Leverage in secondaries: friend or foe?
According to figures released by Triago, in 2017, debt accounted for 23% of the total $45bn of secondaries deal value in, a massive uptick from the 4% of debt represented in 2013 deal value. Furthermore, Triago estimated that 65% of secondaries buyers used leverage in 2017, up from just 15% in 2013.
Clearly, the use of leverage in secondaries transactions is on the up. But, lack of discussion around the use of debt in these deals has left many uncertain as to their impact. With the secondaries market set to reach record transaction volume for another year running, is the concurrent rise in leverage a healthy development for the market, and most importantly, is it safe for LPs?
It is of little surprise that the growth and innovation witnessed in the secondary market is giving rise to increased debt levels. Says Samantha Hutchinson, Fund Finance Partner at Cadwalader: “The use of leverage in the secondaries market is by no means a new phenomenon. But as the secondaries market has grown, the types of deals have become more varied, which has given rise to more complex strategies, and with it, a greater array of tools.”
There are clearly many advantages for using leverage in secondaries transactions. Enhanced returns and filling the funding gap or replacing deferred consideration are the most obvious. Another driver is to increase a bidder’s edge in a competitive process by providing greater firepower. And the potential for accelerated liquidity without exiting underlying assets acts as yet another alluring feature.
Despite market growth, there remains only a limited number of lenders active in this space, estimated at between just eight and 10 providers. This is largely due to the specialism required, with lenders undertaking deep dives into underlying assets, fund managers and buyers, as well as investors involved in any given secondary deal.
While expertise creates a barrier for entry, the robust track record of these facilities has not gone unnoticed; with no material defaults recorded. “Over the last 12 months, we’re seeing far more institutions showing an interest in these deals. Large financial institutions are entering the market and that is changing the dynamic,” explains Hutchinson.
Much like the fund financing space two or three years ago, where subscription lines were rarely discussed, if at all, the use of leverage within secondaries has remained a relatively discreet practice. But when fund financing caught the attention of market commentators, they quickly became a hot topic for all the wrong reasons. Almost overnight, the supposed dangers of bridging loans grabbed countless headlines.
Having undergone a period of intense scrutiny, fund financing is now better understood by investors, while trade bodies, including IPLA, have released best practice guides and reporting tools. The overriding message to managers and investors has been to ensure fund facilities are used for limited time periods, and as typically stipulated in the LPA, representing only a small fraction of total fund value.
And it would seem lenders operating in the secondaries market are doing so with the similar levels of conservatism. “The lack of defaults in this market speaks to the specialism and expertise of the lenders,” points out Hutchinson. “This group of sophisticated lenders are able to prudently assess if a portfolio is suitable for leverage. I have certainly seen deals where lenders have taken the view that the portfolio did not support additional leverage at fund level.”
We need to talk
Right across the investment spectrum, the use of leverage will always represent a risk. However, ensuring debt levels are kept to a minimum and that deals are safely structured to protect investors means secondary players absolutely ought to be seizing the advantages brought about by financing. As it stands, thanks to the specialism of lenders, the use of leverage in the secondary market appears to be conservative and well structured.
However, as the secondaries market continues to grow, coupled with the clean track record of these facilities, we’re likely to see more lenders entering the market. But as witnessed in the fund financing space, a rising number of lenders could bring about more aggressive facilities. Against this backdrop, in order to maintain the clear benefits of leverage in secondaries, which ultimately benefit investors, the discussion around financing must move into the mainstream.
Secondaries managers, advisers and trade bodies would do well to consider how best to educate investors on the use of financing and create best-practice guides to ensure leverage remains firmly in the friend zone.