Q&A: Jefferies veteran dealmaker examines PE secondary market trends

From Pitchbook:

Falling valuations in public and private markets have put added pressure on the pace of private equity exits, which slowed in Q2 2022 for the second consecutive quarter. PE firms chose to hold on to portfolio companies longer, instead of selling their investments at unattractive prices.

During Q2, sponsors exited $94.5 billion in investments across 293 announced deals in the US, according to PitchBook’s latest PE breakdown. While the total exit value for Q2 is similar to the figure posted in Q1, it represents a sharp decline after two consecutive quarters of over $200 billion, according to PitchBook data.

Yet the drop in exits, if followed by a decline in distributions, could lead to a flourishing secondaries market. On one side, many PE firms will pursue GP-led secondary deals, particularly continuation funds, to extend their ownership of valuable assets; on the other side, limited partners may also resort to the secondary market to unload older assets and free up capital for new commitments.

We recently spoke to Andy Nick, a managing director of Jefferies‘ private capital advisory arm, about the private equity secondary market—including how it has fared amid sustained public market volatility and what to expect for secondary deal flow and pricing in the coming year. Nick has advised on LP- and GP-led secondary transactions totaling over $35 billion in his career so far.

PitchBook: How has overall investor sentiment in the PE secondaries market been in the last six months?

Nick: With the ongoing war in Ukraine, high inflation, rising interest rates and declining stock market valuations, I’d be lying if I said the market wasn’t affected at all by the volatility we’ve seen in the world and public markets. But unlike the first couple of months of the COVID-19 pandemic back in 2020, where the market did, for the most part, grind to a halt, the secondary market in the last several months has still been open for business. Buyers are just being more selective on what types of deals they’re looking for and more careful on how they’re pricing transactions.

How did the public market downturn affect pricing of secondary deals in the first half of the year?

We have historically seen secondary transactions priced at bigger discounts to net asset value when public markets are down, as secondary buyers use public market comps when pricing secondary fund interests. This held true during the first half of 2022, with pricing declines first rippling through venture and growth funds starting around February. On average, those strategies are probably down 1,000 to 1,500 basis points from where we would have seen similar funds pricing six months ago.  We have also seen the decline in other strategies, including buyout funds. Albeit these were not down as much as VC and growth funds, as the overall stock market wasn’t down as much as tech valuations.

The pricing declines have occurred because everyone is still negotiating deals based on historical NAVs that haven’t been written down to reflect recent downturns, even though public markets have declined more than 20% since the beginning of the year.

Secondaries transactions are typically quoted as a percentage of the latest quarter’s NAV reported by private equity funds. The pricing of deals in the first three to four months of this year was based on valuations as of Sept. 30, 2021, which were at relatively high levels. Then, if you look at what happened in public markets in Q4 last year, a lot of LPs experienced write-ups in their portfolio in that quarter. So Dec. 31, 2021, valuations were, in a lot of cases, even higher than September.

In May, transactions were starting to be priced relative to the Dec. 31 NAVs. If you look at what happened in public markets since the beginning of this year, stock prices were down meaningfully, but Dec. 31 NAVs don’t incorporate those declines. In fact, even March 31 NAVs don’t really reflect the current valuation environment because GPs largely didn’t write their funds down, despite meaningful public declines.

How will the market downturn likely affect volume and pricing of secondary transactions in the second half of the year?

We anticipate that a lot of general partners who didn’t write their portfolios down as of Dec. 31 or March 31 will do so for June 30’s valuations. That being said, we do expect that there will be a lull in market activity over the summer, as there always is. So you might not see a lot of new transactions launch in July or August. But once June 30 valuations are released in mid- to late August and people come back from summer holidays, the rest of the year is expected to be busy.

There are a lot of LPs who want or need to undertake sales because their private-equity allocations as a percentage of their total portfolio have increased, given the decline in public markets. Meanwhile, you have plenty of capital on the buy-side as secondary buyers are waiting to deploy dry powder. Once valuations reflect reality more than they do now—that is, when the June 30 valuations are out—we expect that it will be a busy Q4, with pricing stabilizing at levels that both buyers and sellers can live with.

Last year, we saw a surge in GP-led secondary deals—mostly continuation funds. Jefferies’ data shows that GP-led secondary deal volume surpassed traditional LP transactions in 2021. Are we still seeing GP-led transactions dominate secondary market deal flow?

The market for LP-led transactions slowed down slightly at the end of Q2, but it did not come to a halt. Until the June 30 NAVs come out, volume will likely remain depressed, as everyone is operating with stale information at this point.

The deal volume of GP-led secondary transactions remains robust, particularly for continuation funds. The changes in markets over the last few months haven’t really affected our volume in that space.

Buyers have an ability to dig into individual companies a lot more in GP-led deals than in LP deals because of the heavy involvement from sponsors. In GP-led deals, buyers can do a very deep dive to get a sense of how resilient a company is likely to be if we do enter a recession and a prolonged downturn. And they are leaning into companies that they think are more recession-proof currently.

There are certain continuation-fund transactions that will have a harder time getting done: Some GPs who were considering a continuation-fund transaction a few months ago now realize that it may not make sense to do a transaction with that specific company, currently, given the new environment that we are operating in.

But as GPs look across their portfolios, there are other candidates for continuation funds. Those could be companies they were planning to exit via traditional M&A in the following six to 12 months. But as market conditions are not as favorable as they once were, many will decide that continuation funds are a good alternative to allow them to hold and grow these companies for a few more years until the traditional exit paths make more sense.

PitchBook data shows PE exit activity has slowed down. How would this trend impact LPs’ decisions about pursuing secondary sales?

LPs have certainly told us they are experiencing a slowing pace of distributions. The IPO window is effectively closed. There are still strategic exits, but to a lesser extent than in prior years. And with the leveraged finance markets being relatively closed as well, you will probably see fewer sponsor-to-sponsor trades. All of these factors are catalysts that will help keep secondary volumes high, both on the LP side and the GP side. As distributions slow, many LPs either have to sell public equities, use cash on their balance sheet or consider doing secondary sales to meet capital calls and continue committing to new funds on a primary basis.  And the good news for LPs is that despite all of the volatility in the world today, the secondary market has evolved to a point where it is able to weather the storm and continue to provide LPs with the liquidity they want and need.

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