Secondaries: opportunistic buyers ready for fund stakes to hit market

Only a few weeks ago, the market was asking what was next for secondaries, given the ever-increasing amounts of dedicated funds being raised and allocated to the strategy. With rising valuations and debt readily available to boost buyers' spending power, global secondaries transactions in 2019 reached $85.4bn, an increase of 7.2% on the previous year, according to advisory firm Setter Capital's activity report for 2019.

And 2020 was set to be another bumper year. Indeed, with close to $45bn raised in the 12 months to December 2019, one of the only concerns of secondaries buyers was finding more niche strategies given that many were being priced out of the plain vanilla ones and returns were being squeezed. One secondaries investor told Unquote in February that it was looking to differentiated strategies in the coming year since it was unwilling to pay the high prices being set for what it deemed as "regular" fund stakes.

But much of this is set to change as financial markets continue to assess the effects of the coronavirus pandemic.

"Pricing has been very high in recent years, at par or premiums to NAV," says Mark McDonald, global head of private equity at DWS. "There haven't been many forced sellers, and investors have mainly been using the secondaries market to tactically rebalance their portfolios. But now, there could be a real liquidity need or rebalancing drive due to the denominator effect, so some secondaries funds could find real opportunities."

With more sellers coming to market, prices are unlikely to stay at pre-Covid-19 heights, which could in turn encourage more opportunistic buyers.

Advisory firm Setter Capital recently released a survey with buyers expecting the pricing of secondaries transactions to go down given the diminishing buy-side appetite: for LBO funds, respondents estimated that current pricing should be at around 77% of 2019 NAV, versus 102% in Setter's December 2019 price report (a 25% drop).

Once more unto the breach
After a pause in activity as people gather their thoughts and rethink their strategies, what follows could be rich and fertile ground for secondaries activity, as was the case after the previous crisis, says Claire Woolston Commons, head of strategy at online secondaries platform Palico.

"After the global financial crisis there was a pause in deals as investors got their bearings, but even then, you saw sophisticated LPs leverage the secondary market in order to react to market realities," says Commons. "What is different now is that secondaries is a much more developed market, having grown five-fold, so you'll see more LPs look to secondaries in order to adjust their PE portfolios at a time like this."

Although not all will be forced sellers, there could be several reasons for LPs to sell, Commons says: "Some LPs, such as family offices, may simply need to raise cash given that other sources of revenue are closed, and therefore need to draw on existing investments. Others will look to sell out of fund positions that have a lot of unfunded capital, as this could be deemed as a future liability since there will be little visibility on when that capital may be called. And lastly, LPs may look to sell out of the funds that have done very well but haven't returned capital, in order to lock in returns and have liquidity, so they can be nimble going forward when opportunities arise."

Many observers are also talking about how the denominator effect will act as a trigger for people to rebalance their overweight portfolios. In some cases, LPs have a lot more PE exposure than they had originally hoped for and some sellers are outside of their asset allocation, so using secondaries could be a way to quickly rebalance. "But the denominator effect can go the other way too," says Common, "as people may want to use the secondaries market to up their exposure, especially if they see the pubic markets getting worse."

Cardinal sin
Although opportunistic buyers could find good pricing, funds themselves could struggle as valuations drop, says DWS's McDonald: "Recent LP portfolio deals and some GP-led deals could be underwater over the coming quarters with firms committing the cardinal sin in secondaries – losing money. Some actors may find they simply overpaid, and, with leverage on top, the new valuations don't match up." McDonald adds that, in some cases, valuation predictions are that PE funds on average may be down around 15-20% over the next two quarters.

However, it could be a little early to try and predict the outcome, given where the market is, and that its participants are still some way off understanding the full impact of this pandemic, says Sam Kay at Travers Smith: "Secondaries transactions are normally priced off the NAV at a particular reference date. Any proposed buyer is likely going to want to wait until more up-to-date valuations are available, to understand the impact of the Covid-19 pandemic on the portfolio. We would expect that to mean a good number of transactions will be delayed. Whether there is a subsequent pick-up will depend on the 'bounce-backability' of the valuations, or whether sellers are prepared to accept a lower price."

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