Private Debt Secondaries and Horse Races

• The denominator effect—A decline in public equity valuations has created a denominator problem in ramped private debt portfolios, despite fundamental confidence in the asset class. To remain within their policy limits, LPs may seek to rebalance asset allocations via secondaries.
• Greater sophistication—If an investor expects loss rates to increase, and the seller has a good sense of its cost of capital, then a lower cost of capital with a differing view on outcomes makes a secondary market.
• Wider dispersion in equity valuations—The cost of equity has ballooned, so the comparatively modest increase in the cost of debt may be appealing on the sell-side. If one must sell something, why not sell the thing which has not widened too much?
• Competitive or privacy concerns—Whether GP- or LP-led, secondaries are often performed bilaterally and therefore remain confidential to both buyer and seller. This generates confidence in secondaries as an investment style.
• The positive interventions of brokers—Placement agents offer transaction-driven, unbiased advice. They reduce transaction risk and aggregate information.
• Specialization and Integration—Some participants offer specialization, often derived from years in investing in private equity secondaries, with positive and consistent outcomes for LPs. Others, including ourselves, integrate secondaries into their broader private debt programs, mixing primary, secondary and co-investment allocations to optimize deployment, diversification and strategy expansion.
• Information advantage (and its perils…)—Contractual cash flow is not equivalent to guaranteed cash flow. Evaluating prepayments, defaults and losses is highly subjective; the ability to make these judgements, is more art than science. Knowing a manager well can lead to an idiosyncratic view. Familiarity may result in overly precise or punitive assumptions, while other buyers may be oblivious to the risks. This creates higher transaction risk for informed market participants. 

Size of Private Debt Secondary Market

The private debt secondary market is in its infancy. Though the data are imperfect, we can infer its size and growth potential from its private equity counterpart. Between 2006 and 2020, private equity secondary fundraising, grew more than fourfold, from $20 billion to $84 billon.1 This follows a similar trajectory as the overall private equity market, where AUM grew nearly 6x over the same period.2 Concurrently, private debt AUM grew 8.6 times, reaching$1.2 trillion in 2020—about one fifth (17.6 %) the size of the private equity market.3 Thus, an established private debt secondaries could be as large as $14.8 billion (17.6% of $84 billion); going forward the market could grow at a similar rate (10% per year) as has the private equity secondaries market.

In some ways, $14.8 billion may be understated: GP-led secondaries are often not included in market stats. However, for the following reasons, we believe private debt’s secondary market will be proportionally smaller than private equity’s.

• The loans underlying private debt funds are relatively short lived; one can wait longer to rebalance.
• The comparatively smaller denominator effect due to lower dispersion in returns and a consequent lower pressure to rebalance or to take early profits.

Differentiated Transaction Types – the potential benefits of captive deals

Investors can generally access secondaries via two types of processes: competitive and captive. We believe the former, while easier to access, are more efficient and, thus, more difficult to arbitrage. Discounts tend to be modest. Captive processes, on the other hand, tend to only come about when one has a strong relationship with the originating lender. Akin to GP-led deals in private equity secondaries, captive deals are less efficient and can usually be purchased at a discount to par. While we use both, the choice, we’ve found, depends on the returns we are targeting and the types of assets in question. Figure 3 summarizes our approach.

• When purchasing entire portfolios of senior-secured loans, we prefer captive deals. Because these types of loans tend to have a more modest return target, minimizing losses is critical; a long-term partnership with the originating GP can be helpful in that regard. That said, we will consider purchasing LP stakes if the funds are well-ramped.
• When purchasing LP stakes, we are open to competitive processes. Here, because we tend to target higher opportunistic-level returns, we can accept modest discounts and greater risk.

1 Preqin, as of June 30, 2022.

2 Ibid

3 Ibid