By Joel Kranc
Last year marked an important tipping point for the private equity (PE) market. The era of declining interest rates and growing valuations came to an end, as inflation reared its head.
That is possibly the reason this year will be a pivotal one for private equity allocators to take advantage of the growing secondaries market. Today, secondaries markets have evolved and deepened substantially with more than $100 billion in estimated volume in 2022 alone, according to Jeffries Global Secondary Market Review.
Looking ahead, several factors are poised to favor buyers of secondaries, including low levels of dry powder on the sidelines and more limited partners seeking liquidity as they reconfigure their private capital allocations.
Stretched Fundraising
One of these factors comes in the form of a stretched fundraising cycle.
“Stretched private equity fundraising cycles and diminished fundraising are a function of over-allocation to the asset class, lower ex-ante return expectations due to higher interest rates, a possibly weakened global economy, longer fund lives with lower paid out capital and a materially diminished IPO market for exits,” explains Michael Oliver Weinberg, special advisor to the Tokyo University of Science Endowment and adjunct professor of Finance and Economics at Columbia Business School.
“This in turn bodes well for the opportunity in secondary private equity, where discounts are on average currently approximately 20%. Similarly, it bodes well for private credit where sophisticated institutional investors can invest in senior secured bonds, with strong covenants, cash flow, low loan-to-value, equity kickers and other enhancements, which may generate equity like returns with credit like risk.”
The ‘Denominator Effect’
As mentioned earlier, interest rates have been an important influencer in the change of the private equity investment market. “Since the start of the ongoing interest rate hike cycle from the Federal Reserve/Bank of Canada and the corresponding market correction, certain institutional limited partners have seen their allocations to private equity and other private assets become relatively ‘overweight’ in their portfolio as a result of declining public market valuations,” say Aaron Hunt, senior associate with Torys LLP and Meghan McKeever, partner with Torys LLP.
“This is commonly known as the ‘denominator effect’ and has led to a pullback in respect of certain institutional investors from committing new capital to private funds. In addition, there is a general sense of caution among many institutional investors to avoid deploying too much capital into an uncertain market.”
But Yusuke Khan, Canada Investments leader with Mercer says, “It’s important to keep in mind that, in many instances, it is more a function of regular portfolio management. These are long-term investments where decisions being made today may not lead to capital being invested for a number of years, and it might be north of a decade in many instances that the value is realized by the private equity investor.
“So it’s very difficult in our view to try to be too tactical around allocations generally in private equity,” he notes. “[It appears] that the denominator effect has bumped up against risk control guidelines.”
Outlook for 2024
Khan also stresses that yes, deals are slower and 2024 will be slower in terms of fundraising, but that is coming off of several years where fundraising was faster than it would have been historically, and maybe now is coming back to a more normal level.
“There are opportunities at the margins … it could be that commitment amounts are much smaller but staying the course with good managers is critical and in a tougher fundraising environment there is an opportunity, where highly coveted managers are looking at expanding their investor bases so there are positives in deal slowdown,” he adds.
Hunt and McKeever agree and note the effect of a flight to quality. “Given the scarce capital available to investors in these challenged markets leading to a liquidity crunch, there has been a greater focus on ‘re-up’ subscriptions to larger managers with established track records with which investors are already familiar with a commensurate reduction in subscriptions to first time funds and other smaller managers that are viewed as less ‘safe’ from an investor perspective,” they explain.
Room at the Top
Vipon Ghai, global head of private equity and credit for Manulife notes there’s something of a disconnect in the market. “Private equity doesn’t have to buy and it doesn’t have to sell. It’s patient capital so what we are seeing is people aren’t buying or selling. Why is that? Interest rates have gone up and the cost of financing makes it difficult for buyers and sellers to meet.”
It’s not an issue that there isn’t capital out there, he explains. In fact, there is a significant amount out there, to the tune of $1 trillion. But he agrees that institutional investors are facing the denominator effect and that cycles are getting stretched, although not necessarily for top quartile funds.
“Institutional investors have capital to deploy, but the money is not coming back as fast and everyone is faced with the denominator effect,” he says.
“Until interest rates come down, 2024 will be much of the same,” he adds. “There’s a limit to secondaries. They have concentration limits that won’t solve the problem in the same way. They’ll provide partial liquidity but won’t solve [the entire liquidity issue].”
Beyond secondaries, Hunt and McKeever say that “many GPs are also exploring the idea of continuation vehicles and other ‘GP-led’ secondary sale models in order to provide additional capital to challenged portfolio assets or to extend the hold period for certain assets to avoid exiting in a down market. Once viewed as a signal of a sponsor’s or a fund’s distress, continuation funds are now often considered by sponsors as a means to secure the time and fresh capital necessary to take a well-performing investment to the next stage.”
With inflation still historically high, and now world geopolitical events adding to economic uncertainty, the wait-and-see approach currently held by institutional investors may be stretched even longer.
