Secondaries in the spotlight

Fundraising for the secondaries market – where investors purchase securities or assets from other investors rather than directly themselves – has finally bounced back after steep falls from the highs experienced during covid-stricken 2020, with H1 2023 showing a 28% year on year jump. Indeed, the broadsheet financial media has been awash with reports of large players raising billions specifically for allocation to secondaries, with the pervading sense from market players that it’s been both undercapitalized and, to a degree, an undervalued part the alternatives eco-system.

While the actual volume of transaction for secondaries didn’t meet expectations in H1, market commentators seem to believe an incredibly robust H2 will make up for any shortfall. What’s clear is that the market has matured and grown in terms of sophistication with players on both sides of the equation using ever more sophisticated asset performance and sectoral data to guide their investment strategies.

Liquidity and economic uncertainty are the key drivers

As the saying goes, not all heroes wear capes, and in a period where liquidity has been increasingly scarce, the secondaries market has been a lever that both GPs and LPs can turn to and pull. If capital is the lifeblood of a financial system, then secondaries can be seen as an essential safety valve that allows that capital to keep flowing through the arteries, meeting investors need for liquidity.

What’s also helping secondaries seize the moment is the ongoing sense of uncertainty still gripping major economic markets. Investors seem either cautiously optimistic or cautious with regards to optimism as they wait to see whether interest rates and inflation will begin to properly descend. On the private equity front, this ever-present uncertainty – the bête noir of deals – has kept the under-performance of 2022 rolling deep into 2023: reigned in investments, blocked exists, and stymied fundraising for many traditional PE transactions abound. The safety valve of secondaries therefore becomes ever more appealing.

The LP advantages

For limited partners, there are two clear ways to take advantage of turning to secondaries; firstly, if there’s a need to re-up for the next investment cycle and reshape their portfolio, then offloading that asset at the right pricing floor becomes an attractive prospect. Secondly, for limited partners on the buy side looking to find quality businesses or assets at a sometimes heavily discounted price on the dollar, there are great deals to be had. Of course, there’s a tango that takes place between buyer and seller and there were times post-2020 where there was no great alignment on price or valuation of assets, hence the slowdown in-deal activity. As things stand in H2 2023, deal flows are good, discounts deep and buyers and sellers are making matches.

On the private equity front, the last 12 months has seen the expansion of secondaries funds aimed squarely at the middle market, with an ever more diverse sectoral selection of well-positioned companies becoming available. Of course, middle market companies have a lot more room to grow both operationally and in terms of scale, and often benefit hugely from PE firms’ capital injections and M&A expertise. The feeling among many investors is that there are bargains to be had in this space, and sellers seem more willing in this illiquid moment in time to adjust their valuations to get deals over the line.

GP-led secondaries have changed market dynamics

Looking at the history of secondaries, there is another key development it would be remiss not to highlight. If first period of the market was defined by limited partners led deals, then the second (let’s call it ‘post-Covid’) has been defined by the rise of GP-led transactions. Historically many GPs have often found themselves facing what you could term a ‘capital conundrum’ – on the one hand the need get a return on an asset as the clock ticks down on a fund, on the other often knowing they may be selling that asset before its value has been maximized.

Enter, stage left: GP-led secondaries

The asset – often held in a vintage fund nearing expiration – is sold into a continuation fund which enables GPs to keep control of their asset, attract investment from new limited partners, and pay out their original fund investors. Holding on to high quality assets for an extended period can help GP’s ensure they extract every bit of value created by their work and effort. It also offers the original investor optionality; an escape hatch if the investor is looking for distributions in order to re-invest or re-allocate their capital due to internal or external economic factors, or the opportunity to roll their capital into the continuation fund and share on the potential upside, often at more enticing economic terms than the original fund vehicle.

The outlook

With momentum building in the secondaries space and greater supply coming on-line, it’ll be fascinating to see where both fundraising and transaction volumes finish in 2023. It’s worth remembering that these are complex financial vehicles; having the right support for the operational process of administering a secondaries fund and the right tools in terms of data capture, delivery and monitoring is essential.

Looking at the horizon there are three factors that might have both short and long-term effects on Secondaries.

1. The potential impact in the US of the SEC’s Private Fund Reform Rule around Adviser-led secondaries and the requirement to obtain a fairness or valuation opinion from an independent party
2. The speed at which private equity players embrace AI and Automation to enhance the deal making decisions
3. To what extent the rise of NAV / Borrowing Base loans will eat into secondaries allocations

We’ll of course be opining on these factors in the months ahead, but, for now, in the ongoing race of financial performance, coming secondary seem to have its advantages.

We are delighted to announce that the Luxembourg Private Equity Association (LPEA) will be hosting two events in the US this October: the Luxembourg Private Equity Seminar in New York on October 25th and in Miami on October 26th.
These events are an opportunity for a select group of private equity and venture capital professionals to discuss European market trends and explore synergies between the Luxembourg and US markets.

Our very own Antonis Anastasiou will be part of a panel discussion with other industry experts, sharing insights on fundraising and distribution via Luxembourg.

Don’t miss this chance to gain valuable insights into the Luxembourg market and make meaningful connections with fellow professionals. Register now and join us in New York and Miami this October!

Considering the transformational possibilities of artificial intelligence on fund operations —the right applications can do everything from reduce costs to help generate new revenue — it may come as a surprise that only 14% of fund executives surveyed by information service Private Funds CFO have implemented AI technology into their portfolio companies. Perhaps more startling is that more than half of respondents said they had no plans to adopt AI in the next year.

For Alter Domus Head of AI and Automation Davendra Patel, that looks like a missed opportunity, especially with areas such as risk management, due diligence, and performance tracking ripe for AI integration.

In a recent interview with Private Funds CFO, Patel said that in the current economic climate, AI is a pivotal tool for gaining a competitive advantage. That’s a view his own company has taken to heart: Alter Domus has created its own versions of ChatGPT and integrated generative AI to automate data from various sources, providing real-time information and insights to clients.

Patel, who has 30 years of experience in IT, acknowledges the potential security risks around AI, including the threat of shared information becoming leaked information. By developing proprietary tools, Alter Domus has optimized data safety. In addition, in-house experts continuously monitor the Alter Domus system for vulnerabilities and breaches.

“We focus on regular reviews, audits, and ethical considerations to ensure AI’s responsible and safe deployment,” Patel told Private Funds CFO.

“It’s essential to balance AI’s potential with practicality, focusing on both immediate gains and long-term benefits.”

Read the full article here.

We’re proudly sponsoring the 9th International Funds Summit & Expo in Cyprus on October 23 and 24.

The summit brings together investment fund professionals from around the world to discuss the evolving regulatory and increasingly competitive landscape in the global asset management sector and much more.

On Day 2, Evdokia will moderate the panel discussion “The Future of Funds Administration”, where experts will explore how the future of fund administration is posing unique regulatory challenges, especially in smaller jurisdictions.

Meet our team at our Alter Domus booth and discover how our solutions can meet your needs.

What are some of the key considerations when identifying the right service operating model for your company?

Your operating model and managed services provider need to be able to accommodate your future growth plans. If you are considering moving into new jurisdictions, asset classes or strategies, they need to be able to flex accordingly to support that next step for your company. Crucially in today’s data-driven environment, you also want to think about your data and technology needs. Investors are demanding real-time access to information and transparency. Do you want to take on the cost and responsibility of building and maintaining the capability to provide that in-house? Many asset managers are engaged in M&A activity, which is a logical moment for a fundamental rethink of your operating model.

How is traditional outsourcing changing?

The need to access data is driving change – for the better in our view. We’re moving away from a commoditized and transactional type of model towards operationally integrated partnerships, where there’s transparency and access to data in real-time. We’re also seeing some consolidation and rationalization of partnerships. Where perhaps a manager might have had multiple fund administrator partnerships in the past, now they might have one or two deeply embedded partnerships that can cover all the jurisdictional and sector specialisms they need globally.

Co-sourcing is a relatively new concept. What is it and why might firms consider it?

Essentially, co-sourcing is an operating model where the manager maintains an in-house data and technology stack that their administrator has access to and can create and modify primary data elements. It’s a hybrid model between fully outsourced and fully insourced. The benefit it offers managers is that it allows total control and ownership of their data and real-time access to it, while tapping into the asset class and systems specialists, and talent acquisition capabilities of a fund administrator, all while reducing manager level overheads.

Beyond co-sourcing, in what circumstances might a full lift-out be the right solution for a company?

That partly depends on whether, as a manger, you have the scale and appetite to reinvest in your own technology and in-house operations or not. There are considerable advantages to partnering with a provider who constantly upgrades their technology platforms and can provide a long-term career path to valuable internal resources. There are also the economies of scale and best practices that a global administrator can offer, without being distracted by the challenges of maintaining a back office. We’ve seen great success for both clients and personnel as we’ve created a playbook to successfully assist with these types of full lift-out transitions.

With this evolution in mind, what should a company be looking for when choosing a service provider?

Ultimately a good administrator is focused on white-glove levels of service and forming a deep partnership with their clients, which will include customizable solutions and specific asset-class expertise that meets specific needs. An administrator should be viewed as a critical member of the team, who when leveraged correctly delivers significant value-add to portfolio, risk management, and investor teams. Critically, you need to have confidence that they are technologically innovative, as well as culturally a good fit for your organization.

This article was originally published in Preqin's Service Provider Report.

How would you describe GP-led dealflow right now?

Tim Toska: Conversations with our clients around GP-led secondaries are becoming increasingly common. Sponsors are identifying high-performing companies where significant value-creation potential remains and are putting them in continuation vehicles. These deals have become a valid fourth option when it comes to exiting businesses.

Brian Mooney: Almost every major private equity firm has completed at least one continuation fund and many have completed several. We observe that firms that have yet to do so are working on one right now or considering their first. However, there is a massive supply/demand imbalance. While the demand side (buyside capital) is growing, it is not keeping pace with supply, particularly given that so many LPs are suffering from the denominator effect. That is impacting fundraising in all asset classes including secondaries.

As a result, GP-led deal volume is down on last year, but those transactions that are taking place involve the highest quality sponsors and the highest quality assets. I would also add that there has been a marked shift towards the mid-market. Very large single-asset or concentrated portfolio deals, meanwhile, are proving more challenging

What impact are those supply/demand dynamics having on pricing?

BM: Only 25 percent of all GP-led deals were priced at a discount to NAV in the first half of 2021. By the first half of 2022, that had increased to 50 percent, and I think that is still true today. We are also seeing more transactions with some kind of structuring involved in the purchase price. It could be a simple deferral or in some cases a portion of the purchase price is based on a contingency such as hitting a certain level of EBITDA at a given date.

How should sponsors prepare their assets and processes to maximize the chance of a GP-led deal completing?

TT: Transparency is paramount, and I think the GP-led secondaries market has benefited from enhanced transparency more broadly in the wake of the pandemic. Historically, there was criticism levelled against the asset class with regards to a lack of readily available information and stale information.

During the pandemic investors began to demand frequent data points and communication around specific companies, which forced managers to put the necessary infrastructure in place to deliver on that. That means that when a GP raises the prospect of a continuation vehicle with a particular asset today, the LP base is already well versed on how that company is faring and why a continuation vehicle might make sense.

BM: Sponsors today are communicating with their investors early and are focused on transparency, both with buyers and the existing LP base. In terms of preparing companies, it is all about finding the ideal candidate and having the right motivations.

What are secondaries buyers looking for in a GP-led deal in terms of alignment?

BM: At an absolute minimum, a GP needs to roll at least half of its capital. For us, as a buyer, the GP must be a net buyer or else the transaction is of no interest to us. We tend to become really interested, however, if the GP is proposing to roll all its capital, meaning the original investment plus carry crystalised through the sale to the continuation vehicle. A GP-led transaction becomes even more interesting if the GP wants to write an additional cheque, which could mean a commitment from its new flagship fund.

Meanwhile, economic terms tend to be more favorable, with lower management fees and tiered carry, which serves to further enhance alignment.

What role can technology and data analytics play in supporting a GP-led process?

TT: With a GP-led process, as with so many areas of private equity, it is vital for sponsors to have a single source of truth in-house. Get your data systems in place and then you can overlay that with market insight to help identify the perfect candidate for a continuation vehicle. Investors are also relying on data analytics to evaluate manager performance. But I would add that data analytics is fundamentally about taking the robot out of the person. It takes away all the laborious legwork and enables teams to bring a new and more valuable set of skills to the table.

BM: Underwriting a continuation vehicle is a very intensive process. You need to underwrite the sector and the company, but you also need to underwrite the sponsor. You need to evaluate how that sponsor has added value to that business and whether that is consistent with the strategy being proposed for the continuation fund. All of that involves pattern recognition and, if you have the data and analytical tools to gain that insight, you can better assess the risk/return profile of the deal.

What other areas of private equity do you see as ripe for tech disruption in the future?

TT: I see the real value of technology as supporting due diligence at the front end of a transaction. I also believe that automation can help streamline processes, making data requests that might previously have taken days almost instantaneous. Meanwhile, the more standardised that data becomes, the more easily it can be integrated into investors’ systems as well.

BM: I think data analytics will play an increasingly important role in LP secondaries, where you are often building portfolios with hundreds of fund interests and thousands of underlying companies. Technology can help make that market much more efficient and support our ability, as buyers, to submit offers more quickly, while also informing our portfolio construction around underlying risk and return drivers.

I agree with Tim that technology in this asset class is about taking the robot out of the person. This is still a people business. As investors, we are betting on the teams that we believe are the smartest and best at what they do.

This article was originally published in PEI’s US Mid-Market Report.

What do you think are the factors driving the incredible growth in distressed debt and special opportunity funds?

First, there’s the legacy effects of a long-term zero interest rate environment, and the proliferation of dividend distributions from a lot of LBOs, especially from the sponsor finance community, or private credit funds. They were done when rates were low – one floor or two for reference rates – and now it’s ticking up to the five range.

And with these legacy spreads and the current reference rates, some of these companies can’t afford that debt service as part of their operating model. That’s starting to trigger a lot of the EBITDA covenants within their underlying credit and lending agreements.

So we’ve seen a lot of our traditional private credit lenders and opportunistic managers launching special situations and credit opportunity funds, where they can step in, restructure the debt, and maybe put it on non-accrual or non-cash pay for a period of time to work these deals out. There was a bump in these funds being formed at the beginning of covid, with the assumption the pandemic would create a boom in distressed situations for the then pending economic distress.

However, due to all the government stimulus, that boom was delayed. But with the prolonged increase in rates, even with the continued economic performance, a lot of these managers are expecting that boom to commence. There are also situations like the collapse of Silicon Valley Bank that suggests there will be interesting portfolios coming to market, priced to be offloaded quickly and able to be worked out at significant returns to investors.

Do you think that same environment is fueling a rise in asset-based lending funds?

Traditional asset-based lending is typically lending where there’s a lag time between when corporate borrowers need to finance their commercial operations and bridge the period of time that their customers are paying them for the product that’s been delivered.

Up until recently, that’s been the world of a money center bank, or a super-regional money center bank that have these facilities where they will make those loans, monitor those loans and pledged collateral, and keep that relationship with a borrower. But given the ultra-sensitivity of those super-regional bank market events, those are really good loans to shed because they have high market value, without the bank to reserve against them.

So we’ve seen a number of those portfolios come to market where it’s private capital that will take on those asset based loan (ABL facilities) on behalf of the borrowers at a pretty good rate from the original bank lender.

And then there’s the role of the traditional investment bank on providing portfolio leverage, which we now see large insurers and actual funds coming in to replace them, despite all the compliance issues and strict rules around what’s applicable, what’s admissible, and substitution rights if a particular asset goes wrong. This is now becoming the realm of large insurers, since they have a more permanent capital base, one that isn’t based on deposits.

We’ve had a few clients entering into lending or refinancing arrangements, and they really liked the term loan and the borrower. The borrower then brings up the fact that they also have this ABL and would like to have the same provider for both.

So the manager decided to meet that market need, and as a result, we ended up exploring what we could do to service them, and licensed a product dedicated to the ABL space that provides transparency to the lender, the borrower and us though the operating infrastructure.

For managers looking to launch their first credit fund to take advantage of this environment, how should they think about the operational infrastructure to administer it?

When I speak with PE managers that are used to underwriting and investing in a portfolio company and valuing their portfolio once every quarter, they’re in for a very different level of activity in the credit space. The same underwriting process and the ongoing valuations occur, but additionally the bank debt pays at a minimum quarterly, and the rate resets typically quarterly. There are amortisation payments. Loans are typically originating below par. So they’ve got non-cash income that they need to recognise.

These deals get amended constantly, so there could be different compliance rules under the credit agreements. Furthermore, the maturities get extended, the size of the deal could move up and down, and all this requires a great deal of monitoring of the underlying borrower. And they need a system that will address and support all those things.

They have to decide who will be the administrative agent on the credit, whether it’s done internally, or outsourced completely.

Then there’s SEC oversight around the custody of investor assets. How are they going to build an infrastructure where they’re not co-mingling investor monies across multiple funds or different borrowers and everything else required to withstand the scrutiny of the SEC? And that’s just on the legal and operational side of things.

As a result, our clients invest a lot of resources on attorneys, compliance experts and our services because we have the appropriate systems for the agent components, the loan administration, which is tracking and ticking and tying all the cashflows, positions, rate resets, amortisation schedules, and then ultimately the fund accounting and investor reporting. Because a direct result of this growth in private credit is there is a dearth of people that know how to do credit accounting because it is very different than PE, or fund-of-funds accounting.

This ends up producing a massive amount of data to monitor and manage. The front office wants credit monitoring. The middle office needs to monitor the compliance with the credit agreements. And then the back office needs the data to produce the reports and everything else. There are big ticket systems available that cost millions to implement or off-the-shelf systems that support various functions for credit managers.

There are much lower cost solutions for data warehouses where they can build report writing software on top of the warehouse – these become a kind of integral hub for the spokes that go out to address reporting requirements. And then there are other inexpensive add-ons that can offer portfolio view technology as well.

Most clients want that data in-house, but it’s a daunting task to build internally. This is why we’re confident that outsourcing will continue to offer a compelling value proposition for the GPs looking to make the most of this particular moment in the credit markets.

This article was originally published in PDI's US Report.