Emerging Opportunities in Private Debt Secondary Markets
The investment industry has proved remarkably adept at developing novel investments that expand opportunities into all corners of the finance markets. One of the industry’s more recent developments is the expansion and growth of private debt (PD) secondary markets. That growth has been fueled by recent global events that have investors demanding new liquidity solutions in the credit space. As evidence of that growth, one prominent group of analysts has announced that it expects the PD secondary market to capture more than US$13bn in assets under management within the next five years.
Currently, most buyers in the PD secondary markets are private equity funds and institutional investors that are looking for opportunistic asset allocations and mechanisms to rebalance portfolios. These and other large investors are driving the market, but the expansion is likely a function of other additional factors:
- Limited partners in private investments are more aggressively managing their asset balances
- The complexity of deals led by General Partners in private investments is increasing
- International private markets are drawing an increasing amount of investment capital.
In many ways, secondary markets for private debt interests are a natural evolution of primary markets. Secondary markets have historically emerged as investors looked for liquidity mechanisms that would allow them to unlock the immediate cash value of their portfolios. The present iteration of secondary transactions generally falls into one of two categories:
General Partner-Led Deals, in which a fund manager proactively seeks a liquidity solution that benefits all limited partners. These transactions might be structured as can tender offers, debt fund restructurings, and new funds (i.e. continuation vehicles). These transactions will also affect both the composition of the base of limited partners and the structure and terms of the vehicle holding the assets.
Traditional Deals, in which an existing limited partner in a debt fund obtains liquidity before the fund’s termination by selling interests to another limited partner. These transactions affect only the composition of the limited partner base, but not the structure or terms of the fund.
Individual investors that are considering entering the secondary private debt market are seeking certain common characteristics that make a deal more attractive. As in all investments in private partnerships and funds, the quality and management capabilities of the general partner in the fund are of paramount importance. Just as an investor would likely not make a private investment in a fund with an untested general partner, that investor will look long and hard at the general partner in a fund whose debt interests the investor is considering buying.
Funds with a greater median age will also be more desirable as they give the investor more information to evaluate the PD interest across multiple economic and industry cycles. On a broader scale, an investor will typically compare industry and sector concentrations in a fund whose interests are in a secondary PD market to verify that those concentrations do not throw off the investor’s own diversification and asset balance targets.
In answering the general question as to why an investor might enter the secondary PD markets, those markets carry several benefits that might coincide with the structure and goals of their wealth and asset management plans.
First, a robust PD secondary market increases the visibility and transparency of private debt investments by enabling buyers to analyze the health and operating history of a fund’s portfolio and the legal protections covering the lenders that originate the underlying debt, including covenants and reporting obligations. Investors often rely on the research and analytical capabilities of their investment advisors to deliver the fundamental information that supports a portfolio decision. As secondary PD markets grow, more information about underlying investments will come to the surface to verify the validity and accuracy of that research and analysis.
Next, secondary markets are more likely to arise for PD interests that are relatively mature and close to completion or closing. This gives buyers and sellers alike an opportunity to get quicker access to yield and to put more of their committed capital into an environment with active returns. Investors with a longer-term investment arc might not look at how fast they can realize yield, but fast yield and ready liquidity should be a component of every well-structured wealth management plan and portfolio.
As an extension of this benefit, secondary PD markets allow for faster recycling of investment capital and an opportunity for investors to get rapid access to liquidity when they identify attractive new opportunities. This benefit is wholly consistent with other innovations that the investment industries have brought to individual high net-worth investors over the past twenty-five years. Many of those innovations had previously been available only to the largest international investment banks that controlled the underlying markets. Secondary PD transactions represent a democratization of those innovations.
Last, secondary PD markets feed every investor’s requirements for a diversified portfolio across industry sectors and asset classes. On average, a PD fund will hold debt assets in 30 to 50 companies. A robust secondary PD market can allow an investor to rebalance holdings such that a portfolio would have broader exposure to ten times that number, thus reducing exposure risk to any one borrower.
Investments in the secondary PD market will be appropriate only for a limited class of investors that have the knowledge and resources to appreciate the risks posed by those investments. The concepts and opportunities described here are for illustrative purposes only and each investor with the qualifications to participate in these markets must make a fully-informed decision to do so before plunging in. No investment advisor will guarantee results, but for the right group of investors, the fourth quarter of 2020 is an ideal time for consideration of a secondary PD investment. Because the markets are still in early growth stages, early participants in those markets have a greater chance to make an impact and to establish themselves as preferred partners for PD fund general partners and intermediaries. Further, the limited capital that has thus far been dedicated to these markets creates current favorable pricing dynamics that give unique opportunities for investors to achieve targeted returns within their portfolios. The market also continues to show potential for additional growth, and investors will not be locked into secondary PD investments as a result.
Investment advisors have a growing slate of liquidity options for consideration by high-net worth investors. Investors that are interested in these or other liquidity options should consult directly with their advisors to determine the best solutions that will work within the structures of their plans and portfolios.