The market for private equity secondaries was something of a damp squib in 2020. GP-leds performed well owing to the relative ease of valuing funds with only one or two holdings to their name, but PE fund secondary deals were few and far between. All told, this core of the market halved in value to $24.9bn in fiscal year 2020.
The challenge of quarterly valuation lags was exacerbated by earnings distortion and the bifurcation of short-term company performance caused by COVID-related restrictions. Stimulus and artificial growth only complicated matters as investors sought to understand the fair value of their assets.
While there is still considerable uncertainty surrounding the pace and evenness of the economic recovery and vaccine rollouts, the stars appear to be aligning for a stellar year for PE secondary activity with three essential drivers likely to play a fundamental role in spurring activity.
• 5 min. read •
Dry powder
Secondary investors are armed to the teeth. In 2020,fundraising for the strategy surged to $95.6bn, a nearly threefold increase from 2019. This was in no small part thanks to final closes achieved by Ardian, Lexington Partners, Goldman Sachs, and AlpInvest Partners, who collected a combined $53.5bn, or 57% of the year’s grand total. Even so, this is an exceptional showing by anyone’s standards.
GP-leds will undoubtedly mop up a significant share of this secondary dry powder, especially as the pandemic has put paid to exit plans and pushed out holding times. Fund managers will seek financing to buy extra time to manage assets whose prospects they fundamentally believe in. Investors have grown comfortable and familiar with GP-led deals, provided they are transparent, and conflicts of interest are addressed and well managed. However, the volume of trades in fund positions should rebound this year following a lacklustre 2020 owing to the sheer mass of secondary dry powder that is ready and waiting deployment.
Earnings visibility
This one is less clear-cut. There have been obvious winners and losers during this pandemic, but even those that have thrived may only be benefitting from a temporary lift. Stimulus has clouded the picture over the past 12 months by propping up businesses that may not be able to survive over the longer term. There is likely more of this to come, with anticipated fiscal support in the US and Europe coming down the pipe.
However, this cannot last forever – policymakers will have to turn off the free-money taps at some point. Likely the ending of stimulus will occur some time towards the end of 2021 or possibly into 2022, depending on how conditions play out. However, investors will soon have an idea of how companies fared since the crisis began and, therefore, will have a clearer view of how much assets should be expected to fetch. Improved earnings visibility can only be a plus for PE fund secondaries activity.
Cashflow management
A recent survey suggests that LPs are facing cashflow constraints within their PE portfolios. For 70% of investors, PE distributions decreased slightly or significantly last year, while for 58% capital calls either remained the same or increased. And more of the same is expected this year, with 63% of LPs anticipating their capital calls to exceed cash returns from portfolio company exits. One option is for investors to fund their drawdowns with spare cash or by selling liquid assets. However, for those who are already fully allocated to the asset class, the need to meet GPs’ calls makes the secondary market an attractive option for raising cash.
GPs have plenty of committed capital to invest and their job is to identify COVID-proof opportunities and stock portfolios with companies that are set for long-term growth, while avoiding paying exorbitant multiples for in-demand assets. The opportunity to capitalize on this period of economic and market disruption is expected to result in a rise in buyouts throughout 2021 and these deals will need to be funded somehow. With exits only being a realistic option for better performing companies, distributions are likely to remain on the lower side. An obvious solution to this liquidity squeeze is to raise cash by pruning existing PE portfolios on the secondary market. And with a record$125bn in managed secondary dry powder waiting in the wings (and that’s not counting the buying power of opportunistic liquid LPs), this year has all the makings of a record-setting year for secondaries deal flow.
