Contrasting fortunes: debt and venture secondaries

This article is from the Secondaries in Private Equity report, published in association with Campbell Lutyens. Click here to download your copy of the full report, including further analysis on secondaries fundraising and both GP- and LP-led secondaries

Wherever there is buoyant primary activity, over time, the natural by-product is a secondaries market. Private equity fund stakes clearly command the biggest market in the alternatives space, but there have been dedicated secondaries strategies for real estate, infrastructure and venture for some years. According to Campbell Lutyens, the transacted value of real estate secondaries amounted to $5.28bn in 2018; infrastructure secondaries $3.65bn; and venture $5.67bn, compared with the $47.4bn in buyout secondaries.

As secondaries become an established part of the market, and demand grows from the LP community for the strategy, it is inevitable that innovators will explore opportunities in other asset classes. Two in particular offer apparent synergies with private equity: private debt and venture capital.

Private debt
"There has been a lot of capital put to work in the private debt space in recent years, so a natural derivative of this activity is a secondary market," says Gerald Cooper, partner at Campbell Lutyens. "We are beginning to see dedicated secondaries funds for private debt and expect institutional demand to grow for this type of exposure."

Last year, investment manager Pantheon was identified in unconfirmed press reports as preparing a secondaries fund dedicated to private debt. Currently, no such vehicle exists in the private market though some institutions have invested through bespoke mandates as part of a more global and diversified strategy.

"Until the financial crisis there were only mezzanine and subordinated debt to talk about in the private debt sphere, as well as funds that were mainly distressed or turnaround. So the only debt secondaries were LPs selling these types of debt positions as part of portfolio re-balancing, in a bid to reduce their exposure to these deals," says Francesco di Valmarana at Pantheon.

There were very few limited partnership fund structures targeting senior debt until banks started pulling back and in stepped the swathe of mid-market direct lending and private debt funds. The mid-market direct lending and private debt space has now been up and running for more than 10 years so there has been an extended opportunity to get to know the managers and their portfolios.

As happens when any asset class matures, some investors are likely to seek exposure to private debt through the secondaries market" – Francesco di Valmarana, Pantheon

"Private debt portfolios have started to follow the trend in the private equity secondary market, with investors rebalancing their portfolios and, to date, it is more common to see trading in distressed debt funds," says Immanuel Rubin, partner at Campbell Lutyens. "So far we have seen mostly event-driven sales what with pension plan selling some interests, for example."

The thing to consider is that it may be difficult to justify selling at large (or any discounts) when selling senior, first lien or unitranche positions and therefore there is more limited upside from buying notably discounted positions in distressed debt funds. But, although overall returns on such credit funds are lower with typically a holding period that is shorter in private debt, it will be attractive to some, says Lutyens’ Rubin.

"As happens when any asset class matures, some investors are likely to seek exposure to private debt through the secondaries market," says Pantheon’s di Valmarana. "You cannot do a private debt deal and expect a private equity return. But you can start to get exposure to private debt through secondaries in order to get a private debt return, often at lower risk," he says.

As investors have become more comfortable with the private debt market and direct lending in recent times, a feasible and liquid secondary market could be drawing closer.

Betting on venture?
Despite having a relatively long history, compared with private debt, secondaries in the venture capital space is yet to be established as a standalone strategy with critical mass.

"Investors have not demonstrated that they are willing to make a bet on the venture secondary market the same way they have for other alternative strategies," says Lutyens’ Cooper. "The opportunity to provide secondary solutions in the venture space is meaningful, but the market is undercapitalised, which limits the scale and breadth of transactions that can be executed. Early-stage investments typically have limited financial information available and the businesses can be highly technical which are barriers that most traditional investors find difficult to overcome," he says.

Investing in venture via secondaries has specific challenges: there is generally less certainty around valuations and the timing of exits, so IRRs tend to be more volatile, say Pantheon’s di Valmarana. It can take longer to exit the companies, and follow-on capital injections may be needed, depending on the stage an investor is exposed to. Finally, it can be difficult for managers to deploy a meaningful amount of cash.

The issue around deployment is exacerbated by difficulties in finding attractive opportunities in the space, particularly when looking at a portfolio of fund interests. "There has always been a market for venture secondaries, but placing a secondary venture portfolio is harder than placing a private equity one," says Pinal Nicum of asset manager and LP Adams Street Partners. "Finding good quality venture is also harder and there is a bigger performance dispersion, so it is a difficult place to find good value."

With the private equity secondary sphere bursting at the seams with players, asset managers may naturally look to different but related asset classes to diversify and differentiate themselves. While venture secondaries will remain an acquired taste for some time, private debt certainly seems poised for a healthy uptick.