Secondaries Special: Going up a gear

The birth of the leveraged buyout gave rise to larger private equity deals and outsized returns; but it also led to some substantial (occasionally disastrous) losses for firms that got it wrong. Now it’s increasingly the turn of secondary market specialists to play the leverage game – with all its potential risks and rewards.

The expansion of private equity’s secondary market – driven in part by the rebalancing of pension portfolios and regulatory shifts likes Dodd-Frank – has created an environment in which banks and institutional investors are selling large portfolios of fund and direct investments on a regular basis. In turn, this has led to a growing number of deals where individual secondaries specialists have acquired massive stakes in private equity portfolios worth hundreds of millions of dollars.

One notable consequence of this increase in deal flow and size – often with pricing driven up by competitive auction processes – is that some secondary firms have started to adopt leveraged strategies to build their portfolios and drive returns. 

“Leverage has certainly come back into the market,” says Tom Kerr, a managing director on the secondaries team at Hamilton Lane. The strategy had previously picked up momentum in the mid-2000s, he suggests, but the economic crisis and subsequent credit crunch convinced many firms to cut back on their use of third party loans.

Utilising leverage clearly has its advantages. It boosts returns and enables firms to pay a higher price in auction processes, which gives fund managers a better chance of securing an asset. 

However, it also bears an obvious risk. That, according to multiple sources, is probably why the growing number of firms using leverage are often reluctant to own up to it.

“Folks are less apt to admit that they do it,” Kerr says. “And I think more folks are using it than say [they do].”

EXCEPTIONAL STRATEGY

But there’s an interesting exception to this general rule: AXA Private Equity, led by Dominique Senequier, which is perhaps the most active player in the secondaries market at the moment. The firm has just managed to set a new record by closing its fifth fund with $7.1 billion of commitments, plus an additional $900 million sidecar vehicle.

Shortly after the fund close, the firm announced a deal that illustrates exactly why it’s seen as the most prolific deal-maker in today’s secondary market: an $850 million acquisition of a portfolio of 11 private equity fund investments and related unfunded commitments from the Ontario Municipal Employees’ Retirement System. It’s the latest in a string of deals the firm has done lately.

The OMERS deal was not levered with third party loans. However, senior managing director Benoît Verbrugghe is not afraid to admit that the firm has used third-party leverage in the past – and will probably do so again.

AXA is comfortable with levered strategies, he tells PEI, because of its extensive fund database – which allows the firm to break down portfolio company information from prospective fund managers and craft an expected cash flow model for the fund over the next several years. That information is aggregated across all included funds in a proposed deal, thus giving the firm enough information to assess whether or not it wants to apply third-party leverage to the transaction.

“Because we’ve been able to put in place a very strong database, a very deep analysis of the underlying companies, then for each transaction – given the maturity, given the profile of the cash flow – we [can] maybe put 20, 25 or 30 percent of leverage on the [deal],” Verbrugghe says.

However, Verbrugghe is quick to stress that leverage won’t be suitable for all of its deals. If a fund’s portfolio companies are already heavily levered, adding third-party leverage to acquire that fund through a secondary transaction could be dangerous. “That’s why we need to have that deep analysis,” he explains.

And if leverage isn’t appropriate, so be it. “We do not need leverage to achieve our returns. For each transaction we are doing, we could do [it] without leverage … The leverage will just be a way to improve our returns a little bit, no more.”

OUT OF CONTROL

But even if they do have in-depth data about the underlying portfolio at their disposal, many secondary firms say they are still reluctant to engage with lenders – given the nature of what they’re buying.

“When you’re not in control of the assets … putting leverage on top of that, you’re really not controlling debt levels of the underlying portfolio,” Kerr says. “You’re left to the risks of the market. In a downside scenario, you’re doubling up on your exposure.”

It’s also true that especially in today’s market, many LPs are uncomfortable with the idea of secondaries firms applying more leverage to already levered assets.

Equally, there’s a practical issue for firms that are willing to consider the use of leverage in a secondaries deal: it’s not always easy to borrow on the kind of terms that would make it attractive.

“When I have spoken to providers of leverage in the past, it’s been at pretty expensive rates,” says Jason Gull of Adams Street Partners. “It’s hard to get very excited about borrowing at LIBOR plus 500 to 700 basis points for 30 to 40 percent of a well-diversified portfolio when you have excellent collateral and very little risk of principal or interest loss.”

These are legitimate concerns – and they’re clearly significant enough to keep some firms away from the strategy altogether.

However, AXA says it has not yet run into a situation in which it has bitten off more than it could chew. “We’ve never had an issue with a transaction with the leverage,” Verbrugghe insists. “We’ve always been able to reimburse the loan in due time”.

Nor does it have a problem getting attractive terms, according to Verbrugghe. He attributes this success with leverage providers to the firm’s 14-year track record with levered transactions, as well as the extensive portfolio company analysis it includes in its investment memorandum. 

Judging by its recent fundraising success, the strategy clearly hasn’t spooked investors. While few would deny that AXA has generated good returns historically (its 2004 fund has distributed $30.2 million on $21.4 million called as of December, according to Pennsylvania State Employees’ Retirement System documents), sources indicate that the firm’s relationships with third-party lenders and successful use of leverage has set it apart from its competitors. 

So perhaps the safest conclusion is that despite LPs’ supposed unwillingness to back secondaries managers that use leverage, they’re clearly getting more used to the idea.

“Institutional investors are shying away from the mega buyout space … but at the same time, these same institutions are paying little attention to the leverage these large secondary firms are using,” Kerr says. “There have been three record size funds raised in the last 12 months, and the use of leverage is something folks have either gotten comfortable with or are not paying attention to.”