At a time when market dislocation is dampening demand and stunting growth in countless private markets strategies, credit secondaries are enjoying a boost to an already bullish upward trajectory. Buoyed by liquidity demands driving activity from both LPs and GPs, along with broad shifts in investor appetite from equity to debt and from primaries to secondaries, new entrants are lining up to get a piece of the credit secondaries pie.
Paul Buckley, managing partner and chief executive officer at advisory firm FIRSTavenue, says: “There have been two years since World War Two in which both debt and equity markets went down, and last year was one of them.”
For many investors, that created a denominator effect and a situation where illiquid fund holdings need to be sold.
“Separately, you have the phenomenon of interest rates increasing on a secular basis for the first time since the mid-eighties, which for insurance companies drives the cashing in of policies and creates a need for liquidity that is also leading to the sale of private funds,” adds Buckley.
This means it’s a good time to deploy capital into secondaries. “Spreads have widened, particularly in very illiquid assets like infrastructure and credit, and we have seen a whole series of new market entrants. We are at a point where the market perceives value and needs to develop with new investors coming in,” says Buckley.
“In this environment the asset class comes into its own and all the infrastructure that has been built over the last two decades for private equity secondaries is being applied to credit. The winners and losers in this marketplace will be decided over the next 18 months.”
The market size for closed-end private credit funds has grown to around $1.5 trillion and keeps on expanding, meaning a wider mix of debt funds in which investors are locked up for anywhere between seven to 10 years. Credit secondaries players argue that a rough rule of thumb is that 1-3 percent of private markets stock turns over each year, as investors seek to rebalance, look for liquidity and more actively manage their portfolios, suggesting sizeable room for growth.
According to secondaries firm Coller Capital, the trade in second-hand stakes of private debt funds hit $17 billion in 2022, more than 30 times the total volume in 2012.
Toni Vainio, partner in Pantheon’s global private credit investment team, says that in a market where investors are looking for the best risk-adjusted returns, many are looking at credit secondaries as an attractive way to get exposure to performing credit.
“Investors like the visibility of portfolios, the immediate yield and the fact that risk profiles for seasoned loans are often lower than for new primary originated loans that tend to have peak leverage at entry, peak earnings adjustments, and often new sponsors and management teams,” he adds. “When the market is more challenging and the risk is heightened, many investors turn to the secondary market as a way to access seasoned loans at a discount and in a diversified way.”
Above average discounts
Ed Goldstein, chief investment officer at Coller Credit Secondaries, says there is another reason credit secondaries held up better than PE secondaries in 2022.
“What we saw last year, because the equity markets had dropped so significantly, was that owners of private equity funds looking to sell faced discounts that were above long-term averages and were higher than the discounts being applied to private credit in the secondaries market,” he says. “That meant that if you were a seller of private assets and you had a choice where to sell and take the smallest loss, you might sell your credit book rather than your PE book. All that helped to add to volumes in the latter stages of 2022 and into 2023.”
Such volumes are piquing interest on the buyside, which has so far struggled to keep up with demand. In April, affiliate title Secondaries Investor revealed Goldman Sachs was eyeing the strategy, following hard on the heels of Ares Management and Mubadala Investment Company announcing a $1 billion tie-up for credit secondaries. Apollo Global Management is also growing its commitment to the asset class.
Ebou Jallow, a vice-president at secondaries adviser Setter Capital, says: “We are seeing an increased number of buyers targeting credit secondaries and, most importantly, they are buying out of accounts with appropriate, relatively lower, cost of capital. It is not just traditional secondary buyers but also groups like insurance companies, family offices and even some pensions doing the buying. That has meant more capital to do these deals, and a narrower bid-ask spread.”
Goldstein adds that Coller has not changed its medium-term outlook on credit secondaries. “We see a very good possibility that the market will be $50 billion by the middle of the decade. Today there is a bit of volatility but in terms of the overall trend, that is not changing. There are billions of dollars in large-cap credit funds in their investing phase today, so there are LP liquidity issues that need to be addressed and it is up to the market to figure out how to address those together with the primary GPs.
“Right now there is a supply-demand imbalance. Our estimate is that there is about half a year of dry powder in the market today, so credit secondaries are still well under-capitalised compared to a little over a year’s supply of dry powder on the equity side. There is still a long way to go.”
While LP portfolio sales dominated activity last year, Vainio predicts growth will soon pick up in GP-led credit secondaries, too.
“On the GP liquidity solutions side, private debt GPs have been looking at the private equity market where GP-led solutions are now almost half of the PE secondaries market and seeing a variety of ways that they might also become more active about managing their books,” he says.
“We have seen more transactions around continuation vehicles, strip sales, tender offers and joint ventures, all of which come down to GPs being more proactive about managing their LP bases, the liquidity of their funds and diversification of their portfolios, using the secondaries market to achieve those objectives.”
Jallow adds that the main challenge to growth is probably still a lack of sufficient capital allocated to the strategy compared with the potential opportunity set. “However, over the last two years, and on a regular basis, I am fielding calls from groups showing appetite to enter the space as buyers and wanting to understand the landscape. That should translate into increased available capital over time, and continued growth.”