The Global Financial Crisis (GFC) of 2007–2009 saw many institutional investors over allocated to private market investments due to denominator effect—publicly traded investments declined in value, thus making their private-market investments a greater percentage of their total portfolio, pushing them out of compliance with their asset-allocation policy, and necessitating rebalancing—and facing liquidity concerns putting their ability to satisfy capital calls at risk. These factors led to a surge in secondary market transactions, that is, the sale of interests in private investment partnerships between investors, colloquially known as secondaries.
We spoke with three leading institutions involved in the private fund secondary market, who offered some insights into what general partners (GPs) and limited partners (LPs) might expect over the next six-to-twelve months.
- The current market bears some similarities to the GFC. There is high volatility in the public markets, uncertainty about the net asset value (NAV) of private investments, and a diminished exit environment for GPs, combining to create a questionable underwriting environment for buyers. A downturn in M&A activity and the decreased access to liquidity and leverage may encourage some LPs to sell.
- While market volumes are muted like they were 2007–2011, the pricing levels are not as low as they were following the GFC, which reached as low as 40% of NAV in some transactions. Sellers are not looking to sell anything at any price. This suggests that variations in market conditions, as well as "lessons learned" following the GFC, may impact an anticipated surge in secondary transactions. The volume of secondary transactions for the first half of 2020 is lower than the prior year, at $15 billion of GP- and LP-led transactions for 1H versus an expected $50 billion. Today, LP sellers have not had the near-term cash needs they did previously and sale processes until pricing have been postponed awaiting for the bid/ask spread to tighten.
- Nonetheless, our panelists do anticipate a dramatic acceleration of volume through the remainder of 2020 into 2021. While deal activity has decreased, many funds have called capital to reduce leverage and pay down capital call lines of credit and asset-backed loans. Many institutional investors, including university endowments and hospitals, are struggling and need cash and may turn to the secondaries market to offload unfunded commitments and to generate liquidity in their closed-end portfolio.
- There are many buyers interested but a clearing price is needed. The bid/offer spread remains wide. Funds with the best clearing prices are expected to be large cap funds as buyers look to purchase quality assets from well-known GPs. Conversely, off-the-run limited partnership interests will see steep discounts. Most sellers wanted just cash at close but there is growing receptivity to alternative funding options by sellers.
- Though historically many GPs have discouraged transfers of their fund interests, many investors believe GPs should see the secondary transactions as a positive, providing depth and liquidity to a closed market, thereby decreasing the illiquidity premium demanded by investors. Our panelists posit that GPs supporting secondary transactions are more attractive to LPs and secondary transactions can be a good thing for GPs too by allowing an LP to raise cash and commit to new vehicles.
- While the market remains dominated by sales of interests by existing LPs to new investors, GP-led secondary transactions are a growing trend as many fund sponsors recognize that secondary transactions may assist in restructuring older funds near the end of their term and support fundraising for successor funds through stapled transactions. In 2019, GP-led secondary transactions made up 30% of total transaction volume, and our panelists anticipate that this ratio may increase as GPs turn to the secondaries market to address current market challenges. They caution, however, that LPs should be cautious about values assigned to sponsor-led secondaries as discounts may be greater than warranted and the repricing of assets can reset the GP carry for GP, a concern in a fund where the GP has not earned any carry to date.
Lessons learned from the GFC likely will impact how market participants utilize the secondaries market to address similar market challenges arising from the global pandemic. For example, many LPs learned to have less rigid allocation targets or to permit overweight allocations for longer periods to reduce the need to sell in a weak market. However, the secondaries market will continue to offer much-needed liquidity in an illiquid market and provide flexibility to both GPs and LPs in closed-end funds.