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The obstacles blocking secondaries

We continue a conversation begun last week with reflections on why the private debt secondaries market may struggle to establish itself.

In last week’s Friday Letter, we noted an uptick in private debt secondaries activity together with the launch of new teams dedicated to the market. However, the bigger story was arguably the very small number of LPs currently willing to consider making private debt secondaries allocations. Although there are signs of life, this is a part of the investment universe that remains extremely nascent.

In subsequent conversations with sources, we have learned more about why this may be the case. One issue that makes things difficult for buyers is lack of familiarity with the underlying assets. Private equity secondaries buyers tend to have clearer insights into the assets, in part because they may have been exposed to them through other funds. In private debt, there is little overlap of this type. Moreover, you may be looking at 30 to 40 names in a typical private debt portfolio compared with maybe 12 to 15 in a private equity one.

The harder due diligence work needed to understand these private debt portfolios – including loan documentation that can be challenging to access – makes returns an issue. Wading through a huge volume of data might be considered worth the effort for private equity-type returns, but this is not so much the case in private debt, where the focus is on limiting the downside rather than maximising the upside.

Private equity secondaries buyers may spy an opportunity to buy an underperforming portfolio on the cheap and then turn it round by pulling various operational levers. However, private debt investors are typically looking to hold for longer. The profile of these investments is also designed to enable investors to offload cash steadily and with low volatility.

Nevertheless, there are situations that do lend themselves to secondaries buyers, and perhaps the most prevalent currently is where funds are approaching the ends of their lives but still contain a few underperforming loans. GPs and LPs alike may well be motivated to move on from these ‘tail-end’ positions. Distressed funds are another source of potential secondaries dealflow, since they offer relatively high returns and share more in common with private equity funds.

Moreover, some speculate on the consequences that may follow from the next economic downturn, especially if it’s a sharp one. Leveraged loan secondaries activity emerged from the 2008-09 crisis, and a broader private debt secondaries market could rapidly arise from dislocation as investors are forced to re-evaluate their exposures.

Write to the author at andy.t@peimedia.com

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