Generating alpha in secondaries

The secondaries

market

This is intended for investment professionals, and not for retail use.

February 2018

Dry powder is at record levels; firms face constant pressure to differentiate the investments they can offer to clients.

With debt more important than ever in the secondaries private equity market, what strategies are you adopting, and how are you responding to your clients’ needs?

In this report we’ll cover the following topics:

Generating alpha in secondaries 3

Differentiation 4

Alpha generation through leverage 5

A specialist partner 6

2

Debt is playing an ever-larger role in the secondaries private equity market as record levels of dry powder put pressure on firms to differentiate their investments. With firms increasingly seeking a competitive edge through leverage, Investec continues to tailor innovative products to help clients bolster returns.

Supporting the huge deal activity is the buoyant fundraising market – Secondaries Investor (referring to PEI data) published on 11 January 2018 that final fundraising for 2017 came to $38.3 billion across 26 final closes. This is a record-breaking sum.

Meanwhile, dry powder has reached a new peak, standing at $94 billion in September 2017, up from the previous record of $77 billion in December 2016, according to Preqin’s Q3 Secondary Market Update.

Generating alpha in secondaries

Global fundraising for secondaries funds: July - September 2017

$5.4billion

The year to date’s total: January - September 2017

$29billion

Total fundraising $38.3 billion across 26 final closes”$9.3 billion raised from September 2017 - December 2017 bringing total fundraising to $38.3 billion across 26 final closes.

Secondaries Investor (referring to PEI data), 11 January 2018

Up from the previous record of $77 billion

Dry powder has reached a new peak

$94billion

With firms increasingly seeking a competitive edge through leverage, Investec continues to tailor innovative products to help clients bolster returns.

3

The rush to put capital to work is driving up prices and lowering returns, leading players to increasingly seek ways of gaining a march on the competition.

Gregg Kantor, Investec’s head of Fund Finance in the US, said:

“The demand for secondaries has gone through the roof because funds are raising large amounts and there are lots of new entrants.”

Speaking in June 2017 at the London edition of Investec’s annual Secondaries and Fund of Funds debt seminar series, Matt Jones, a Partner at a global secondary firm, Pantheon Ventures, said the enormous growth of the secondaries market meant most buyers typically approached the big flow names with similar strategies. He explained:

“Certain parts of the market are very competitive. It’s hard to eke out any advantage. Despite what people say, I think it is very rare for any buyer to have a particular angle on any of the large buyout funds.”

Today’s highly intermediated market has left firms with fewer truly proprietary deal opportunities, while today’s sellers have far greater pricing power than during the financial crisis as they look to the secondaries market as a means to actively manage their portfolios. These factors mean firms must become more creative in the way they originate, underwrite and execute secondaries deals to generate alpha.

Established secondaries funds are differentiating themselves by focusing on niche strategies. Just a handful of funds are large enough to access the market’s biggest deals, giving the biggest vehicles a significant advantage.

Those unable to tap the upper end of the deal spectrum must hone their strategies by geography, sector or transaction style. Investec sees more firms focused on specific countries and regions; asset classes, including credit and real estate, and types of deals, such as tail end funds, funds of funds and secondaries directs. Furthermore, in a saturated market, buyers can use the promise of a fast completion to negotiate a lower price.

Differentiation

Today’s highly intermediated market has left firms with fewer truly proprietary deal opportunities

Established secondaries funds are differentiating themselves by focusing on niche strategies

4

However, origination and strategy are often not enough to guarantee alpha generation in the context of high deal valuations. In addition to finding a niche, funds are increasingly considering the most efficient capital structures to maximise returns and gain a competitive advantage.

Firms can decide on all-equity transactions or use an appropriate amount of debt for more attractive returns. In fact, each discussion we have with clients regarding secondaries today includes a conversation about how to use leverage to make capital structures more efficient both in existing portfolios already owned by the client, as well as in portfolios clients are looking to acquire.

According to Jones, more secondaries funds have begun to lever their investments, having felt the need to continue to deliver IRRs in the high teens and 20%-plus range following stellar historical performance. He said:

“That puts a lot of pressure on people to generate those IRRs even when the underlying assets aren’t doing the job. The key to then bridging that gap is through financial structuring.”

Various forms of leverage, from subscription capital call facilities to non-recourse asset backed debt, are now widely available to secondaries portfolios but the complex nature of secondaries means that not all types of debt structures are appropriate for certain deals.

Complex portfolios, especially those with concentrated assets or back-ended cash flow profiles, are higher risk and may require more specialist and flexible debt packages. Investment structures with multiple co-investors in a single vehicle may also need greater room for greater flexibility.

Facilities can combine various pots of collateral, including net asset value and undrawn fund commitments. This tailored approach maximises flexibility in terms of covenants, repayment mechanisms and cure periods. Borrowers can offer better pricing whilst at the same time achieving their returns.

Across the market secondaries firms are also looking to preferred equity, which offers buyers greater downside protection, to finance concentrated transactions that may not qualify for other forms of financing.

Preferred equity is winning approval from LPs as well as GPs as institutional investors look to secondaries deals for liquidity while retaining some ownership.

Ben Pearce, a principal at advisory firm Campbell Lutyens, said:

“Specialist investors have been using preferred equity on the buy side for a long time but for the first time we’re seeing interest from LPs on the sell side who are interested in evaluating such alternatives alongside a cash offer. The sell side is becoming more sophisticated with their approach to the market and are considering alternative risk sharing structures as part of their secondaries toolkit.”

Generating alpha through leverage

In addition to finding a niche, funds are increasingly considering the most efficient capital structures to maximise returns and gain a competitive advantage.

Preferred equity is winning approval from LPs as well as GPs as institutional investors look to secondaries deals for liquidity while retaining some ownership.

5

The complex nature of the secondaries market demands bespoke facilities. A lender must understand the individual risk profiles of the underlying investments and craft each product according to the borrower’s needs and goals. In addition, the crucial role speed plays in alpha generation puts great importance on a debt provider’s ability to deliver a facility in line with the borrower’s timeframe.  

Kantor explains:

“Innovation, flexibility and agility in how we develop financing strategies that are unique to our clients’ needs is an integral part of how we work with our clients,”.

“As a global team of professionals focused on lending to leading funds and management teams across private capital strategies, it’s important that we adopt a partnership approach when working with our clients.

“We’re strong believers in long-term business relationships – an inseparable element in each credit agreement we place.”

A specialist partner

Innovationflexi

bili

ty

partnership

unique financing strategies

long-term business relationships A

specialist partner

6

About usInvestec, an international specialist banking and asset management group, is dual listed on both the London and Johannesburg Stock Exchanges and is a FTSE 250 company. It has offices in 42 cities, with headquarters in London and Johannesburg, and a staff compliment of over eight thousand.

With offices in London, New York, Johannesburg and Sydney, Investec Fund Finance is a specialist finance provider focused on developing and delivering smart lending solutions for funds and fund management teams.

Working closely with our clients, we get a deep understanding of their goals and requirements so that we can offer flexible finance solutions at each stage of the fund life cycle. We aim to help clients enhance returns, maximise the efficiency of their fund’s equity and increase competitiveness in an aggressive market environment.

This material is issued by Investec Bank plc (“Investec”). The opinions and views expressed are for information purposes only and are subject to change without notice. They should not be viewed as recommendations or investment, legal, tax, accounting or other advice of any nature and recipients should obtain specific professional advice from their own appropriate professional advisers before embarking on any course of action.

Investec Bank plc is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Registered under Financial Services Register reference 172330. Investec Bank plc is Registered and incorporated in England and Wales No. 00489604 and has its registered office at 2 Gresham Street, London EC2V 7QP.

Get in touch

UK & EuropeInvestec Specialist Bank2 Gresham StreetLondon, EC2V 7QP

Simon Hamilton+44 20 7597 4866simon.hamilton@investec.co.uk

Matt Hansford+44 20 7597 3914matthew.hansford@investec.co.uk

Ian Wiese+44 20 7597 2897ian.wiese@investec.co.uk

USAInvestec USA Holdings Corp. 10 East 53rd Street, 22nd FloorNew York, NY 10022. USAinvestec.com/fundfinance

Gregg Kantor+44 20 7597 4107gregg.kantor@investec.co.uk

Edoardo Levy+1 646 557 4957edoardo.levy@investec.com

Alessandra McKell+1 646 557 4968alessandra.mckell@investec.com

South AfricaInvestec Bank Ltd100 Grayston DriveSandton2196

PO Box 785700Sandton, 2146, South Africa

Grant Crosby+27 11 286 8266grant.crosby@investec.co.za

Kim Hatzkilson+27 11 286 7246kim.hatzkilson@investec.co.za

Nick Dempsey+27 11 286 9358nicholas.dempsey@investec.co.za

investec.co.uk/fundfinanceFebruary 2018