By Daniel Dupont, Managing Director, Northleaf Capital Partners
The private equity secondaries market started out as a cottage industry in the late 1990s, with a few distressed sellers, a few buyers, skeptical GPs and very few intermediaries, and has grown into a full-blown investment, management and even fundraising tool. It has become a more mature, efficient and transparent market, thus increasing the pressure on pricing for buyers and impacting returns for investors.
Before the 2008-09 financial crisis, average high bids were at a record high. Years 2008-09 were not really representative, as the volume of transactions dropped significantly, sellers and buyers having great difficulty agreeing on prices because of the low visibility on exits caused by market turbulence. Since then, average high bids command low discounts, even at or above par for more commoditised large portfolios of buyout positions.
Pricing is obviously very important for the seller, as it will command a profit or loss on the sale of a portfolio. Other important considerations which will be relevant to the seller are speed of reaction, discretion and the willingness of the seller/buyer to help the existing managers of the positions to access fresh primary money.
For many buyers such as Northleaf Capital, the discount (or premium) is a consequence of: a) a detailed and rigorous bottom up analysis — an exercise involving building cashflow projections by company under various scenarios, and b) an assessment of manager capabilities and alignment of interest to balance and meet the seller’s expectations as well as investment returns.
Although secondaries buyers occupy various market niches, finding compelling deals in a more competitive, high priced environment has become more challenging. What tools and strategies can secondaries buyers employ to keep delivering good returns?
- The mid-market segment does present an interesting niche, because of various factors, including the large number of smaller funds and managers, underlying portfolio companies and the more private nature of financial information. Pricing is less efficient than at the larger end of the market.
- Access to information as an investor, and close relationships: some secondaries buyers with primary dry powder have developed close relationships with certain managers through previous transactions, a distinct advantage of primary investors and funds of funds versus pure secondaries investors. Access to information and good understanding of the portfolio is particularly important as portfolios are often more concentrated in the mid-market segment.
- Growth companies present a better hedge over the medium term. While a high discount on a mediocre portfolio may represent a short-term profit through a revaluation exercise after closing, the purchase of a portfolio including growth quality companies whose value will increase over time does represent a better risk/return proposition over the medium term.
- Quality of deal flow: deal flow comes from various sources: sellers, intermediaries, and more increasingly fund managers introducing secondaries positions to buyers willing to build a long-term relationship.
- A well-established platform, with long-term investment experience and extensive network, where reliable and trustworthy team members form a solid foundation to attract recurring business with various parties.
- Tail-end and structured transactions: plain vanilla LP position portfolio sales are very competitive. Extension of fund’s life and participation in GP-led restructurings (from providing fresh capital to an existing fund against a preferential return, to a full transfer of a fund’s remaining assets into a new fund structure while buying out existing investors’ positions) is less competitive. It will, however, demand an intimate knowledge of the portfolio, a good relationship with the manager, and high negotiations and structuring skills.
- Financial tools: well-known use of certain financial tools such as deferred payments, earn-outs, leverage and use of a best valuation date can also unlock certain discussions to meet sellers’ expectations and buyers’ investment returns.
Low discounts are definitely a reality, and are here to stay with the increasing efficiency in the secondaries market. Having said that, seeing hefty discounts as the only way to superior returns is a myth. One should never fear paying the right price for a quality portfolio, even at par or premium. Neither should one lose sight of relative returns in comparing various investment options. Prudent private equity investing remains, without doubt, an excellent quality option.
This article was written by Daniel Dupont, Managing Director at Northleaf Capital Partners, and is an edited extract from "Mastering Private Equity: Transformation via Venture Capital, Minority Investments and Buyouts" by Claudia Zeisberger, Michael Prahl and Bowen White.