Global private equity secondary deal flow could fall by as much as 40 to 50 per cent this year, compared to 2019, as the repercussions of coronavirus play out over the next few quarters. But for those operating in the lower middle-market, discounted opportunities could be highly attractive.
Last year, transaction volumes exceeded USD85 billion, a jump of 7.2 per cent on 2018. But those numbers are going to look markedly different come the end of 2020, as the expected number of completed transactions fall over valuation gap fears.
Across the PE secondary landscape, it is possible that overall deal volume for 2020 falls by 40 or 50 per cent compared to 2019, according to one source, who asked not to be named.
“As soon as the market tanked, there were a lot of larger secondary deal processes that went into disarray,” comments Michael Bego, Founder and Managing Partner, Kline Hill Partners, a specialist PE secondary investor that operates in the lower middle-market. “These larger deals aren’t KHP’s focus, but if you look at most of the big sellers (such as pension funds and banks) they were really just doing portfolio management. And, in a lot of cases, buyers would have required pricing 20 per cent lower than prior to the outbreak of Covid-19. To many large LP pools, this was unacceptable.
“GP-led secondary deals are even more sensitive to pricing as they need to transact close to par and those have all been put on hold.”
Already, a lot of the deal flow at the larger end of the secondaries market has dried up; not only are sellers just not there, but many of the larger PE secondary funds have put down their pencils as they wait to see how things play out. The issuance of Q2 financial statements is likely going to be a key metric for both buyers and sellers alike.
“When the Q2 financial statements publish, we will likely see buyers re-engage en masse and this may drive higher optimal pricing. The question will be: Are the sellers happy with that higher optimal pricing or will they sense a potential recovery in value over the subsequent months as we head into Q3 and Q4? It is possible that the bulk of sellers will hold off a bit waiting for better value. That’s what the market will be looking to discern,” suggests Bego.
The issue over how to agree on fair valuations will be a big deal in 2020 because of the severity of the market drop in March, which wiped out trillions of dollars on global markets. Secondary transactions involve an intricate dance between buyers and sellers, where the deal price has to be of mutual benefit.
But if there is no clear sign this year of an economic recovery, or that things start returning to normal post-lockdown, one should suspend any belief that LP-led deal volume will revert to the mean.
GP-led deals have been sabotaged
As for GP-led deals, “In my view they will almost certainly be on hold for most of 2020 now,” says Bego.
He says there are two key issues at play: 1) Sellers will require pricing close to par, so there is a very high pricing expectation among GPs willing to sell their positions. 2) There is a huge lead-time in executing GP-led secondaries.
“The consensus among some of the large PE intermediaries is the kick-off of resumption in such activities will not likely happen until July/August; and even then those processes can take up to six months to complete. GP-led deal volume has been completely sabotaged by Covid-19.”
Kristof Van Overloop is Director, Investments at Flexstone Partners.
He confirms that Flextone continues to actively assess and review secondary opportunities in the current market but thinks bidding off the 2019 reference dates will be challenging with significant bid-ask spreads, “and only very motivated sellers anticipated to transact in the near term”.
“Nevertheless, we expect sellers will be coming back to the market relatively soon, for a variety of portfolio construction reasons (repositioning strategy, denominator effect).”
He too believes the market share for GP-led deals will fall this year but suggests that with expected delays in company exits, many GPs will have to consider GP-led transactions to address potential capital needs in order to support existing portfolios, or avoid having to sell assets in the open market at depressed valuations.
“With a number of LPs potentially facing liquidity needs or considering reallocations in their portfolio construction, we anticipate to see motivated sellers coming to the market, willing to accept meaningful discounts to intrinsic value, and not just to NAVs, to get a deal done.”
Opportunities in lower middle market
Kline Hill Partners focuses on smaller transactions in the lower middle-market. The team were involved in a number of deals before the markets collapsed that re-set at much lower prices. Even so, Bego says the sellers were content to continue to move forward “because they understood that while the updated pricing was unfortunate, it was still fair value given the market conditions”.
As a high volume, small-deal focused investor, KHP believes it is in a fortunate position as re-pricings can be less material to sellers than for larger secondaries transactions.
In this environment, there will inevitably by LPs who, through no fault of their own, become forced sellers because they need liquidity and will countenance deals at lower, but fair prices.
Moreover, there will also be some LPs who simply wish to offload unfunded liabilities, which in a sense is less expensive and easier emotionally, to part with.
Unfunded liabilities are where the LP has committed capital to a GP but has not yet received any capital call notices. An investor might make a USD10 million capital commitment, for example, but it might take a three- to four-year period for the GP to call that capital.
“For sellers who need the cash, if they want to part with unfunded – or less funded – liabilities, the discount doesn’t matter so much, whereas if you are buying a fully funded pool it can be painful for LPs to take a big discount on invested assets,” explains Bego.
Continuing with the above example, if the LP had a fully funded commitment, it would be much tougher to accept 50 cents on the dollar. However, if the PE fund had only invested 20 per cent of its capital, offering that same LP 50 per cent on USD2 million would be more palatable as they would get the benefit of walking away with the remaining 80 per cent of their cash to fund other liabilities.
Flexstone focuses on the small- and mid-cap market segments with limited publicly listed exposures, following an asset-centric approach and working with GPs and funds we know well.
“We believe we are in a good position to source and continue to fundamentally diligence transactions and approve offers in a timely manner, something which we believe differentiates us from many other buyers. In fact, our target allocation to secondaries has increased significantly based on strong appetite from both our cornerstone and new investors,” confirms Van Overloop.
With distressed opportunities likely to emerge over the coming years, it is unsurprising to hear Bego opine that unless the world heads towards the next Depression, “it should be a good time for cautious PE secondary investors. However, the risks are still there; caveat emptor. So even if the opportunities look attractive, overall deal volumes could end up being lower.
“That being said, I think there will be less of a decrease in smaller-sized deal flow, compared to large-cap secondary deal flow, on a relative basis. Any deals that get done this year should be the ones that perform well,” suggests Bego.
“In in the lower mid-market, which is typically characterised by more limited available information and less competitive process dynamics, and where having a bottom-up view on a fundamental key value drivers is even more critical, we expect to see highly attractive buying opportunities,” concludes Van Overloop.