Appetite grows for secondaries

Record numbers of LPs are committing capital to secondaries funds in private debt.

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Private credit secondaries are coming of age in 2023, with more limited partners planning to commit capital to secondaries funds in private debt than ever before, and more planning to buy and sell stakes in the secondaries market.

According to Private Debt Investor’s LP Perspectives 2023 Study, 17 percent of LPs will commit capital to secondaries funds over the next 12 months – a significant jump on the 7 percent that said the same this time a year ago, and the highest level we have seen over the history of the survey.

Rakesh Jain, partner and global head of private debt at Pantheon, says: “Investor interest comes down to two things, the market opportunity and the risk reward attributes of the strategy or asset. Investors are increasingly recognising that the credit secondaries market opportunity is a large one, it is growing quickly with a lot of favourable tailwinds, and there are limited players of sufficient size, scale and expertise to take advantage of it.

“When it comes to risk-reward, investors are focused more than ever on both income and total return opportunities. Credit secondaries, when executed properly, provide both current income and attractive total returns.”

Jain believes the strategy offers excellent risk-adjusted returns. “People are now recognising the positive attributes of secondary private credit portfolios. We focus on performing loans and portfolios that are highly funded at closing, with a much shorter duration than new issue loans, and we can generate high levels of diversification across company, strategy, GP and vintage year. Taken together, we believe this provides significant risk mitigation against losses or below average returns.”

LPs are also showing growing appetite for engaging with the secondaries market as both buyers and sellers of fund stakes. Today, 27 percent of investors tell us they will buy or sell in the credit secondaries market over the next 12 months, significantly higher than the 19 percent that said the same for the past three years.

“There is a lot of pressure on LPs to rebalance their portfolios,” says Daniel Roddick, founder of secondaries advisory firm Ely Place.

“That may be driven by the need to reallocate portfolios from a strategic point of view, or to address the denominator effect where they find themselves overweight in private assets relative to public assets as public markets have devalued.

“LPs have become much more aware of the liquidity options available to them over the last few years, and in credit secondaries we have also seen the sudden emergence of a number of specialist buyers going out and demonstrating to LPs that they can be of value. Those buyers have a very different cost of capital to traditional secondaries buyers, so sellers now know they can get a fair price from a specialist buyer as opposed to being seen as a forced seller.”

In addition to LP portfolio sales, a growing number of general partners are recognising the value to be achieved through GP-led secondaries. Roddick says these GP-led deals accounted for roughly half the overall private markets secondaries in 2021 and remain popular: “Many private debt managers have come to learn the usefulness of some of that GP-led technology, and they know they need to be increasingly creative in offering liquidity solutions for their LPs. It is also a means for GPs to bring new LPs into their investor base. That appetite for continuation vehicles has grown and will carry on growing in private debt.”

Across asset classes, 90 percent of LPs now feel that mandatory independent third-party valuations are necessary in GP-led secondaries processes, while 69 percent say they feel negatively about high levels of leverage in GP-led transactions. Just 7 percent say they are most likely to roll over their exposure in a fund they are committed to if a continuation fund process takes place, with 18 percent saying they would be most inclined to sell, and 75 percent preferring to judge on circumstances.

Jain says: “GPs are increasingly looking to the secondaries market as a means to build a relationship with a new investor, raise new capital or get liquidity on assets for LPs to bridge to a next fundraise, create more runway to continue to invest, or clean up legacy portfolios.”

Looking forward, Jain expects credit secondaries to continue to grow in popularity. “The primary market has grown so much over the last 15 years, with many different investor types accompanied by myriad fund or vehicle structures, and this has created more tailwinds around the supply of secondaries opportunities. We feel the trajectory will remain strong because the penetration rate of this strategy is so low. We have done investments with 60-plus GPs since 2018, and dealflow has increased 15-20 percent every year that we have been in this business.”