you pay a fuller price and still keep your returns? Use debt." Among this year's survey respondents, 21% cited the availability of leverage as the top driver of secondary pricing, edging out stock market performance and competition from other secondary buyers. The responses reflect how the presence of debt is shaping the entire market. Buyers have no shortage of different lenders to choose from and for deals involving large diversified portfolios, debt can account for as much as 50% of the purchase price, according to financing providers. Deals involving smaller, more concentrated portfolios typically use less leverage, but still debt often is a significant chunk of overall transaction sizes. The use of debt in secondary transactions has grown considerably in recent years, a trend borne out by the latest Private Equity Analyst survey. This year, 19% of respondents said they used debt at the deal level in the past year, compared to 21% in last year's survey and only 9% in 2015. However, of the 81% of respondents this year that didn't use deal leverage at all, nearly one-third said that they were considering its use. Firms that didn't previously use debt increasingly feel pressure to turn to it to compete effectively with those that do and boost their internal rates of return. "People are only paying attention to the IRR numbers," said Sean Gill, director of private markets research at consultant NEPC LLC, causing leverage to become "part of the arms race." Meanwhile, buyers are more commonly borrowing at the fund level, using investor commitments as collateral, to better manage capital calls. A little more than half of this year's survey respondents reported using such loan facilities, with another 22% saying they are considering their use. Lenders tend to offer cheaper rates for fund-level debt, typically about 1.5% above the London Interbank Offered Rate, compared to LIBOR plus up to 4.5% for deal-level debt, market participants said. A Seller's Playground The healthy pricing environment resulting from this intense competition favors sellers. Nearly all of the respondents to this year's survey, 90%, characterized the secondary space as a seller's, rather than a buyer's market. Large institutional investors continue to use the secondary market to manage their portfolios or to shed older unwanted assets. For example, the North Carolina Retirement Systems and Harvard Management Co., which invests the Harvard University endowment, are among those institutions exploring sizable secondary sales of private-equity assets, according to reports and people familiar with the processes. But institutions remain price-conscious sellers and not all of them see an outright sale as the only way to accelerate cash flows from their private investments. In June 2016, Singapore state investment company Temasek Holdings Pte. Ltd. raised $510 million in bonds backed by cash flow from more than $1.1 billion in private-equity funds. A unit of the sovereign-wealth fund packaged 34 fund stakes into a vehicle, which then issued the bonds. The bond offering drew eight times more in investor demand than it could accommodate, according to Azalea Asset Management, the arm of Temasek behind the securitization. Boutique firms such as 17Capital and Whitehorse Liquidity Partners are stepping up as providers of preferred equity and structured financing for pensions and endowments. These firms can buy a stake in private-equity portfolios and in exchange, seek a higher claim on the future cash flow from funds. These alternative sources of financing can make cash available to institutions without a sale of underlying fund stakes. Smaller Deals Bounce Back Although large transactions attract more attention, smaller deals are expected to make up a growing share of secondary deal flow as investors seek to offload tail-end funds left with just a few holdings. Average transaction sizes fell to less than $180 million last year, down from more than $200 million in 2015 and about $300 million in 2014, according to Greenhill Cogent. "There have been fewer large portfolio deals done and more opportunities for smaller and more concentrated sales," Adams Street's Mr. Akers said. "Our expectation is the market will trend towards smaller deals." The rising number of smaller deals reflects a thriving part of the market the biggest secondary titans tend to avoid. "Big players can no longer look at every deal," said Mr. Tsai, of UBS's secondary advisory unit. "So there's a little less congestion in the middle to lower end of the market." GPs Drive the Bus as Banks Step Back Increasingly, private-equity firms themselves have become the catalyst for secondhand sales. Survey respondents expect general partners to become bigger sources of secondary deal flow this year, while banks—one of the industry's biggest drivers of deals—pull back. A ruling in December allowing banks to request more time to comply with the Volcker rule—a set of regulations limiting bank holdings of riskier investments—took some pressure off of financial institutions to sell. The extension gives banks five additional years to comply with Volcker. The extension, combined with hopes the new U.S. administration in Washington could scale back regulations, leaves banks less motivated to sell their private holdings. Among this year's survey respondents, 39% said they expect deal flow from banks to decrease, with only 16% expecting an increase in transactions. In contrast, however, buyers expect GPs to power more activity in the year ahead, with 77% of this year's respondents predicting an increase in GP-driven deal volume, up from 58% who answered the same way in last year's survey. GPs, which often have the ability to veto proposed transfers of stakes in their funds, increasingly want to ensure buyers of existing stakes will be able to support future funds. For example, when the Montana Board of Investments decided not back CIVC Partners' newest fund, the Chicago private-equity firm lined up a buyer for the pension's stake in an older pool who would also make a new commitment to its latest investment offering, according to a pension memorandum. The stapled secondary deal ultimately resulted in the sale of Montana's stake in CIVC Partners Fund IV LP at a premium to the fund's NAV as of Sept. 30, according to the materials. Some GPs are looking to drive sales to unload assets from older funds of their own. Their push to clean up aging portfolios that are a drain on their resources is driving more tender offers, fund restructurings, recapitalizations and direct secondary deals. UBS projects 35% of the $71 billion in dry powder—about $25 billion—is earmarked for deals such as these that are initiated by private-equity firms. Although fund restructurings have become more commonplace, investors are negotiating harder over their terms. "The early deals caught limited partners by surprise," said David Wachter of secondary firm W Capital Partners. "The LPs have figured out how early GPs got a good deal and now have standards." More than half of this year's survey respondents said they have backed a GP-led restructuring in the past year, down slightly from two-thirds of respondents in last year's survey. First Reserve Corp. last year proposed a deal to shift assets from a troubled 2006 energy fund into a new pool that would give the portfolio more time and more capital. The proposed deal hit a roadblock, however, when the California Public Employees' Retirement System and other investors objected. Calpers voiced concerns a reset of valuations on the fund holdings meant First Reserve stood to capture the upside more readily, while sellers had to accept unfavorable pricing. First Reserve ultimately ended up only extending the fund's life, as too few investors opted to sell their stakes. As limited partners become more familiar with fund restructurings, they have become bolder about blocking a deal if they think it would unfairly enrich the GP at their expense. "Since all the noise around secondary fund restructuring started about two years ago, the low-hanging fruit has been picked," Mr. Wachter said. "There's no way deal volume and supply will match expectations." Reality Bites Secondary transactions continue to play an important role in investor portfolios. But the use of leverage and the rise of emerging innovations in deal structures reflects the hard truth many types of secondary transactions aren't as lucrative as they once were. Median expected net IRRs from new funds steadily have declined during the past three years of Private Equity Analyst's survey to 17.5% in 2017 from 20% in 2015's survey. "Buyers are admitting that they are underwriting deals to lower returns than before," said Mr. Tsai.