Coronavirus & secondaries: Niche dilemmas

There are two main channels of secondaries deal flow: hot tickets in the form desirable fund positions and portfolio companies where new investors clamor for exposure and the various situations where existing investors need liquidity, often but not always for pressing financial reasons. There are many unknowns about how the macro disruptions of COVID-19 will impact private equity secondaries in the medium term, but when it comes to which of these deal channels will grow and which will shrink, there is little debate.

For investors primed to sell fund positions or company stakes, increasing difficulties raising capital –  felt by both fund managers and their portfolios companies – are creating pressure to go to market with uncomfortably dented valuations. Likewise, buyers that deployed significantly at the top of the market will experience devaluations of their own and feel pressure to bolster their portfolios by pushing for discounts in new acquisitions.

The complex deal structuring needed to alleviate the friction that comes with this scenario will be curtailed by the ubiquitous travel restrictions of COVID-19, but there remains hope that secondaries professionals could nevertheless continue to execute in locked-down markets thanks to their existing familiarity with one another. However, niche market advantages will do little to resolve the issue of pricing agreement, the current macro environment’s greatest challenge to secondaries deal flow.

Out of whack

The usual pricing methodologies based on previous financing rounds, ongoing financial metrics, and public market comparables for underlying portfolio companies have become all but unusable. The most recent deals have been valued on pre-virus third-quarter net asset values (NAV), which are now seen as disconnected from market realities. While a weakening in listed benchmarks can normally be adjusted for, the key development is a new invisibility in operating environments and revenue streams.

“What we’ve seen in the primary market is investors continuing with what they’d planned to do anyway. The secondary market response could be a bit quicker because it’s more valuation driven, but I don’t think we’ll get any pricing from secondary funds at the moment,” says Immanuel Rubin, a partner at Campbell Lutyens. “This is not just a market correction or a change in sentiment. People are not working, they’re not producing, and you can’t sell things. It’s the real world this time.”

As for when pricing terms will be clear enough to drive an appreciable level of deal flow, the most optimistic appraisals point to the publishing of first-quarter NAVs in June and July. More common outlooks suggest secondaries activity may rekindle once second-quarter marks are released in September-August, but all projections are admittedly guesswork. Everything comes down to how long the outbreak will last, and here again, there is little confidence in strategies other than wait-and-see. 

The conservatism is most palpable among sellers, which are generally advised to hold on for a recovery in pricing certainty unless they are in a distress situation. There is expectation that the declines in public market valuations will leave some LPs suddenly overexposed to private equity and scrambling to offload positions early, but it remains too early to tell if that scenario will play out. Among buyers, there is also an instinct to proceed patiently, if only to see how a slowdown weeds out the market.

“A lot of money has been allocated to private equity funds, particularly at the larger end, so it’s probably not bad to have a pullback in some of the valuations,” says a director with a global secondaries investor. “With these things, it shows which managers have remained disciplined and have had their investment thesis hold up. They always talk about buying very resilient companies with defensive cash flows, so now let’s see in this environment what comes out the other side.”

The need to put dry powder to work will shake up the stagnancy, however, especially where creatively structured deals can overcome pricing gaps by offering preferred positions or other protective measures. Delayed or thwarted IPOs will cut back on deal flow where investors seeking a quick flip come into a portfolio late-horizon, but this effect could also push managers with tail-end assets to pursue single-asset or fund restructurings.

Whether this results in a boom for GP-led secondaries remains to be seen. To some extent, such deals are seen more as a theme for the recovery than the doldrums of a downturn, since larger discounts would be considered less credible. Meanwhile, there is concern that any noticeable escalation of GP-led secondaries in a depressed macro context risks triggering a frantic race to the bottom in terms of pricing, even if intentions are more farsighted than fire sale. 

Tailored solutions

Hopes for an uptick in secondaries amid the COVID-19 malaise are sturdier in hybrid, company-level deals, which typically see a struggling portfolio company raise a down round or flat round through a mix of primary and secondary commitments. These transactions are not well reported since companies tend to downplay or suppress the fact that investors are selling out at lower valuations, but they appear to tick several boxes in the current climate.

“We’re going to see more hybrid deals because buyers will demand lower valuations and hybrid deals satisfy that need while providing liquidity for investors who cannot wait. They also give underlying companies good headline numbers from a PR perspective, so it’s really attractive for many reasons and to a lot of parties,” explains James Lu, a partner at Cooley. “There’s a lot of this going on, and it’s almost a new normal in the deals being executed.”

Still, for portfolio-level transactions – or any deal with a number of moving parts –secondaries transactions may prove too inherently complicated to be feasible in a deal making environment frozen by coronavirus-related work and travel precautions.

For example, China’s Kinzon Capital realized a $100 million renminbi-to-US dollar fund restructure earlier this year whereby TR Capital underwrote seven companies based on their prior mid-year valuations. While this pricing method is seen as utterly unworkable today, the practical difficulties of brokering a multi-party, multi-currency deal under emergency quarantines and transportation suspensions may be just as discouraging.

“After we did this deal, a lot of my colleagues approached me and asked how it could be done because they have similar issues, and I know some funds that are talking to potential secondary US-dollar buyers, so I think we will definitely see more deals like this long term,” Jun Wang, a founding partner at Kinzon. “But restructures are complicated and there is a lot of work that needs to be done. There’s always video conferencing, but you can’t make a deal like this happen if you can’t see the companies and their customers, and talk to the management face-to-face.”

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• Topics
• Secondaries
• Trade sale
• Secondaries
• Asia
• coronavirus
• covid-19