Q&A: Morgan Stanley Investment Management’s Patrick Reid

Q: What are you seeing in the secondaries market?

A: From the numbers we have seen, the secondaries market has tripled since 2011 and reached well over USD 100bn for the first time this year. The GP-led component now makes up the majority of the market, and there’s an argument that this could continue if we have a significant market slowdown. So, there’s an effect in private equity where the average tenure of funds is getting longer – perhaps longer than LPs had anticipated when doing asset allocation modelling. From the LP perspective, there could be frustration that you are not necessarily getting the full experience that you expected when you invested in a fund because there is a decompartmentalization of investments.

Q: How are LPs getting used to GP-led secondaries?

A: For LPs that are new to secondary funds, there’s not a huge amount of blind pool risk. These deals are somewhat already evolved. We are seeing the risk of j-curve effects being significantly mitigated. These deals provide current LPs with an opportunity to exit, and we have had discussions with investors about GP-led secondaries being interesting because it reduces the overall duration risk in their private equity portfolios. There’s also typically an incentive for GPs to see success in a prolonged deal, with new investors requiring that recalibration. We have seen that there tends to be a refocus on deals that are recapitalised.

Q: What are the risks of GP-led deals becoming a bigger part of the secondaries market?

A: If there’s a euphoric explosion of interest, at some point demand could provide an opportunity for a lower quality of supply. That would be something I would look at and be sensitive to on a long-term basis. But right now, I just think there are enough quality transactions that are seeking extensions that are available for investment. However, there is not an unlimited supply of perfect deals – there are several questions that must be asked relating to the extension and the logic behind it. But I think they remain attractive. Quite a few of them are buy-and-build transactions, and they have been priced appropriately.

Q: What would happen if the GP-led space started getting too big?

A: We don't see it getting too big anytime soon, our view is there is a lot of room for growth. The thing to look out for firstly would be who are the asset managers doing the investments. Do they have relevant experience? Are the underwriting standards appropriate? If there was a fund that was unclear on the number of investments it planned to make, that might be a warning sign. If people are willing to buy at levels that are heavily discounted on the GP-side, then that might suggest it is more of a liquidation sale. If you see a significant drop-off in the concentration of deals by GPs doing these deals, that would also be a red flag.

Q: What about on the LP side?

A: LPs doing GP-led secondaries in my experience are quite strong-willed and influential, so there has been a full realignment of interest with the GPs, and that is tangible. If that started to become vague or there was significant selling power provided to GPs in those transactions, it would amount to a warning sign of a shift in the power dynamic. Right now, it is still high-quality asset managers doing these collaborations with GPs. The LPs have influence and a degree of choice.

Q: How else have longer tenures influenced private equity?

A: A longer duration private equity market will lead to a much more active GP and LP secondary market, firstly. Where investors are willing to accept longer terms, you are seeing a growing space in the market for clients looking to provide the managers with the flexibility to invest in hybrid investments or what is sometimes called opportunistic investing in private markets. It can have some of the components of fixed income, some protection against rising interest rates, and some equity upside but remains with a piece of illiquidity premium. For investors looking to broaden their asset allocation, hybrid private investing could become a more meaningful allocation because it’s got some of these features. The concept provides a degree of flexibility, but it’s all about quality and structuring.

Q: What kinds of organisations are you seeing as part of this hybrid theme?

A: We have seen a change in who and how capital providers are providing these types of solutions. In the US, several large private equity players now have interests in insurance companies, and they have got some permanent capital. So, they are looking for ways to provide both diversification from their traditional private equity model with a return source that has this kind of credit profile. It’s a space that banks used to traffic in a lot. I think you will see more private equity here. In these solutions, the structuring element is akin to some of the traditional arguments for longer-duration hedge funds around complex transactions, and we have seen some hedge funds play in this space also.

Q: What are you seeing in terms of cross-over between the PE and hedge fund space?

A: In 2021 and the first half of 2022, we were seeing more hybrid funds from the hedge fund side as well as a lot of migration between the two, especially in venture and growth equity investments. More recently, the hedge funds have perhaps retrenched a little. We are seeing a democratisation of private equity with more efforts to increase allocations across wealth management channels and family offices. As you democratise, there should be ways to provide more consistent exposure, so I think PE investors are going to contemplate more open-ended structures as we see in hedge fund structures. Some of that will be through structural developments such as tokenisaton and evergreen funds – but that means some fundamental principles about asset-liability mismatch need to be borne in mind. Even if someone is really smart in providing unlimited liquidity to a private equity fund, there remains an implicit risk behind it. That needs to be carefully evaluated.

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