Covid-19, oversubscribed funds fuel interest in early secondaries

Alessia Argentieri
19 November 2020

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Early secondaries are tipped to become more plentiful in the coming months, as some LPs will want to offload undrawn liabilities while buyers look for alternative ways to get into oversubscribed, must-have funds. But market observers urge caution to mitigate the pitfalls of the strategy, writes Alessia Argentieri

Following the rapid expansion and diversification of the secondaries market in recent years, marginal and less explored strategies have emerged to supplement vanilla sales of LP stakes in mature PE funds. Undiscovered niches of the market have been brought to investors' attention, multiplying the opportunities available for secondaries players.

Among other strategies, early secondaries – for funds that are less than 50% committed – have captivated the interest of some investors, a trend that seems to have recently increased.

"Early secondaries can be considered as a hybrid strategy between secondaries and primaries," says Ely Place Partners' Daniel Roddick. "Investors get some blind-pool risk mitigation, with part of the capital put to work immediately. At the same time, there is still an assessment of the GP to be done as an LP would for a primary investment, considering that the remainder of the fund is yet to be invested."

Several fund managers have pursued this strategy across the US and Europe, usually as a supplementary approach that can complement a more traditional secondaries programme. This can be particularly convenient to increase the level of diversification offered by a secondaries manager to its investors. It guarantees a certain degree of exposure to recent vintages, while the majority of the capital is securely deployed across more mature secondaries.

In some cases, GPs with high specialisation in the secondaries market have dedicated a specific range of vehicles to this strategy. One such example is Ardian, which is currently investing its sixth generation of early secondaries funds, a $1.2bn vehicle raised in 2016, and is planning to launch a seventh generation.

Fit for the times
Either as a small portion of a wider strategy or as a dedicated programme, developing an early-secondaries focus might prove to be particularly beneficial in the coronavirus era, when diversifying allocation and expanding the investment timeframe can be essential for navigating the crisis successfully.

"Early secondaries are of greater interest today, because they are able to provide a better balance between pre-Covid and post-Covid vintages," says Sunaina Sinha, managing partner at Cebile Capital. "Buying early secondaries, an investor will likely have some deployment in the pre-Covid period and some deals to be done in the post-Covid period. This results in a nicely blended portfolio and subsequently in a much better fund, able to deploy capital at better valuations and across a more favourable timeframe."

In addition to investment decisions influenced by the current pandemic, investing in early secondaries can also be motivated by the desire of getting a larger allocation with an oversubscribed GP. "Investors often use early secondaries to gain more exposure with popular GPs," Sinha says. "It can sometimes be difficult to get the desired allocation with a highly requested GP that is always oversubscribed. This is when the early secondaries market can come in handy, allowing LPs to achieve greater exposure to a GP they consider particularly strong or successful."

It is an approach that necessarily implies a much longer holding time, which can make traditional secondaries players quite uncomfortable and worried about timing and distributions" – Sunaina Sinha, Cebile Capital

Despite the advantages, this strategy also presents several risks and requires maintaining a stable balance within the portfolios. "Secondaries portfolios are supposed to deliver J-curve mitigation," says Pinal Nicum, a partner on the secondary investments team at Adams Street. "They are supposed to have a shorter duration profile than primary funds, and if you put too much of this early secondary exposure in your programme you are just extending the duration profile of your fund. Careful portfolio construction and management of the size of these exposures are very important aspects to consider when looking at this segment of the secondary market."

Returns also need to be considered with a different approach when dealing with early secondaries, which might affect LP expectations. Sinha says: "Generally, secondaries investors prefer fully funded secondaries because they do not want to be responsible for too much uncalled capital, which might drag down the IRR. This is why early secondaries are often reserved for multiple-based investors, which are looking for a cash-on-cash returns rather than a high IRR. It is an approach that necessarily implies a much longer holding time, which can make traditional secondaries players quite uncomfortable and worried about timing and distributions."

Know your GP
Several factors are essential in mitigating risk when pursuing this strategy, including a careful and effective evaluation of GPs' abilities, and not only in mere terms of backgrounds, competencies and specific areas of expertise. Nico Taverna, a partner at Mill Reef Capital, says: "Quality management becomes absolutely essential in these types of positions, and it is necessary to understand if the GP will be able to deliver in the current market scenario. Selecting a manager able to diversify, take on some distress and develop a strategy to successfully navigate the crisis can make early secondaries investments very interesting and rich in attractive opportunities."

These transactions entail a high level of sophistication on the LP side as well, requiring investors able to deal with complex transactions that are resource-intensive and often carry greater execution risk. Nicum says: "LPs that have secondary capabilities and experience in evaluating GPs on a primary basis – such as funds-of-funds, or some endowments and sovereign investors – are well placed for pursuing this investment strategy. These players can find attractive opportunities, often at good discounts, in the early secondaries market."

Another important factor to consider is the direction that the market will take. The industry closed 2019 with more dry powder on hand than ever, and the secondaries market has recently been flooded with record levels of cash, thanks to exceptional fundraising in H1 2020. However, with the scale of uncertainty resulting from the Covid-19 crisis, the path ahead is not entirely straightforward.

Roddick says: "Early secondaries often arise when sellers wish to offload their undrawn liabilities. This potentially presents some interesting opportunities in this post-Covid environment. However, a buyer will have to pay close attention to how the assets have been affected by the pandemic if they were acquired before the outbreak. This is of paramount importance, especially considering the concentrated nature of this type of fund."

As part of the versatile and multi-strategy approach embraced by the secondaries market in recent years, early secondaries might see a peak in activity in the coming months. Taverna says: "The current market scenario is probably going to trigger a few more of these transactions because some investors have committed too much capital to a new product and now might be willing to offload some of their unfunded commitments. This is a trend that might increase and strengthen in the coming months."