Pandemic freezes secondary market

Uncertainty surrounding private equity valuations and the pandemic’s effect on the overall economy have changed the game for secondary dealmaking, particularly for large portfolios of fund interests.

Buyers are taking a more cautious approach to pricing, in some cases exploring more complex deal structures in an effort to bring sellers to the finish line. However, against this backdrop of caution, intermediaries and buyers say they believe the changing market dynamics that have emerged from the pandemic will ultimately usher in a fresh wave of selling.

“Anytime there’s been a massive disruption to well-laid plans, it’s been good for the secondary market,” said Jeffrey Akers, partner and head of secondary investments at Adams Street Partners.

WSJ Pro’s latest Guide to the Secondary Market Buyer Survey – “State of the Secondary Market,” 2020 Edition illustrates the dramatic shift in market sentiment that took place in the course of just a few weeks. When secondary buyers were surveyed in February, 72% or nearly three-quarters of respondents predicted that the secondary deal volume would hit another record in 2020. When the question was asked of those same respondents in April and May, however, not one respondent predicted volume would reach a record.

“This time last year, the secondary market would have printed $40bn in deal volume,” said Michael Griech, managing director at PA Capital, formerly Private Advisors. “Thinking about where we are year to date, most of us are thinking about a first half for 2020 of $5bn to $10bn in transaction volume.”

Distressed or stressed sellers have accounted for a small percentage of deal volume for most of the past decade, but some secondary buyers predict the pandemic will change that.

“Anytime you have dislocation, there is a transition where fair-weather sellers exit the market and more distressed sellers enter the market,” said Michael Granoff, chief executive at secondary firm Pomona Capital. “People who are fair-weather sellers today can be distressed sellers tomorrow.”

Portfolio management
As the secondary market has expanded in recent years, portfolio management has been the biggest driver of deal flow with this year’s survey respondents estimating that it drove a median of half of their deal flow. General partner-led transactions came in a close second, representing a median of 30% of deal volume, according to the most recent survey results. By contrast, respondents estimated that only 10% of deal flow came from distressed sellers.

But buyers say they see that dynamic shifting, at least at the margins, as market volatility pushes investors to focus more intensely on managing risk and liquidity.

For many years, a favourable exit environment allowed private equity firms to return massive volumes of cash back to their investors, which many investors used to meet capital calls on the growing volume of commitments they made to the asset class.

“If you had a private equity portfolio that had some reasonable maturity, it was essentially self-funding,” said Granoff. “You never had to put your hand in your pocket. It seemed like you had a perpetual motion machine.”

Distributions have slowed much faster than capital calls, however, which are forcing some investors to focus more intently on managing their liquidity, potentially driving more secondary volume.

University endowments, particularly small and midsize ones, and high net worth investors, could fall into the category of stressed, if not distressed, sellers in the coming year or two, according to several buyers. Endowments and foundations as well as family offices and high net worth individuals were the two types of sellers that ranked highest when buyers surveyed during the pandemic predicted which types of sellers would generate increased deal volume.

Operating stress
“One thing we’re watching closely is operating stress, where you have institutions and businesses that have idiosyncratic factors putting stress on what they’re doing,” said Akers of Adams Street. “Think about a university that doesn’t know when students will be back on campus. What’s that going to mean for their endowments? Instead of being overexposed to the asset class, this time there would be a different set of factors that would drive them to use the secondary market.”

High net worth investors and family offices may face different pressures particularly if they generate much of their wealth from ownership of a business with operations that are hard hit by the pandemic.

“A lot of these families and individuals have more wealth concentration,” said Michael Bego, founder of Kline Hill Partners. “They may want more liquidity from their private equity assets. Some also have operating businesses. Say it had steady revenue for 20 years, but now it’s down 80%, because it’s a restaurant.”

The shifting priorities have helped drive continued, albeit slow, activity at the smaller end of the transaction spectrum, even as the pandemic intensified. In some cases, the pandemic helped push a seller to the deal table sooner than expected.

Venture Capital Fund of America, which targets investments in growth-oriented venture portfolios, for example, was part of a buyer group that closed a roughly $60m deal involving the spin-out of an investment team from a large financial investor, according to managing director David Tom.

Although the secondary firm had been talking to the institution for more than a year, the pandemic encouraged the seller to move on the deal. “It was the kind of thing that facilitated ‘hey we have to get this thing done’,” Tom said. “It didn’t happen because of Covid, but it probably wouldn’t have closed as quickly without Covid.”

Kline Hill, which typically targets secondary deals ranging from $100,000 to $10m in size, has signed at least 17 deals since 1 March, according to Bego.

Easier to negotiate
Buyers say small and midsize deals have been easier to negotiate and close because sellers at that end of the market, on average, tend to be less motivated solely by pricing. Larger institutions and asset managers can often afford to hold a portfolio if they don’t get the pricing they want, assuming they aren’t under serious distress. Asset managers such as funds of funds and other secondary buyers are perhaps among the most price sensitive, which contributed to a dramatic change in buyer expectations of deal volume from these two groups before and during the pandemic.

Among those buyers surveyed in February, 62% predicted that deal volume from fund of funds and advisers would increase in the year ahead, while 56% predicted that deal volume from secondary firms themselves would increase. By April and May, however, many of those same respondents had changed their minds, with 57% predicting that demand among funds of funds and advisers would decrease and 68% predicting a decline in volume from secondary buyers. Buyers also displayed a similar pattern with their sentiment on sovereign wealth investors, with 61% of those surveyed in April predicting that deal volume from those investors would decline versus just 15% of those surveyed in February that made such predictions.

“Those are the groups that have taken a step back and have chosen to wait this out,” said Rudy Scarpa, co-head of the global secondary team at alternative investment firm Pantheon. “You have institutional investors interested in selling LP stakes anchored in a valuation that’s six to 12 months old and buyers that want to buy these interests at material discounts.”

Widening price gap
Mounting uncertainty surrounding portfolio valuations has created a gap between seller expectations on pricing and buyer willingness to meet those expectations.

“Many GPs today aren’t certain on where portfolios are heading,” said Tom Kerr, head of secondaries at Hamilton Lane. “They’ve identified acute problems, but we need to get to a period where there’s a bit more stability and an understanding of what we can expect to see broadly. That lack of conviction is an impediment to transaction volume.”

For years leading up to the pandemic, strong valuations for private market assets and stiff competition among buyers created a favourable pricing environment for sellers. Secondary buyers surveyed over the past several years have largely characterised the market as a seller’s market, including more than 90% of buyers in the 2019 secondary survey. Even before the pandemic hit, however, buyer sentiment was starting to shift, with only around two-thirds of buyers surveyed in February characterising the market as a seller’s market. The pandemic pushed the majority of these buyers into a completely different mindset by April, with 96% of survey respondents characterising the current market as a buyer’s market. The results mirror a similar survey we conducted in the midst of a recession in 2009, when 97% of respondents characterised the secondary market as a buyer’s market.

Secondary investors predict that declining valuations in underlying private market portfolios, along with declining distributions and a heightened focus on risk, eventually will set the stage for more buyer favourable pricing.

“There are a lot of variables that will swing how meaningfully they will drop. But I think directionally, it’s hard to imagine pricing not coming down,” said Keay of HarbourVest.

Pricing for secondary deals has remained fairly strong in recent years with buyout fund assets attracting more favourable pricing than venture assets. Among the buyers in WSJ Pro’s 2020 survey, 77% said on average they paid prices for buyout assets that represented discounts to those assets’ underlying net asset values, up from 66% of respondents in the 2019 survey. An even higher percentage, 97%, paid prices that were below NAV for venture assets. The growth trajectory of secondary pricing began to level off somewhat even before the pandemic, with a smaller percentage of survey respondents indicating they had paid higher prices in the past year than they had the year before, both for buyout and venture assets.

The uncertainty and volatility ushered in by the pandemic, however, appear to be shifting how buyers prioritise different factors when pricing deals. Public market exposure and expected distributions stand to play a more prominent role in pricing. Among secondary buyers surveyed in April, 18% cited changes in the pace of distributions as an important factor influencing pricing, up from only 6% of respondents surveyed in February. The shift is hardly surprising given how much of a secondary fund’s returns stem from early cash flows generated by exits from the portfolios they buy.

The Guide to the Secondary Market Buyer Survey also revealed that buyers are paying much more attention to public stock performance and public market exposure when pricing transactions. The percentage of survey respondents that cited the amount of listed securities in a fund portfolio as an important factor in pricing rose from just 3% of those surveyed in February to 10% of those same buyers that responded to a similar survey in April and May. By contrast, none of the respondents to the 2019 survey cited listed securities as a driver of pricing.

Heavy exposure
For years, many secondary buyers have been reluctant to acquire portfolios with heavy exposure to listed securities, partly because of the heightened volatility associated with public equities and the reduced influence private equity managers tend to have over companies after they have taken them public. That caution is heightened in down markets, given the immediate negative impact that falling stock values have on portfolio returns.

“If you look at the average public company, it is still down for the year, even though the overall market index has come back from where it was,” said Mark Benedetti, co-head of US operations at Paris-based Ardian, which earlier this year raised a $19bn pool for secondary deals.

Public stock-market performance also rose in prominence between the February and April surveys. In our first survey, 16% of buyers ranked public-stock performance as an important driver of pricing compared with 24% of those same buyers that answered our April survey.

Many private equity firms value their portfolio companies based partly on the value of comparable public companies, although they tend to lag public markets by at least a quarter when reporting that performance. As a result, public-stock behaviour can often be an early indicator of spikes or declines in private equity valuations. A secondary buyer may be willing to pay a slightly higher price for assets when public stocks are rising, because the buyer can be reasonably confident that private-asset valuations will grow the following quarter. But when public stocks fall, secondary buyers tend to be more cautious in their bids for fear they will end up overpaying or at least appearing to overpay.

That caution, combined with the expectation of further markdowns in private equity valuations, has left more buyers hesitant to underwrite deals without applying serious discounts to the assets underlying NAV.

“While we’re optimistic that there’s a recovery coming, there is obviously a fair bit of impairment,” said Akers of Adams Street. “No one wants to step into losses. We’re not seeing a lot of stuff getting priced even off of Q1 marks, because there’s the expectation that there may be another shoe to fall.”

Joseph Marks, global head of secondaries at Capital Dynamics, said he is seeing a lot of bidding in the market that he would characterise as “uncertainty discount bidding”.

“It’s like that used car that you can’t test drive,” Marks said. “You will discount it so much that you think you’ve done a good job of pricing.”
Although many sellers are unwilling to stomach steep discounts, some buyers say certain deal structures such as preferred equity deals, earn-out provisions or deferred payments can bridge the pricing gap with some sellers.

“We have done more structured deals where we will pay one price upfront to the seller but a much lower price, and then have an earn-out once we get some multiple of our money,” said Kline Hill’s Bego. “We’ve always done it, but we’re doing it more now.”

As buyers negotiate new deals once the pandemic’s effects start to ease, many may be doing so with less debt.

It’s probably the elephant in the room right now,” said Adams Street’s Akers. “Investors have been getting very nice returns out of the secondary market and in some ways not assessing the risk taken in order to achieve those returns. “It’s going to be very interesting to watch what the impact of markdowns over Q1 and Q2 is going to have as you look at highly leveraged assets.”

An abundance of cheap debt prompted more secondary buyers to use leverage in recent years both at the transaction level and at the fund level. Among this year’s survey respondents, 29% said they had employed debt at the deal level, up from 17% of buyers in a separate survey in 2019. The use of fund-level debt, in which a firm secures a credit line backed by investor commitments to its funds, has been even more popular, with 66% of buyers surveyed this year indicating they have used such debt, nearly even with the 67% of buyers in last year’s survey that said they use such credit lines.

But the onset of the pandemic and the economic damage it has created have altered the risk calculus associated with leverage both for buyers and for lenders themselves.

“I think buyers are going to be a little more cautious around leverage at the company level and the fund level for the foreseeable future,” said Gerald Cooper, partner at secondary intermediary Campbell Lutyens & Co.

Green shoots
Despite the slowdown in deal activity and challenges associated with pricing so far this year, many secondary buyers say they expect the market activity to pick up in the fourth quarter of this year, provided there isn’t another widespread pandemic lockdown.

“We already know from conversations with GPs and LPs that they are already planning to trim back exposure for some relationships that are less active,” said Griech of PA Capital. “We believe that in 2021 there will be a big surge.”

Although far fewer deals are closing, many buyers say they have continued to engage with prospective sellers even during the pandemic with some saying they expect structured deal activity will pick up first as GP liquidity needs intensify.

“There are a lot of deal processes launching or preparing to launch,” said Campbell Lutyens’ Cooper.

Even at the largest end of the market, Ardian’s Benedetti said his firm is currently in various stages of discussion with three sellers that are weighing large fund portfolio sales.

Timing the secondary market’s resurgence with precision may be difficult, buyers say. Still, some add that explosive growth in private equity fundraising over the past several years, combined with mounting liquidity needs and the increased sophistication of secondary transactions, will ultimately prevail.

“There’s probably $3.5tn of inventory in terms of primary capital raised over the past six or seven years,” said Wilson Warren, president of Lexington Partners. “Say it turns over more slowly for the next year, my guess is that when the bid-ask [spread] comes together, there will be big volumes in the secondary market.”