In the December 2020/January 2021 issue of Private Debt Investor, I mentioned that the private debt secondaries market was an estimated $5 billion to $10 billion in size. This figure was based on what we are hearing anecdotally rather than any official measurement of the market.
But to measure the size of a market, you need to define it. So what do we mean by the ‘private debt secondaries market’? To think of it solely as the transfer of interests in funds from one LP to another would hugely underestimate its size.
This is a market that is actively being formed by GPs working with sophisticated credit secondaries firms to proactively put forward liquidity solutions to LPs. They are managing the liquidity profile of funds, while raising new capital through co-investments, staple deals or recycling of proceeds. These players are creating secondaries.
Being a dutiful GP
GP-led transactions accounted for 44 percent of all secondaries in 2020, according to Greenhill. In many ways, GP-led transactions lend themselves better to private debt than PE. A buyout group has more control over liquidity – it can weigh up what value it can expect to get in an auction process for a given asset in its fund, versus rolling that asset to a continuation fund to extract the most future value.
The debt in a PE sponsor-backed deal, however, will generally only get repaid when that deal is exited by the sponsor, is refinanced or reaches the maturity of the loan. Partnering with a secondaries investor can allow a credit GP to achieve the liquidity which otherwise would not be possible, while maintaining the management of the credit.
Many debt managers will have some loans that have been restructured or that have extended hold periods. The covid crisis has had a somewhat binary effect on the performance of companies: some have thrived, while others have suffered.
As a result, many debt funds are likely to have tail-end positions of underperforming assets after the better performing ones have been exited. By engaging with credit secondaries specialists on an ongoing basis they can take a view as to the optimal time to propose a liquidity solution to their LPs. They may conclude it is better to start a liquidity process today while the stronger, performing loans are still in the portfolio rather than wait and risk being unable to sell a tail end of underperforming assets at the end of the fund term.
Whatever the circumstances, we are advising our GP clients to do the right thing by their LPs by exploring options with secondaries funds. Even if it does not lead to an immediate transaction, it helps send the right signal to LPs that the GP is proactively managing the liquidity profile as well as validating the valuation of the assets.
Forming new LP partnerships
This engagement with the secondaries market is also an opportunity for GPs to build new LP relationships.
This is where we at Ely Place Partners feel there is the greatest potential – to capitalise on the recent growth in this nascent market not only as a liquidity offering, but also as a means of enabling GPs to raise capital, grow AUM and build long-term partnerships with LPs.
“Whatever the precise circumstances, we are advising our GP clients to do the right thing by their LPs by exploring options with secondaries funds”
However, not every GP can embark on a GP-led secondaries process. It needs to make sense for the current investors to begin with; and, even with their full support, the process requires a commitment of time and resources and is fraught with uncertainty. So how else can GPs think about engaging with credit secondaries investors?
If we take the basic ‘ingredients’ that a secondaries investor typically requires – a strong drawn element, a discount/prospective short-term uplift in valuation and near-term liquidity – then there is in fact a whole range of possible options for a credit GP to take advantage of this growing market to build new relationships with LPs and raise capital.
Below is a list of some of the types of transactions we have either recently completed or are currently active on:
Late primaries: Our clients have had funds that are 80 percent-plus drawn by the time they get to final close. Often there has been an uplift in valuation in the assets due to outperformance. Even taking into account the late commitment interest charge, an investor could still commit to the fund at an effective discount. With a minimal J-curve, reduced blind pool risk, an uplift in valuation on day one and potentially early liquidity depending on the investments’ profile, these deals have all the characteristics of a secondaries transaction.
Creating portfolios of co-investments: A GP may find itself needing to free up capital in an existing fund – eg, managing liquidity needs in a BDC, right-sizing a loan in a fund or selling down a strip of the assets to free up capital that can be recycled. These assets can be sold to a new vehicle funded by the credit secondaries investor, but still under the management of the GP, alongside new pipeline co-investments. An appropriate fee and carry structure is then applied to create the right alignment between the GP and investor.
A few months ago, investors were nervous about funds with pre-covid loans. Ordinarily, having seeded assets in a fund is seen as an advantage – it lowers the J-curve, accelerates the deployment of capital and allows the LP to de-risk the commitment to the fund by diligencing the portfolio.
However, as covid took hold, for a period this was largely seen as a disadvantage – these funds potentially had exposure to troubled companies that may default on their loans. Fast forward 12 months, and many investors are actively looking for exposure to strong companies that have withstood the covid impact and proven themselves resilient. If a GP can offer this to an LP, then it can present a potentially very attractive proposition.
Bespoke SMAs: An extension of the above is for GPs to work with LPs to build bespoke portfolios to match their precise requirements: senior vs subordinated return target; cash yield vs PIK, in addition to target currency, geographic or sector exposure. A GP may be able to seed the SMA with existing loans currently under management that fit the criteria giving the LP diversification of vintage. Again, the GP economics will be negotiated with the investor, and leverage may be used to further enhance returns.
This is one way we envisage the market evolving, with LPs demanding bespoke SMAs with precise portfolio construction. Simply committing to blind pool funds does not work for many investors.
Therefore, rather than the traditional concept of marketing a fund with a set strategy to LPs, we are advising our GP clients to listen to what LPs need and work with them to structure custom solutions.
Role of the intermediary
In a recent discussion, one credit secondaries investor described the market as being more ‘partnery’ than the PE secondaries market – ie, less about a single transaction and more about forming tailored solutions for GPs with a focus on longer-term partnerships. These are not deals where the price is the only or even the main determining factor, and such transactions do not fit well into a traditional auction process associated with PE secondaries.
So, what role does an intermediary have in such a market? We see our primary function as being advisors to GPs. We are here to advise them on what solutions are available in the market, and what LPs are seeking in terms of risk, return, liquidity profile, cost of capital, appetite to leverage, part of the capital structure, currency, deal size, concentration, etc.
Our role is to advise a GP how best to provide liquidity to its existing LPs, how best to renew its LP base if need be, and which LPs are likely to be most supportive of its strategy. Our role also involves managing a process to generate the best outcome for the GP’s investors and, in the case of a continuation vehicle, ensure that the GP can agree acceptable terms with the secondaries investor. Where a syndicate is involved, this can require a degree of coordination that is hard to achieve without an advisor.
So, how big is the private debt market and what is its potential? The answer depends on how large a market we all wish to create.
Daniel Roddick is a partner at Ely Place Partners, a London-based investment advisory firm