In this Ropes & Gray podcast, asset management partners Isabel Dische and Katie Waite discuss some of the reasons why the credit funds secondaries market has historically been smaller than the private equity secondaries market, and why and how that has been changing recently, including as a result of market declines triggered by the COVID-19 pandemic.
Katie Waite: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts and webinars focused on topics of interest for asset managers and institutional investors. I’m Katie Waite, a partner in our asset management group based in Boston. Joining me today is Isabel Dische, an asset management partner in our New York office and co-head of our institutional investor practice. In this podcast, we will cover some of the reasons why the credit funds secondaries market historically has been smaller than the private equity secondaries market, and why and how that has been changing recently.
Isabel Dische: By way of background, while the secondary market for private equity fund interests has been very robust for many years – indeed transaction volume in 2019 exceeded $75 billion, the secondary market for interests in credit funds has historically been much smaller, and last year was just over $3 billion in size. To an extent, that reflects the smaller size of the industry – it’s estimated that just over $100 billion of credit fund capital was raised in 2019, as compared with nearly $600 billion of private equity capital. The typical terms of credit funds also influence the market size, as credit funds typically have only a 5-7 year term as compared with 10-12 years for private equity, meaning that there are fewer years in which an existing investor might consider selling. Secondary buyers’ target returns, typically higher than typical credit funds returns, also have hindered the market, as those buyers have to buy at a discount existing LPs may find unpalatable in order to achieve their target returns.
The underlying nature of the asset class also impacts the size of the credit fund secondary market. Your typical private equity investment is held for many years, whereas private debt investments are typically refinanced or repaid much more quickly, meaning they have their own built-in exits. Put simply, the nature of the asset means investors in credit funds may have less of an immediate need to sell. That said, there have been a steady stream of private debt portfolio transactions and even GP-led restructurings in recent years. We’ve also seen some of the classic secondary buyer establish funds that are focused on credit secondaries.
The current market disruptions triggered by the COVID-19 pandemic also may upset the self-liquidating feature of many loans at a time when the holders of interests in those credit funds have a heightened need for liquidity, and we expect to see an uptick in seller interest. The comparatively broad holdings of credit fund interests may also result in pockets of motivated sellers, as some credit fund LPs may be disproportionately impacted by recent market developments.
Katie Waite: Credit and distressed funds have accounted for a growing percentage of GP-led activity in recent years. These transactions allow GPs to offer liquidity to existing investors and find a new investor base on an expedited basis because investors are buying into a known portfolio. They also give a GP more time to optimally manage a portfolio where some of the positions have, as is inevitable, fallen into watch or distress status. It takes time to resolve a watch list or distressed investment, and sponsors may also need additional capital to resolve the situation. By contrast, fire sales only impair overall returns.
Credit fund GPs may also benefit from additional time to manage a portfolio as a result of the recycling terms that typically apply to credit funds. In particular, due to the GP’s ability to recycle investment proceeds from early investments, it is common that a credit fund is still holding a significant number of investments at the expiration of its term. Even when the positions are not moved to a watch list or on distressed status, secondary buyers will often expect to purchase the positions at a discount. A GP-led restructuring may give the GP additional time to realize the portfolio (and even to infuse additional cash, as needed).
Isabel Dische: We noted earlier that many classic secondary buyers have historically had a hard time meeting their returns expectations in the credit space, where anticipated returns are lower. Recent market events, however, have driven the values of credit portfolios downward. For buyers who view this dislocation as a temporary one, this opens a new window of opportunity. We’ve also seen some secondaries buyers conclude that having an allocation to credit may be beneficial from a portfolio management perspective. Needless to say, there’s a lot to consider.
Thank you, Katie, for joining me today for this discussion. And thank you to our listeners. For more information on the topics that we’ve discussed or other topics of interest to the asset management industry, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we’ve discussed – please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.
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