The stars are aligning in secondaries

Is it time to explore the secondary market? Jason Holland assesses the factors which have converged to present potentially strong opportunities, and what needs to be considered before taking the plunge.

This article was first published in the Private Markets Profile, which can be viewed here.

Who doesn’t like a bargain? The secondaries markets appear to offer exactly that to investors, with excellent value across private equity, infrastructure and debt.

While many investors and asset allocators have explored the opportunities, the asset class remains a bit of an outlier for LGPS investors.

But it needn’t continue to be that way. For Vanessa Shia, head of private markets at London CIV, secondaries can and should feature as a key part of an LGPS portfolio, and is “certainly a key way that we access and invest in private markets on behalf of our partner firms”.

Shia was speaking at Room151’s Private Market Forum in early June, where she was joined on a panel discussing the secondaries market by David Atterbury, managing director at HarbourVest, and Achal Gandhi, CIO – indirect real estate strategies, chair of the global DE&I council at CBRE Investment Management.

Atterbury believes that secondaries represents an “attractive risk reward almost whatever the cycle”. HarbourVest, a global firm in private markets that has been in business for more than 40 years, sees “great opportunities out there”.

State of the market

Describing the origins, rapid progress and status of the secondaries market, Atterbury said it had been “quite a journey going back over a number of years”. The volume of transactions in the marketplace has grown dramatically, with around £100bn worth last year. Atterbury said there had been “something of a step change over the last three years in terms of how the market has transacted”.

He added: “If you think about what drives the global secondary market, whether it’s a stock or private equity assets that are out there today, and if you think about the volume of capital that’s been raised in primary markets, ultimately over time that transacts in the secondary market.”

Another important theme is that as investors face challenges. recently in terms of allocations, “you begin to see that frequency of churn go up” – which has happened more lately. There has been a lot of flow into the marketplace in the past few years with institutions looking to reduce allocations as the private market values went down, he said, although this has abated somewhat.

“What you see today across the marketplace is a need for liquidity,” Atterbury said. “LPs are looking to generate cash flows, sometimes to meet other obligations, often simply to be able to recommit and begin reinvesting into the market opportunity that exists today.

“What we’re also seeing is that those LPs are knocking on the door, or they’re GPs looking for distributions, and those GPs have had a challenge over the last 12-18 months in terms of finding exits. They’ve also turned to the secondary market in the form of GP-led solutions. This is where a general partner will come to the secondary market and look to raise liquidity from the secondary market, move those assets into a continuation vehicle, and that liquidity gets returned.”

GP-led deals in the secondaries market have accounted for about half of the transaction flow over the last three years.

That is a promising position to be in for the supply of opportunities, but what about the demand side? Are secondary funds raising significant volumes of capital?

Atterbury described it as a “pretty tight marketplace”, with the top 10 buyers accounting for around “60% or so” of the overall demand and capital that’s managed.

“When you look at the level of dry powder in the marketplace, it’s actually relatively benign in terms of the competitive dynamics,” he said. “There’s about a year and a half of dry powder in the marketplace today compared to the buyout markets, where we estimate somewhere around three years.”

This situation leads to a widening of the bid offer, and a widening of the discounts that are in the marketplace, which has occurred over the last couple of years, Atterbury reported.

A good time to invest?

Atterbury said many investors now recognised the broad risk reward benefits of investing in the secondaries market, rather than simply seeing it as a good way to build a private equity programme and mitigate the J curve.

“You get immediate diversification to mitigate your downside risks and you get access to mature assets,” he explained. “You get access to early cash flows, and in periods of dislocation, you get the opportunity for some real outsized returns.”

Additionally, Atterbury pointed out that lost capital in secondary funds has been “minimal”. Strong performing secondary funds can “very much deliver the type of upside that you’re looking for”, he said, but “even if you’re at the bottom of the stack, there’s still good solid performance and a much narrower dispersion in terms of secondary market investing”.

Building and leveraging relationships is hugely important in the secondaries market, and Atterbury describes it as “one of the few markets out there where there is a real asymmetry of information in favour of the buyer generally”.

LGPS involvement

For London CIV’s Shia, the secondaries market can “certainly help address some of the challenges that LGPS funds have had”, but can be misunderstood “as perhaps a different investment strategy or different fund structure, or a different investment type – but really, it’s just a different way to access primary fund investments”.

Investment typically comes during the “harvest” period, instead of right at the start of the investment period, and Shia agreed with Atterbury on the many benefits offered by secondaries.

However, she noted that “in the LGPS world, there perhaps hasn’t been as much familiarity on how to access secondaries”, including how to price them or how to determine when the right entry point is.

London CIV’s approach is to take advantage of the benefits and to have “immediate access to a very mature diversified portfolio, not to mention the immediate performance where you deploy quicker and see return quicker”.

Historically, secondaries were “a key way to divest out of underperforming assets”, but that is changing with “a lot more quality assets coming to the market”, Shia said.

That has been driven by “companies wanting to balance their portfolios and, particularly for GPs, wanting additional runway to extend the whole period of some of their assets”, she reported. “Some companies are getting extra time to realise their business plan, so we are seeing a lot better quality assets on the market. That to me is the key difference, along with the rise of GP-led secondaries as well.

“We’ve been in a fortunate situation where we’ve had a decent amount of dry powder, so I think we can be very selective on the secondary opportunities that we’ve seen, in particular the big allocation or potential allocation of primaries in GP is quite receptive to us on the secondary side.”

Real estate secondaries

The real estate secondaries market is “not as longstanding as private equity but very fast catching up”, according to CBRE Investment Management’s Achal Gandhi.

Noting the phrase that ‘history doesn’t repeat, but it does rhyme’, he explained that while there are not exactly the same stressed financial conditions seen post-financial crisis today, “a lot of the liquidity constraints that existed back then are present and that is why right now is such an attractive vintage for investing in real estate secondaries”.

But, he said, secondaries are not an investment strategy, but rather an execution channel – a method of buying and selling real estate. “For really attractive and successful secondaries execution, you need to have a real estate investment strategy that you overlay. So as a real estate investor, that is what we start with,” he explained.

CBRE Investment Management solely invests in thematic sectors which are driven by long term structural and demographic trends, and therefore have long term tailwinds in terms of rental growth, Gandhi said.

Looking at the real estate valuation cycle, he noted a peak 18 to 24 months ago, but that today “we are very close to the trough point in valuations globally” – meaning the conditions are right to acquire real estate secondaries.

Currently, there is “significant” capital market dislocation, and the availability of equity and debt is limited. “As a result of that, you are able to not only get into real estate close to the trough of the valuation cycle, and via a secondaries execution method, you can get in at [a good] price because for anyone who needs liquidity today, there is a price for that liquidity and you can therefore get discounts on the secondary market,” he explained.

The real estate that’s predominantly transacting today is in sectors like logistics and residential, he added. “If you are in need of liquidity today and you have to sell, all you can sell is your best quality kit,” he said.

But in a “story of two halves”, while there is capital market dislocation, there is no occupier market dislocation, as rental growth continues to be positive.

“When you put all of that together, we think it makes for a really interesting time to acquire good quality real estate at the trough of the market and at discount because of the liquidity constraints,” he said.

This does beg the question of why anyone would want to sell today. Gandhi explained that “there are a number of catalysts for secondary market activity”.

On the GP-led secondary side, factors include capital shortfalls, “where there is a refinancing event, whether there is a capex requirement, and there is very limited equity available on the existing investor base. As a result, the GP then needs to find a recapitalisation partner to finance those events and has to accept a discount because of that”.

The second factor is time extensions. “A number of vehicles would have had a termination of fund life date that terminated just at the start or during the pandemic and at that point, the GP would not have wanted to sell because of the dislocation of the pandemic,” Gandhi said. “In their documents they are allowed to extend the vehicle by one year or two, and those extensions have happened. Then we had an interest rate cycle on the back of higher inflation. And again, it wasn’t the right time to sell. And now all of these time extensions have been expired and investors want liquidity, so the GP has no option apart from looking to recapitalise their portfolios.”

A final factor is the emergence of specialist operating partners in real estate.

On the LP-led side, Gandhi described “a vast number of triggers”. He said: “What we have seen is liquidity requirements in LP portfolios, driving them to generate liquidity and therefore ‘have to sell’ positions. We’ve also seen rebalancing; investors struggling with denominator impacts, changing of asset allocation plans and therefore having to rebalance their portfolios.”

Finally, there has been a widespread shift in strategy. “We have seen a number of LPs around the world have a change of head of real estate or change of CIO and that has resulted in strategies changing,” Gandhi said.