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Private equity secondaries investing explained

14 April 2020

Some investment strategies are better suited than others to take advantage of the current market dislocation. In the current environment we anticipate that private equity secondaries are likely to experience a period of exceptional performance.

What is secondaries investing?

Investors in secondary private equity transactions buy existing private equity investments, either in private equity funds or in underlying companies.

The investors holding these illiquid stakes are often motivated sellers, which means that secondary investors may be able to acquire these investments at a significant discount to their current real asset value.

There are several benefits to investors of secondary investing, not least the fact that the buyer is able to gain greater transparency and assess the merits and performance of the investment to date. As these investments are at a later stage than traditional ‘new’ primary private equity investments, secondary investors often benefit from earlier cash distributions and earlier exits than is usual when investing in traditional private equity.

The current environment creates opportunities for secondaries investors

Typically, private equity is a long-term and largely illiquid asset class. But situations and circumstances may change over the life of the anticipated investment period, meaning that liquidity may be required from these investments before the anticipated exit point.

Reasons for selling could include liquidity events such as the need to raise capital, the desire to avoid future capital calls, the need to reduce an over-allocation to the asset class or for regulatory reasons. Think, for example, about institutional investors such as pension funds, which have strict portfolio allocation parameters.

The global coronavirus pandemic has had a widespread impact on both public and private markets. Stock markets are currently some 20% below and in private markets, exits and realisations are likely to be deferred while businesses seek to cut costs and take stock. These impacts alone could easily see an institutional investor dragged overweight on an allocation to private equity and kick out the timeline on anticipated exits.

Motivated sellers with such liquidity requirements means an increased pipeline of supply and the likelihood of favourable pricing for buyers with dry powder to deploy into the sector.

Investing in 'preferred equity'

Not every seller with a requirement for liquidity wants to dispose of holdings. For example, it may be the case where a private equity investor may have a requirement for liquidity, to make a new investment or support an existing portfolio company. Let’s think about the example of a private equity fund manager running a fund which is fully invested but now, due to the impact of the coronavirus, needs funds to support its portfolio companies.

If those portfolios still contain upside, a secondary sale potentially at a discount is not attractive or beneficial to the longer-term performance of the portfolio. Although borrowing against the portfolio is an option, this can be problematic, as debt typically has a set repayment profile or amortisation schedule which may not suit the unpredictable cashflows from the underlying portfolio.

By providing capital, on a bespoke basis, with a priority return, private equity investors can monetise their portfolios without the need to forgo upside. This is known as preferred equity and sits between equity and debt in the capital stack. This liquidity solution can appeal to institutional investors, family offices, corporates, fund of funds (‘Limited Partners or LPs’) or private equity fund managers (‘General Partners’).

Our view is that this preferred equity secondaries strategy should deliver mezzanine type returns for a risk which is closer to senior debt.

Investing in secondary private equity

Secondaries can offer tremendous opportunities for investors. Investments in secondaries are generally for a shorter timeframe than traditional private equity investments. Capital can be deployed faster and there may already be ongoing distributions to investors.

Secondaries have historically outperformed most other types of private equity funds and there is little evidence that return assumptions have moderated even as money has flowed into the market. Buyers expect they will earn annualised IRRs (internal rates of return) of about 15.1 per cent (source: Financial Times).

How to access private equity secondaries investments and managers

The secondaries market, like the primary private equity market, is largely the preserve of the institutional client and therefore, often these funds are difficult for private investors to access. There is also the challenge for a private investor to perform the necessary due diligence on the fund and the manager and even if access was available, this would unlikely be in the minimum fund investment amounts accessible to most private investors.

At Connection Capital, we’ve been able to offer private clients investments in secondaries via two different institutional grade managers. Having worked with both Headway Capital Partners, which deals with both traditional secondary transactions and more complex liquidity solutions and 17Capital, the preferred-equity specialist.

Both are specialists in their niche and while minimum investments in their funds are in the millions of pounds territory, our clients have gained access through our syndicated approach.

If you're looking to consider these strategies in future, register with Connection Capital here.

Lorna Robertson, Head of Funds
April 2020

Sources

1. https://www.ft.com/content/5bdc8c3f-815b-39fd-be3c-99b1cebc767d

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