Measured against the circa $70bn private equity secondaries market, private debt secondaries are small potatoes. For now, at least. However, good sense suggests that is about to change. So far, 2019 has provided compelling evidence of what could be the coming advent of private debt secondaries.
For one, an estimated $2.2bn of such fund positions changed hands in the first half of the year. This equates to a 279% gain on the same period last year. Not to mention that it already puts it above the $1.5bn of LP stakes in debt funds that sold during the entire of 2018.
The fundamentals are certainly in place. Primary fundraising in the direct lending space has surged in recent times as fund managers stepped into the breach left by traditional banks who have focused their efforts on shoring up their balance sheets with regulatory capital in the last years. At the same time, investors have flocked to private debt funds and other high-yielding fixed-income assets as an antidote to the low-interest and stubbornly low-yield investment environment.
Financial sponsors have also grown accustomed to using credit funds to finance their leveraged buyouts. As the firepower at debt funds' disposal has increased, they have proved to be suitable lenders for even the largest private equity deals. Furthermore, lacking the bureaucracy that can plague banks’ credit committees, these funds are able to transact rapidly — and often at higher leverage ratios.
All of this has created a fertile environment for debt funds to flourish. Despite a dip in 2018 to $45bn raised by direct lending funds, this followed a $68bn total in 2017. It follows that with so much capital being concentrated into these funds on a primary basis, a healthy secondary market will emerge on the back of it.
Directs versus Indirect
A secondary market for loans is already well-established, of course. As part of their efforts to raise regulatory capital, traditional lenders have spent recent years bundling weaker loans and selling them on to credit funds. A recent example saw the UK’s Metro Bank, a challenger bank launched in the aftermath of the global financial crisis to compete in the country’s heavily consolidated banking market, offload more than £500m worth of mortgages to US special situations firm Cerberus. Even non-banks have been on the selling side of these deals. Last year, start-up lender FundingCircle agreed to sell $1bn worth of US loans to Alcentra. This can be characterized as a direct secondary market.
Traditional, indirect secondary deals — which see LPs trade out of their fund positions — have been less common in the private credit space. Seizing on this untapped opportunity, Pantheon may have been exploring investor interest for a debt secondary fund late last year. It is not exactly clear what came of those plans; however, it is true that the London-based private equity fund of funds and secondaries firm has engaged in a joint venture with German peer Solutio AG for these exact purposes. The firms' Solutio Premium Private Debt I was registered in Luxembourg last year. Since then, Pantheon is believed to have been involved in a $400m GP-led deal of Avenue Group’s €3.1bn Avenue Europe Special Situations Fund II. Avenue Pantheon Broadway Fund; the associated rollover vehicle was registered with the Securities and Exchange Commission in March of this year.
Why not?... Why now?
One of the reasons why debt secondaries have until now remained relatively niche is market inefficiency. Traditional secondaries funds are more highly capitalized than ever, but their cost of capital is modelled on equity returns. After all, their modus operandi is to acquire positions in private equity funds, not debt funds. Therefore, any deals that have succeeded have necessarily required steep enough discounts in order to meet those higher return requirements. Sellers have been happy to swallow these discounts as part of multi-billion dollar portfolio sales comprised largely of buyout funds — a small price to pay for securing large sums of liquidity in one fell swoop.
However, LPs who simply want to resize their private debt portfolios have had few, if any, options to do so. It now looks like that could change — and fast. There is substantial capital locked up in direct lending funds. Some of these have the option to recycle capital, and many LPs sitting in vehicles that are nearing the end of their lifespans are likely to seek an early exit.
Investors are beginning to recognize the significant buying opportunity that is lying in wait. There is every reason to believe, then, that the $2.2bn of fund stake transactions that completed in the first half of 2019 are just the tip of the iceberg. Firms such as Pantheon are the early movers and will likely enjoy the fruits of having a market largely unto themselves. Opportunistic secondaries buyers would do well to pay attention to their example. Today, private debt secondaries are little more than a talking point. This time next year could be very different. LPs should see this as a welcome development in the private capital secondary market.