Turbo-charged: How leverage is powering up secondaries

"Leverage has increased steadily over the past few years," says Mathieu Drean, global head of secondaries at fund advisory firm Triago. "It is being driven by a classic combination of increasing demand and expanding supply."

With more players chasing a finite number of transactions, competition is fierce. Prices are rising, so buyers are using leverage to boost their spending power and also get the requisite returns for their own investors. What is more, there are many more banks and specialist funds actively promoting leverage today than there were five years ago.

"The use of leverage in secondary deals – a minority practice a few years ago – is now a majority practice. Not to use any leverage places buyers at a disadvantage today," says Drean.

In a bull market, leverage can enhance returns. But if a market turns and assets are devalued, then returns could disproportionately worsen" – Tarang Katira, Hamilton Lane

"All big names – Coller, Lexington, Ardian – use leverage to enhance returns," says a UK-based LP. "It is their model." In many ways, the practice can be considered to be representative of the professionalisation of the secondaries market and an indication of how the private equity market has evolved.

Last year, leverage used to buy secondaries was equal to 23% of the market's total volume of $45bn, according to Triago's December quarterly report. Leverage levels soared to an average of 49% (in each transaction using leverage) compared to 36% a year ago and 17% five years ago. Not every transaction employed leverage, hence the lower overall proportion of annual volume accounted for, but the trend towards using more debt is clear.

Reasonable risk
"Current levels of leverage are low-risk for lenders," says Drean. "That's a key reason why growing numbers of banks and funds are supplying it, with levels well within the realm of the reasonable, even as the practice expands."

But buyers using leverage are seeing their risk profile rise, he cautions. And if a downturn were to occur tomorrow, paying back leverage on a recently signed deal would typically eat up most near-term distributions, lowering annual internal rates of return.

"There are pockets of the market where leverage levels are not as conservative," says Tarang Katira, a principal on the fund investment team at Hamilton Lane. "On some of the larger deals, things are fairly aggressive, especially by historical standards. Ideally, in a bull market, leverage can enhance returns. But if a market turns and assets are devalued, then returns could disproportionately worsen."

Larger funds have outperformed historically as leverage has worked in their favour. But some would say that, like the buyout market, buying cheap and relying on the fundamental assets for growth is the best approach, and that leverage is not a substitute for buying cheap and growing.

There is currently not much talk of default rates, but the real test will come as prices continue to creep up and increasing levels of leverage are used to beat the competition. On the other hand, some industry professionals argue that the underlying assets of a secondaries portfolio are usually fairly diversified, so wholesale defaults are less likely unless a portfolio is heavily concentrated in one sector. Either way, there is no sign of leverage levels decreasing or abating.

Advisory firm Greenhill & Co estimates that there is about $125bn in dry powder for secondaries - of which $72bn is equity dry powder, $18bn is available leverage (25% of equity dry powder based on LTV ratios of secondary deals) and $35bn is near-term fundraising.

Debt mechanisms
As well as the classic use of debt at fund level – typically a bridge facility for capital call purposes – leverage on individual secondary transactions is the real growth market and is a hot topic among industry professionals. This usually takes the form of fund credit facilities or acquisition debt.

In the case of acquisition debt, buyers set up a special purpose vehicle (SPV) to buy the LP positions in the secondary market funded by the vehicle and a loan at SPV level, explains managing director Briac Houtteville of advisory firm Greenhill & Co. The loan is generally secured against the net asset value (NAV) of the underlying positions, but can also include recourse on the fund to the unfunded component of the portfolio.

"Lenders carry out significant due diligence to understand each portfolio fund asset that the secondary fund has a stake in," says Aimee Sharman, a specialist in fund financing at law firm Hogan Lovells. Depending on the borrowing structure, the bank may also have recourse to the unfunded commitments of that borrower. A lender will want to ensure any borrower has sufficient capital and debt to meet unfunded commitments of the underlying portfolio fund assets, she says.

"There will be covenants in respect of NAV, which will often apply various haircuts to ensure sufficient diversity and credit worthiness of the underlying portfolio fund assets," says Sharman. "For example, a lender may not deem venture capital a core part of their lending strategy and therefore not include it in the NAV. The lender would then test the loan to value (LTV) ratio based on the resultant calculation."

The facilities are typically repaid via cash sweeps from distributions received, so in a sense the debt is amortised.

"Although these types of facilities are considered higher risk than typical subscription line financing, certain banks consider these facilities as attractive, since their return is often higher in comparison to subscription line financing," says Sharman. "These transactions are not uncommon, but we have seen significant momentum in use of these types of financings given the competitive market and the use of leverage by funds to boost returns."

Lenders are definitely more comfortable lending against these types of transactions, concurs Peter McGrath of advisory firm Setter Capital. "[Secondaries] is a relatively new industry – I would say we are in the third inning of secondaries – so who knows where we will be in 10 to 20 years' time."

While some borrowers have a preference for a one-stop-solution, we often see this as resulting in a sub-optimal outcome on each of the bridging and NAV line" – Gavin Rees, Silicon Valley Bank

Prices have increased on most individual secondary transaction types over the past year. In western Europe, the average price for a secondary transaction in October 2017 was 100.45% relative to NAV, compared with 95.09% the prior year, according to a pricing report by advisory firm Setter Capital.

The global average of an LBO transaction for the 90 days to the end of October 2017 was up 3.67% at 97.99% compared with a year before; growth transactions were up 2.32% at 91.85%; and infrastructure was up 17.39% at 99.53%.

The only transaction types to take a dip in pricing over the past year were venture, which suffered a 3.87% drop to 80.6%; funds-of-funds (private equity) -0.24% at 86.06%; and secondary private equity funds -3.88% at 83.28%, according to the report. However, compared to five years ago, the rise is still significant when prices were at 76.37%, 76.09% and 78.43% for venture, funds-of-funds and secondary funds respectively.

Exercising caution
The banks that specialise in fund bridging lines are typically different to those specialising in NAV lending. While the clearing banks provide the classic bridge facilities, it is the likes of Whitehorse, Credit Suisse, Nomura and Investec that are the common NAV lenders.

"While some borrowers have a preference for a one-stop-solution, we often see this as resulting in a sub-optimal outcome on each of the bridging and NAV line," says Gavin Rees, European regional head of Silicon Valley Bank's global funds banking team. "Having separate facilities, each with recourse to its own pool of collateral, is cleaner and consistent with when and where the bridging line is needed – when uncalled capital is available and at the fund level – and when the NAV line is necessary, when the assets have been acquired and preferably at the holdco level. This also helps avoid inter-creditor issues at the fund."

It is true that secondaries, as an asset class, are considerably more diversified, and wholesale defaults are rare, but LPs should exercise caution when looking at the use of wholesale leverage in secondaries, says Hamilton Lane's Katira. "You need to look at leverage levels in the context of underlying assets and the pricing of the deal. It is this type of analysis that needs to become more prevalent at the LP level," he says.

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