Capturing alpha in the secondary market through GP-led investments

Stewart: Welcome to another edition of the InsuranceAUM.com podcast. I’m Stewart Foley. I’ll be your host. Welcome back. Lots of people are talking about secondaries these days and that there’s value there, and I’m very happy to be talking about that exact topic today called "Capturing Alpha in the Secondary Market through GP-Led Transactions."

We’re joined by two industry leaders, Paul Sanabria and Jeff Hammer, senior managing directors and global co-heads of secondaries at Manulife Investment Management. Gentlemen, thanks for being on. Thanks for taking the time.

Paul: Great to be with you, sir.

Jeff: Likewise. Great to be with you.

Stewart: All right. So we’re going to start it off the way we start them all. Where did you grow up? What was your first job, and we’re going to go with high school mascot? Go ahead, Paul.

Paul: Well, my father’s in the service. I’m an Air Force brat. So I grew up over the place, although I was born in Southern California. I lived in England, New York, back to California. So I’ve been all over the place, a bit of an Air Force brat. The first job was grocery bagging, how’s that, as a youngster. But first job out of college was working for Hewlett-Packard as an engineer. The mascot was the Lancers.

Stewart: Wow. You’re the second Lancer. Well done. All right, Jeff, what about you? Where’d you grow up, first job, and your high school mascot?

Jeff: Stewart, I grew up on an island, so I might have an island mentality. It happened at the island. It was the island of Manhattan. So I had a specific exposure by growing up on the Upper East Side of New York where the Hudson River seemed this impermeable barrier to the world. I have spent the rest of my life growing out of my Manhattan-centric view. My first job was actually as a busboy, but my second job was with The New York Times, and my third job was with Goldman Sachs where I was a financial analyst. High school mascot was the Dutchman, actually.

Stewart: Oh, wow. There you go.

Jeff: I went to a small school in Manhattan that was founded in the 17th century by the Dutch, and so the mascot was the Dutchman.

Stewart: I love it. All right. So, I hear secondaries. We just had our symposium. People were talking about secondaries. The actual definition of a secondary market transaction is often not clear, especially to me. Can you help define it for our purposes and help dimension it, please?

Jeff: Sure. Why don’t I jump in and take that, Stewart? A secondary market transaction is really a transaction between holders of illiquid financial assets, as contrasting to the public markets where you typically have transactions on a secondary basis, but they’re of listed vehicles. In our market, there is no such thing, and there is quite a bit of inefficiency and an unknown universe of buyers. So, really definitionally, it’s a transaction between two holders of illiquid assets.

The most developed part of the secondary market is the private equity secondary market, and it typically involves the purchase and sale of partnership interest because that is the vehicle of choice for which private market investments are made. They’re partnerships. Partnerships were really only formed or began to be formed after the Second World War and momentum for forming partnerships and aggregating capital in partnerships really began ramping up in the 1980s and then has followed through to the present day.

Often, the transactions in the past were instigated by limited partners or LPs. That is how the private equity secondary market took root. Over time and more recently, sponsors or general partners, GPs, began to instigate transactions in the secondary market. It began to use the secondary market for its own purpose. These secondary transactions began as trades. Today, it is clearly a business, and the size of the market has accelerated over $100 billion annually.¹

To give you some sense of scale, Stewart, it was about $2 billion 20 years ago, so quite a lot of growth.² Half of that market today is in what we call the GP-led secondary market, and half of the market is in what we call the traditional LP market. It’s been that way for a few years now.

Stewart: So it seems to me, given the inefficiency, a very wise and wealthy person once said to me, “Well-bought is half-sold.” So it seems that this market, although it’s growing, is becoming a viable market to make a dedicated allocation to. Have I got that right, that it’s no longer just selling things that we must sell? It’s much larger than that today.

Paul: It really is. Maybe I’ll take that, Jeff. It really is much larger than that today. In many respects, when the market originally started to take off, you had dislocated sellers or dislocated assets. That’s no longer true today. It has become a more efficient part of the market. And why is that? Because liquidity is a critical part of any market, and the instruments that Jeff described were, by their very nature, illiquid, and so a solution was required. That’s really how the secondary investment strategies came about to become solutions to address the liquidity need.

Just to put that in perspective, the market is not just a dislocated market but, in fact, a solution-oriented market. To add a few statistics on to what Jeff described, if you look at the last three five-year periods, the transaction volume in the market has doubled.² Just even further dimension, that over the course of the last 10 years, the transaction volume has been about $640 billion. Over the last 20, $790 billion.²

So the preponderance of the transactions or the liquidity in the market’s really been over the course of the last 10 years. Part of that is because it’s actually been built out beyond just the corporate marketplace. While the buyout market is the largest market, there’s, of course, the closed-end market, which is the fund market that Jeff described in real estate, in infrastructure, in private credit, in venture capital, and growth.

The secondary market has evolved into all of those various adjacencies, and so solutions needed to be created for all of those. While the market, as Jeff described, historically was addressing illiquidity in the limited partnership marketplace, as sponsors started to participate in this market who also invest in illiquid instruments, that has really spurred on the growth more recently over the course of the last three years, as Jeff described.

Stewart: So is the secondary market only private equity or are other private market asset classes involved? I’m really trying to understand debt and broad scope of the market.

Jeff: I’ll jump in quickly, and then Paul can follow on. The market is broader than simply private equity. It does, Stewart, get to your point that there are secondary markets that are subsidiaries really of the larger secondary market in infrastructure, real estate, credit, venture capital. Each of these sub-markets have different characteristics, but the basic structure of the market is the same in that private investments have been made out of partnerships.

Those partnerships, by virtue of their contractual duration, have created illiquidity. So the secondary market, as Paul said, emerged as a solution-oriented market to solve those issues. The analysis, of course, is going to be different across whether the underlying assets or credit assets or real estate assets or infrastructure assets and, thereby, the degree of specialization is required. But the basic parameters of what you understand to be the secondary market are the same.

Stewart: It’s really interesting. I was on the podcast yesterday with the CRO of Principal. This is also a big topic of conversation in our symposium, which is there is a clear march to private assets in the insurance industry, without a doubt. One of the things that challenge the industry is where’s the line of how much illiquidity I can take into a portfolio?

The idea that there is a viable secondary market that exists, I’ve got to think would help with the allocation decision on the front end when people know that it is not just a dislocated market, that it is a viable solutions-based market. So it sounds like there are quite a few different strategies within secondary investing. Can you outline the strategies that you think have the best risk return profile right now?

Jeff: Yeah. Why don’t I grab that? Stewart, I just wanted to augment what you said before in that the market has become so efficient that economically you’re not taking a hit if you come into the market. Oftentimes, people in the secondary market, they put a 30-year-old frame on it and they say, “Wow, that’s going to be a heavily discounted market. We’re going to have to take a big write down if we sell these assets in that market.” Not so much anymore.

It’s such a broad market with so many participants. If I’m an insurance company executive and I say I need to depend upon the secondary market as reserve liquidity, will I get my book value? So it really becomes a portfolio management tool, as you had alluded to before.

Stewart: I’ll tell you, I really want our audience to hear that because, I mean this is maybe my own bias, but to me, it’s like, “Oh, we’re going to sell our private assets.” It’s like, “Oh my god, we’re going to take a huge haircut here.” I got to think that there’s other folks who are managing insurance portfolios that are going to be glad to hear that as well.

Jeff: Yeah. To respond to your question as to the strategies in the secondary market, from an investment perspective, there are two basic strategies and then I’d say three to four subordinate strategies. The two basics I believe I alluded to earlier are known as traditional LP investing and GP-led investing. Traditional LP investing involves two limited partners, passive participants in a partnership, trading that partnership among one another.

GP-led investing involves the sponsor, the general partner, selecting assets out of an existing portfolio and then re-potting them in a new structure. That can be done in different ways. But fundamentally, in the first instance, the traditional LP strategy, the sponsor is really a passive observer and approver of the transaction between two limited partners. In the latter, the GP-led, the sponsor itself is accessing, on behalf of its limited partners, the secondary market as a source of capital.

Those are the two primary strategies of the secondary market, and they are roughly equal today in a secondary market, as we said, that’s above $100 billion. They’re roughly 50-50.³ Now, just to go through the other strategies quickly, there is another strategy known as secondary direct and that involves the sale and purchase of shares directly into a company cap table as opposed to through a partnership vehicle. That’s a small portion of the market.

There’s a strategy called preferred equity, which involves a contractual agreement, really, how to cut up distributions and cash flows. It can present itself as an equity layer or it can be a subordinated debt layer. And then finally, as a very faint derivative, people lend against private equity portfolios, which is, in a broadly defined secondary market, considered a secondary use of capital. That’s known also as NAV lending.

Those are really the choices that one has when looking at the secondary market in which to invest. But as I said, GP-led and traditional LP is today where the action is.

Stewart: I love this next question because I think we’re going to get into your personalities a little bit. But the tell me about yourselves, I just happen to know from our prep call that you guys have been together for a really long time and you know each other really well. How did you two come together? Can you talk a little bit about how you are executing the secondary strategy there?

Paul: Sure. So why don’t I take that? It is unusual. Jeff and I have known each other for over 30 years, and we’ve been working together professionally for 24 of those years, believe it or not. We met at Harvard Business School, actually, in the same section. A little-known fact, we actually lived together for a period of time, so quite unusual for co-heads of anything. We’ve known each other longer than our wives, believe it or not.

But, as we started off, we come from very different backgrounds. Jeff’s a New Yorker with a finance background and first job at Goldman Sachs. I’m an engineer by trade from California, my first job, as I said, as an engineer. So we come at it from a different perspective and, historically, we’ve used that as a strength, not only between ourselves but in terms of the teams that we built over time.

Jeff and I had separate careers for a period of time, post-business school. And then we came together about 24 years ago and got involved in the secondary investing business quite by accident, to be honest with you, buying our first portfolio off of AIG, an insurance company, believe it or not. We really got excited about the innovation that existed in the market and, in fact, have been doing secondaries for the last 24 years.

Another unusual factor in our partnership is that we have been both investors as well as bankers or advisors in this business. We’ve spent 14 years investing, the first 10 of those years investing, as Jeff said, in the traditional LP secondary market and the last 4 years exclusively focused on the GP-led business. But in the middle of that, we also spent 10 years as investment bankers and were actually very involved in the creation of the GP-led secondary business, effectively creating fundamentally a different use case with GPs using secondary investing capital to address their own liquidity needs.

So really, a really strong arc both historically as individuals as well as professionally. Just to put a point on that, as Jeff said, when we got in this business 24 years ago, the transaction volume was single-digit billions. For the last 2 years, it’s been over $100 billion. So we’ve seen quite a lot in our history together as it pertains to the secondary market.

Of course, the second part of that question you asked, Stewart, was in regard to what it takes to build this business and how we focus on the business. I think what’s most important is really the choice of platform that we joined in order to build this out. As it is, as it pertains, they’re actually involved in Manulife. Manulife, of course, is at its core a big insurance company. Like many insurance companies, they have a very big and active asset management business and a very big alternative investment business.

All of those were very important to Jeff and I, a long history of investing in the private markets. More importantly than investing just in the private markets, they’d done it in a very integrated way and a multi-strategy way, meaning they had a very strong primary program, a co-investment program, and then a private credit program both in mezzanine or junior capital in direct lending.

What that means, if you think about who uses that capital to put money into their funds on the primary side and/or the assets that are within those funds, it’s really the sponsor. So we call it a very sponsor-centric model. In this secondary market, information flow in an opaque asset class is extremely important. So the Manulife Investment Management platform is specifically our strategy leverages that information and those relationships, and we think that that gives us really an edge in this particular part of the market.

Stewart: So it sounds like you need a different set of skills for GP-led secondaries. Can you tell me a little bit about that and your team and how that compares to other secondary investors?

Jeff: Fundamentally, GP-led is a different type of investment activity than LP-led, and I actually think it cuts differently in four ways. I’ll try to take you through them quickly. First, finding the deals, or what we call sourcing, is different. You have to be proactive about going and getting your deals. I think about it, the yin and yang of the secondary market is opportunism and purposefulness. The secondary market is, by definition, an opportunistic market. You can’t control exactly where you can invest in, but you can lay out some parameters as you’re going about building a portfolio and where you find deals. That leads to the purposefulness of the portfolio. So it’s that dynamic that you have to manage and be on your toes, not on your heels in managing it. So finding deals is different.

Building a portfolio is different. You can very intentionally sit down and say, “These are the sectors we want to be in. We want to be aggressive. Do we want to be defensive? How should we construct our portfolios? What should we overweigh? What should we underweigh?” There are shades of being a public markets portfolio manager that GP-led, not traditional LP, but GP-led allows you to do really for the first time.

Underwriting is different. This, Stewart, is probably what you’re getting at. If you want to underwrite concentration, which is what you do in the GP-led market, you have to have a group of people who know how to go deep and long, not how to go broad and wide. Traditional LP, which is a great investment category, requires you, for the most part, to sit at your desktop, spread out the numbers, and make some broad assumptions. Obviously, you need to check on those assumptions. When you’re doing GP-led, you’re actually focusing on one, maybe two concentrated positions. You have to do exactly what a sponsor does, and you have to due diligence the sponsor itself because, again, we are passive capital here, not active capital. We don’t hold the joystick when it comes to a company. The sponsor does. So we have to build a team that is really focused on going deep and long.

And then last, post-investment activities require close monitoring. You have to get yourself in a position so that you can capture information and use that information. You may need observer rights. You may need board rights. You may not need any of that. You may just need good information flow. You need to be able to real-time analyze the information and real-time understand results. If you’re a platform like Manulife and the sponsors are smaller, you may want to coach the sponsors as to where to go for capital market solutions as to what might be coming along. As Paul mentioned before, we have a sponsor-centric platform. We are active with 200 sponsors. We have enormous information that we can turn into comparative advantage if we do that for our sponsors.

So our team was constructed among those elements. And yes, we have veterans of the secondary market on our eight-person team. All eight of us are only dedicated to this GP-led investing, and we’re not distracted by anything else. We have experience, and we have people who want to be focused in this sector. So I’ll finish there by saying that we believe that the way we’ve constructed our team, its pedigree, its credentials, have given us a comparative advantage in a pretty robust and vibrant and evolving market.

Stewart: That’s really helpful. Kind of on the back end of things here, and you’ve touched on this, but what is the value proposition from the secondaries market for insurance companies and their asset management capabilities? And then along those same lines, what do you think the next five years brings for the secondaries market? If it continues to grow at the way that it has, is that a positive? Is there anything negative about that meteoric growth? Can you talk a little bit about how you see the next few years in this market?

Paul: Sure. Well, maybe I’ll take the first part and, Jeff, you can take the latter part. What’s the value proposition for insurance companies? Look, at the end of the day, insurance companies typically need to match long-dated liabilities, and the private markets historically have been long-dated strategies.
Number two, they need to manage risk. An enormous portion of their portfolio is obviously more in fixed income. They need to manage risk in that way, but they also need to manage risk in the portion of their portfolio that’s non-fixed income. These aren’t direct equity sponsors that are looking to take single-asset risk. And lastly, they need good performance. You need to balance out that performance. You need to achieve yield in that non-fixed income component of your book.

The performance has absolutely been there across periods of time. Your ability to be able to offer liquidity over different market cycles has proved to be incredibly important because liquidity is a critical part of the overall marketplace.

I think the next level of understanding though is the sophistication of the insurance company. So sometimes we deal with investors, both insurers or non-insurers, who are newer to the asset class. Those programs that are newer to the asset class, let’s just say private equity, often use secondaries as a beginning step in their journey and alternatives, the ability to be able to create diversified portfolios, to put money to work in the ground because you’re typically buying assets. You’re not buying unfunded commitments or a smaller portion of unfunded commitments.

The ability to buy yield, believe it or not, I use the word yield, but oftentimes, particularly traditional LP secondaries, because the money’s going to work faster, you’re buying more mature assets. They actually liquidate sooner, and it actually creates yield-like cash flows. So I think those are all important for newer programs. The more exciting things, perhaps, is for the more sophisticated programs, the ability to be able to buy and sell.

The ability to buy and sell individual LP interests or blocks of LP interest, very important for sophisticated programs which are used all the time. Now with the advancement of GP-led and other of these sub-strategies that Jeff just described, the ability to be able to … Just like you don’t go into one buyout manager, you may go into several large cap, several mid market, several lower mid market, the ability to be able to manage your secondary program with shorter duration, different risk reward, higher returning assets, more of the private equity index.

That’s really, I think, exciting. I’ll finish it out for the most sophisticated insurers. The most sophisticated insurers that have very strong asset management capabilities, I would say, have two other potential uses of the secondary market. The first is you have the ability to be able to partner with secondary platforms and be able to do joint ventures with th