In brief 8 min read
While there has been a hiatus in new deal activity in fund secondaries markets during the significant market dislocation experienced in the first quarter of this year, we look ahead to the green shoots in the secondaries market with expectations of increased deal activity in the second half of 2020 and discuss the thematics for superannuation and institutional LP participants over this period.
The second half of 2020 will see a number of drivers influencing both sell-side and buy-side demand in the secondaries market, as outlined below:
Denominator effect – opportunity or recurrent threat?
While some superannuation and institutional LPs will continue to rebalance their alternative asset portfolios as a result of the 'denominator effect' (being the decline in the value of equities holdings outpacing alternative assets holdings, resulting in an overweight allocation to alternative assets), for others, the rebound in public equity markets during the second quarter of this year will have resulted in alternative asset allocations falling back within target asset allocation bands (or slightly underweight), presenting opportunities to increase exposure to alternative assets during H2. That said, such opportunity could quickly be tempered by any subsequent equity market correction as a result of the continued volatility caused by COVID-19 or the outcome of the US election.
Historical performance data demonstrates, as compared to the last period of significant market dislocation caused by the GFC, that alternative asset portfolios acquired in the period immediately after the GFC significantly outperformed, with returns driven by a combination of alternative assets being acquired at steep discounts to net asset valuations (NAV) and underlying portfolio company valuations rebounding as the economy recovered.
Secondaries dry powder
Significant capital awaits deployment by specialist secondary managers, with BlackRock and Manulife, to name a few, launching new secondaries strategies or funds in late 2019 / early 2020. The second half of 2020 presents an opportunity for those strategies to meet deployment targets.
Leaning-in on co-investment programs
For those LPs with mature co-investment fund programs benefiting from reduced (or nil) carry and enhanced governance rights, the continuing pressure on superannuation funds to lower indirect costs of their alternative asset portfolios driven by ASIC's Regulatory Guide 97 Disclosing fees and costs in PDSs and periodic statements (RG97) may motivate superannuation funds to trade their exposure to higher cost private equity main or flagship fund investments.
What deal mechanics can we expect to see in secondaries sale negotiations in the current environment?
Bridging valuation gaps
The traditional pricing structure deployed in a fund secondaries transaction is to value the fund stake(s) based on the previous quarter or half yearly NAV, coupled with a purchase adjustment for distributions and any other payments paid to the seller between the valuation date and closing date and capital call amounts paid by the seller between the valuation date and closing.
In an environment where distributions have been reduced or turned off, frequency of capital calls increased and NAV discounts widened, the market swung wildly in favour of buyers. As a result, creative earn-out structures have made a resurgence in secondaries market transactions, offering a way to bridge valuation gaps and allow the seller to exit while retaining a contractual right to participate in some of the upside that may be expected after close, as fund valuations improve over and above an agreed return hurdle.
Supporting the seller's entitlement to earn-outs and deferred consideration
Deploying earn-out structures or offering the buyer deferred consideration terms brings into sharper focus the financial substance of the acquirer, particularly if the parties are transacting in more recent vintage portfolios and the buyer is assuming significant unfunded commitment liabilities. While historically unheard of in secondaries transactions, taking security over the disposed fund interests, agreeing third party escrow arrangements or seeking guarantees from other buyer group members are now being sought to support the seller's contractual right to an earn-out or deferred consideration under the purchase and sale agreement (PSA).
If buyers and sellers are subject to different international regulatory regimes or currency risk needs to be allocated between the parties as part of the sale structure, these can present novel issues which need to be worked through and may extend the usual expedited timetable in which a PSA can be negotiated.
Caution with respect to distressed sellers
Caution should also be exercised by buyers acquiring fund interests from distressed sellers in the current environment (in particular, where the interests relate to earlier vintages and there is a longer period of ownership being warranted by the seller). Buyers are becoming more focussed on the ongoing financial substance of a distressed seller having the means to stand behind the typical range of 'excluded obligations' for which the seller customarily remains responsible (being those obligations and liabilities referable to the seller's period of ownership (including any LP clawback obligations)). This can result in contingent or deferred consideration structures or escrow arrangements being pursued by buyers.
Structuring of portfolio sales
In structuring the sale of a portfolio of fund interests, the traditional focus of parties was to ensure that:
- consecutive closings of each fund interest could be held as soon as possible after the conditions to closing of that fund interest were satisfied; and
- failure to satisfy conditions to close of one fund interest would not derail the closing of other fund interests being transacted.
In the current environment, sellers will be focused on ensuring sufficient fund interests close with certainty (particularly those interests which carry larger unfunded commitments) so as not to allow the buyer to cherry pick and walk away from closing on the remaining interests.
While MAC clauses are back on the negotiating table after some time on the sidelines in the preceding few years of buoyant secondaries market volumes, as the pandemic plays out and we see a broad range of health and economic outcomes across different jurisdictions, precision in articulating the parties' intended risk allocation outcomes has never been more important. If parties proceed into the territory of negotiating a MAC, they should ensure that the time invested in negotiating and settling MAC triggers (which both operate in a way that provides the parties with certainty as to risk allocation and are appropriate to a portfolio of fund interests (which traverse investments in multiple jurisdictions that may be impacted in very different ways by COVID-19 and subsequent economic consequences)), will be proportionate and warranted, having regard to the size of the transaction and the anticipated time period between pricing of the transaction and closing.
Finally, with an enhanced level of diligence and disclosure of information expected in the current environment, some sellers may also seek to limit the buyer's ability to bring particular PSA warranty claims if such a claim relates to information disclosed to the buyer during the diligence process (and there are agreed parameters around the record of information disclosed).
Other structured solutions being considered by LPs wishing to achieve liquidity while maintaining partial exposure to future upside on their alternative asset fund investments include:
- Preferred equity structures - which can take a number of different forms (and may be LP-led or GP-led). Preferred equity has traditionally been structured as a transfer of the fund interest into a new vehicle managed by the preferred equity sponsor. The seller receives part cash consideration upfront, while continuing to hold an interest in the new vehicle, entitling the seller to returns achieved above an agreed hurdle rate with the sponsor. Depending on the nature of the structure and scope of affiliate transfer provisions, some preferred equity structures can be implemented with limited conditionality and without requiring GP consent. Deployment of preferred equity structures remains in its infancy in the Australian market, but we expect will continue to grow in line with their continuing evolution internationally.
- NAV based lending - in the current environment, we have continued to see increased marketing of NAV-based lending facilities to LP investors as a liquidity solution, being secured over a portfolio of limited partnership, unit trust and other equity interests in hedge funds and private equity funds. The difficulty in the current environment, reflecting what so far has proved to be a valuation crisis rather than a liquidity or credit crisis, is the challenge lenders face on settling on NAV valuations (the base from which LTV ratios are struck). An impediment to regulated superannuation funds deploying NAV-based lending facilities is the prohibition on borrowing in section 67 of the Superannuation Industry (Supervision) Act 1993 (SIS Act) and corresponding prohibition of charging of fund assets, resulting in the need to restructure the secured fund interests into an SPV before the NAV-based facility can be effected. Superannuation trustees should also be mindful, in undertaking such restructuring, of the in-house asset rules under the SIS Act and APRA's expansive directions powers (which appear to us to be broad enough to include directions in relation to borrowing activity of a controlled vehicle).
The evolution of the global secondaries market over the past decade (2019 volume notably hit a record close to $90 billion) has resulted in a liquid and transparent market with a well-developed set of legal terms at the disposal of superannuation, pension fund and endowment fund LPs. Subject to agreeing price referable to the last available NAV valuations (and we don't downplay the difficulty of this task in the current environment), a customary secondary market transaction can be negotiated within a few weeks, with closing to follow at the next month or quarter end.
As a result of market dislocation and the Government's change in policy settings introducing the temporary early release of superannuation payments, ASIC and APRA's regulatory focus shifted to monitoring liquidity and ensuring regulated superannuation funds could meet their payment obligations, including early release payments. While debate has ensued over certain segments of the superannuation sector's exposure to private equity and alternative asset investments traditionally considered 'illiquid', the maturation of the secondaries market and its ability to provide liquidity solutions over the short term was largely glossed over in the debate. That is not to say that superannuation LPs have been distressed sellers of alternative assets in secondaries markets – having weathered the combination of a severe equities market correction and the unforeseen liquidity challenges brought about by the introduction of the Government's early release regime, it is a testament to the liquidity management planning and stress testing undertaken by regulated superannuation funds in Australia, demonstrating the prudential strength of the sector.
With the secondaries markets seemingly being pulled in multiple directions, from the opportunities presented by the secondary dry powder available and reset in NAV prices expected as Q2 valuations are released, to the risks associated with a second equities market correction or rolling COVID-19 lockdowns globally weighing on secondaries sentiment, it couldn't be more different from the record volumes achieved in 2019. With Q2 portfolio valuations arriving from GPs, we expect LPs will take this opportunity to consider their core and outlier alternatives positions (and the associated direct and indirect cost profile of those portfolios), ready for what is shaping up to be a dynamic, challenging and opportunistic six months ahead for portfolio management in alternative assets.