Secondaries: As the cycle lengthens, the first signs of an upturn are appearing

Observers say Europe’s secondaries market, eclipsed for so many years by the boom in direct lending, is starting to show early and patchy signs of an upturn, writes David Turner.

Jaime Prieto, a London-based founding partner at Kartesia, a fund manager involved in both direct lending and buying secondaries, has noticed a change in Europe’s biggest private credit market. “In the UK, we are starting to see better opportunities in the secondary market than we were before, and fewer opportunities in direct lending,” he says. This reorientation of opportunity “really began to materialise this year”.

In the UK, Prieto thinks the potential for secondaries has increased in apparel retailing and restaurant chains. He attributes this to fears over Brexit and late-cycle dynamics. Brexit uncertainty hit the pound, which has pushed up the costs of materials. Meanwhile, government moves to increase minimum salaries, and to hike business rates in some places, have further depressed margins. Prieto sees this government action as a late-cycle phenomenon because, after a long period of economic growth, “everyone wants to take a piece of that” – including the state.

Prieto thinks secondaries opportunities are also growing in Germany, though “not massively”. He believes it may take a year or two before they increase substantially in the country, a largely cyclical economy hit by the slowdown in international trade.

Sunaina Sinha, managing partner in placement agent Cebile Capital’s London offices, thinks that – at the moment, at least – only a few funds are focused on credit secondaries. However, she adds that “many other secondaries managers are doing private credit secondaries deals out of their main funds. They’re carving out allocations opportunistically”.

Some observers say the upturn in secondaries opportunities is apparent only in the UK and Germany, though others see fainter signs of an upturn elsewhere. Everyone we spoke to agreed that the opportunity currently lies mainly in purchasing loans from banks. This has always presented “a consistent opportunity for those people who are focused on it,” says Jeffrey Griffiths, principal at Campbell Lutyens, the placement agent, in London. However, “this opportunity is increasing now, because of low economic growth in some countries, and because some banks are looking to reduce risk in their loan books”. He thinks, for example, that some European banks might want to reduce UK exposure because of Brexit.

Other observers agree that the market in buying secondaries from direct lending funds may not heat up for a long while yet. Even in the UK, where there is more stressed credit than elsewhere in Europe, Prieto says there may not be much offloading by direct lenders until two years from now.

Admission of failure

This reflects direct lenders’ mentality. Even if only a small number of loans go bad, it can wipe out performance fees, destroy reputations and make it impossible to raise funds. Because of this, many are reluctant to admit defeat and sell a loan on at a substantial markdown.

However, Prieto urges lenders to sell sooner rather than later. He recalls the later stages of the last credit cycle: “The best CLO performers were those that rotated away from some loans that were not performing well, giving a chance to someone else with the ability to get better value out of them.”

He notes that some loans can be sold for as much as 85 cents in the euro, if they are in decent shape. By contrast, in the later stages of the last credit cycle, “those CLOs that did not want to sell, that did not want to accept failure, had a worse return”. This is because a loan in a worse state can only be sold at a steep discount. Beyond 85 cents, the next level down tends to be at around 60 or 65 cents, he says – which is a long way to fall.

Some managers are betting that direct lenders, or at least their limited partners, will act sooner rather than later. As the managing partner of a distressed/special-situations strategy in London tells us: “In recent months we’ve been hearing of a number of organisations that are forming a secondary business focused on private debt.”

The managing partner’s sphere of interest includes the purchase of impaired loans from direct lending funds, and of LP interests in the funds. “You’ll start to see teams, launches, funds that are setting up for this opportunity,” they say, adding that none of these funds have yet gone public with their intentions.