The Private Capital Secondary Market and flexibility

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Interview of Remco Haaxman – Partner and Head of EMEA Fundraising at Coller Capital as  featured in Insight Out Magazine #22

Stephane Pesch interviews Remco Haaxman who showcases the evolution of the secondary market and the flexibility provided by the model to both Limited and General Partners.

Could you briefly present Coller Capital?

We are a Private Capital Secondaries specialist, founded in the early 1990s and we are currently investing from our 8th fund. Coller International Partners VIII, is a USD 9 billion AUM fund backed by over 200 institutional investors from all over the world. We are one of the largest independent firms in the secondary space, focused on both private equity and private credit, with an investment team of close to 70 people – one of the largest in the industry – which allows us to source many
transactions. This also means that we can work on several transactions at the same time and bear the opportunity costs of choosing not to win them. For us a key objective is to remain as selective as possible and only choose the most attractive investments.

Could you please explain what private capital secondaries are and describe the transaction process?

The market for secondaries has grown strongly and there has been significant innovation. At the core, a secondary transaction is the sale of private equity
assets prior to their natural end of life. Traditionally speaking, secondary transactions generally arise where, following a fund investment, a Limited Partner (LP) wants to exit that fund early. The secondary market buyer will step into the shoes of the existing investor, paying an agreed price to take over the net asset value and take on the unfunded liability that is associated with the fund’s position. This is what we refer to as an ‘LP-led transaction’ and it is what the secondaries market was built upon.
However, what we increasingly witness now are ‘GP-led transactions’ (i.e. initiated and led by General Partners), where the manager of a fund provides a liquidity option to its existing LPs. In these situations, and for a variety of reasons, existing investors get a choice to sell their stake in an underlying company (or multiple companies) to a secondary buyer. The way the transaction typically happens is by setting up a new entity that buys the existing asset(s) from the fund. The original investors in that fund, then get a choice between cashing out as a result of the sale, or to roll into the new vehicle and effectively stay invested.

What is the private capital secondaries market size?
In 2021, market volume for private equity secondaries was an estimated USD 130 billion and, with the exception of 2020 due to Covid, the market has shown a very strong growth in recent years; since 2006, the market approximately doubled every five years. In terms of market composition, 15 years ago, there were very few GP-led transactions and today they represent about half the market. The growth of the market is to a large extent currently driven by GP-led deals. Since 2020 about
half the market has been composed of GP-led transactions, an increase from 2019 when it amounted to 32%, or about 25% back in 2017.

 

What are the forces driving investments in Secondaries?

Typically speaking, secondary buyers tend to be specialist secondary funds. Some fund-of-funds may not have secondaries as their specific focus, but can still be active in this space. There are a couple of core reasons why a Limited Partner may wish to invest in secondaries. The first and most well-known one is ‘J-curve mitigation’. What that means is when an LP invests in a typical private equity fund, the GP will take a couple of years to deploy the capital and will generally be charging fees based on commitments during that period. That means that the value of the investment might go below 1x invested capital early in the life of the fund before starting to increase. That phenomenon is called the J-curve. Secondaries can mitigate this issue, since the investor gains its exposure to a fund at a later stage of its life, meaning that there has already been some value uplift with respect to the underlying investments and the fees (payable to the private equity fund GP) are already beginning to ‘step down’. Therefore, secondaries are considered to be a helpful way of addressing the J-curve, especially for organisations that want to avoid having to show negative returns early in the life of their new private equity programme.

The second major reason to invest in secondaries is that it provides a means
of gaining exposure to a hugely diversified portfolio in an easy and quick fashion. The typical secondary fund will invest in a large number of deals and every transaction will consist, generally speaking, of a large number of underlying fund positions and, therefore, an even larger number of portfolio companies. Our own secondary funds have exposure to thousands of underlying companies – in different sectors, vintages and geographies. We are also diversified across the different private capital asset classes and cover large PE buyouts, the mid-market, growth, some VC, private credit and so on.
Investors may also choose to invest in  secondaries for the attractive risk-return profile. Secondary funds tend to deliver strong returns, relative to the underlying risk. The key factors that mitigate risk include diversification, as well as the fact that secondary portfolios tend to generate cash early on. Secondary investments can often generate a cash yield from the portfolio almost from the day of closing due to their maturity and diversification; one or two years into the investment,
a secondary deal can be significantly de-risked with part of the returns ‘locked in’.

 

“One or two years into the investment, a secondary deal can be significantly de-risked with part of our returns locked in.”

 

Can you develop more on the difference in risk between primary and secondary investments?

Sure. When you buy existing assets in an underlying private equity fund alongside a GP, you take a different kind of risk compared to when you write a primary check to a buyout GP. Of course, when buyout GPs make a new investment, they will have conviction about the asset. However, the GP will only really get to know the company it invests in once they own it. Is the company’s management as good as they thought? Are there any hidden surprises? This risk is mitigated when
investing through a secondary fund. Therefore, the risk profile is inherently different in the type of deals that secondaries funds make when compared to what primary investors. The returns also come quicker in a secondary fund, which brings us back to the maturity point.

How did secondaries lift off?
When Jeremy Coller founded our firm in the early 1990s, secondaries didn’t really exist and there was effectively no way to exit private equity funds early. In those days, it could be quite hard to raise private equity funds and there were some investors that were more interested in selling private equity exposure, than buying it, and that is when the secondary market started. In the early days it used to mainly involve distressed investors or the ones truly needing liquidity. Secondaries later
evolved into a commonly accepted portfolio management tool. Investors now use the secondary market to shape their portfolios if they feel they are overexposed to, for example, a certain sector, manager, or geography. This is a significant change from the early days of secondaries, when an LP selling a stake was not necessarily viewed so positively. In those days, GPs felt that a LP leaving their fund would make them look bad. Today, GPs usually know the reason for the sale and this usually has nothing to do with what’s in the portfolio, but is much more driven by the situation of the seller.

 

“Investors now use the secondary market to shape their portfolios if they feel they are overexposed to for example a certain sector, manager, or geography.”

 

So secondaries have advantages for both sellers and investors into the secondaries asset class. How does the rise of GP-led secondaries impact the industry?

That’s very much the case. We discussed diversification, but of course this is much more a characteristic of LP-leds than GP-leds, which by their nature are more concentrated. This requires a different approach from secondary investors. Interestingly, GP-led secondaries, as a reasonably recent phenomenon, went through a
similar journey as LP-led transactions. In the very early days, GP-led secondaries were associated with GPs that had a problem to solve but it has now morphed into a tool that even the most ‘blue chip’ of GPs will use in order to continue to own their ‘trophy assets’. That’s why are we are positive about this trend, as it gives us an opportunity to align ourselves with quality GPs to invest in their best companies. Secondaries and private equity are all about alignment of interest and we feel that
if a GP is doing it for the right reasons then we can really align ourselves and generate great returns together. GP-leds are not easy to get right though, as GPs are, by definition, conflicted, with GPs acting as both buyer and seller in the same transaction. This means we must make sure all parties in a transaction have confidence that the process is run with integrity and that both buyers and sellers have received access to the same information.

 

Family offices often underline their need for liquidity. So I think you’re also bringing an interesting value proposition here?

That’s right. Both from the point of view of family offices as potential sellers, where GP-leds provide investors with optionality, as well as from the point of view as potential buyers, where GP-leds provide a compelling investment opportunity. In my view, well-structured GP-leds, where potential conflicts of interest are managed
appropriately represent a positive development for the industry, benefitting investors and GPs alike.

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