Reopening the secondaries market for illiquid assets

As the COVID-19 lockdown continues, the private equity secondaries market remains in a state of suspended animation. Some predict a prolonged paralysis, others a return to normalcy within months, and still others a long-lasting gold rush of historic proportions. We believe the next cycle’s leading secondaries investors will be the nimblest and most innovative: They’ll be the fastest to deploy capital and the most creative in structuring deals. They’ll embrace new solutions while demonstrating superior discernment through fundamental analysis. They’ll also consider credit and equity opportunities, investing with dexterity up and down the capital stack in imaginative, customized ways.

Secondaries market history is rooted in the free movement of capital

To better understand how the secondaries market might reopen, it’s useful to review the evolution of the asset class, paying attention to its relationship with past economic crises.

In many ways, the foundation of the modern secondaries market was laid by the Jimmy Carter administration in the late 1970s. The Monetary Control Act of 1980 was a watershed piece of legislation that removed controls on bank interest rates and repealed federal usury laws. This was followed in 1982 by the Garn-St. Germain Depository Institutions Act, a Reagan-era law that further deregulated banks, enabling capital to flow even more freely throughout the U.S. financial system. Over the decades that followed, financial deregulation flourished. London saw its stock exchange revitalized as a private enterprise in the Big Bang of 1986. In 1999 the U.S. government repealed portions of the Glass-Steagall Act that separated retail banking from investment banking. Meanwhile, emerging markets across the globe restructured to allow more capital inflows from developed economies. The result: The world’s capital markets became highly interconnected.

The loosening of capital controls within sectors and across borders has been one of the most important drivers of global economic growth over the past 40 years.

The loosening of capital controls within sectors and across borders has been one of the most important drivers of world economic growth over the past 40 years. While the political debate continues whether flexible capital flows have been equitably channelled in light of competing policy goals—a question of slicing the pie—few would deny that the positive impact, including broad-based innovation, productivity gains, and wealth creation—a matter of growing the pie—are direct results of less restrictive regulations.

Still, the relatively free movement of capital is not without unintended consequences, some of which remain problematic. Asset bubbles have emerged repeatedly in different jurisdictions over time, resulting in financial crises as waves of capital flows washed over unprepared economies and ill-equipped regulatory regimes. The Latin American debt crisis of 1982 was among the first in this series, followed by the U.S. savings and loan (S&L) crisis of 1988, the junk bond crisis of 1989, the Asian debt crisis of 1997, the dot-com bubble of 2001, the global financial crisis (GFC) of 2008, and the European sovereign debt crisis of the early 2010s. Ultimately, all these crises were resolved by a combination of self-correcting market mechanisms and timely government intervention. Central to the market mechanisms was the emergence of a global secondaries market for illiquid financial assets.

These crises were resolved by self-correcting market mechanisms and timely government intervention. Central to the market mechanisms was the emergence of a global secondaries market for illiquid financial assets.

Liquidity providers have been rewarded for courage in past crises

Many of today’s marquee alternative investment franchises were formed in the secondary market crucible of financial crises. Would Goldman’s Whitehall Street funds and Morgan Stanley’s real estate investment management franchise have come into existence if not for the S&L crisis? How about Apollo if not for the junk bond crisis and the failure of U.S. insurer Executive Life? What about Fortress, Oaktree, Lone Star, and Avenue if not for the Asian debt crisis? Lexington, Landmark, and Coller Capital if not for the dot-com bubble? TPG Sixth Street Partners and Blackstone Tactical Opportunities without the GFC? These firms were able to differentiate themselves and create lasting track records by courageously investing into the deflating asset bubbles while others were retreating or holding their dry powder.

The wash-rinse-repeat cycle of the serial financial crises has been a proving ground for the secondaries market. Having grown out of episodic, turbulent points in financial history, the market has become a durable, vibrant, and institutional pillar of the private capital markets, one now available in the ordinary course of business, as well as in moments of crisis. The secondaries market today serves as a critical ballast, counterbalancing excesses of freely flowing global capital.

The secondary market for illiquid assets was forged in fires of crisis, and this timeline highlights a half-dozen financial crises and secondaries market developments that followed each, 1980s to present.

The secondaries market still has a role in rejuvenating our economy

And now COVID-19 presents a new type of challenge. A global health crisis, rather than a financial crisis triggered by an asset bubble, is causing immense economic damage with mounting cumulative losses for many businesses, some of which won’t survive. This crisis is indeed different, and perhaps we can’t depend upon playbooks from earlier days. So, will the secondaries market assume the corrective role it did in earlier crises?

We believe the answer is yes, and then some. The secondaries market is bound to play an important role in rejuvenating the larger economy, perhaps in ways that few would imagine. In the wake of past financial crises, the role of the secondaries market was largely limited to serving as a clearinghouse for mispriced private assets. But an unprecedented crisis calls for unprecedented solutions. This time around the role of the secondaries market will be more flexible, innovative, and sophisticated.

Reinventing the secondaries market again for the first time

The common narrative for post-COVID-19 activity seems to be that the secondaries market will see a surge of preferred equity transactions before limited partner (LP) portfolio sales return in force, followed later by general partner-led, or GP-led, transactions. The consensus is that GPs and LPs will execute structured, or preferred, transactions—pref trades—to meet liquidity-induced demands. This line of thinking echoes back to 2009 when similar arguments were put forward that structured transactions would lead to a surge in 2009 secondary volume. But the volume never materialized. In fact, in 2009, we saw a decline in secondary transaction volume of roughly 35% to 40%, making 2009 the only down year in secondary market history.

When the market did pick up in subsequent years, traditional LP book transactions drove the market. What’s different now is that financial institutions themselves aren’t in crisis as they were in the GFC. They and other holders of LP interests won’t be under regulatory and financial pressure to sell. In addition, holders of LP portfolios understand how quickly pricing can stabilize in subsequent quarters. Therefore, most will have little appetite for sales at sizable discounts to book value and will instead be inclined to wait.

A GP-led path: investing with analytical rigor, structure, and conviction

In contrast to the big LP portfolio fire sales of 2009 to 2011, we believe the 2020 to 2022 secondaries market will be led by GP needs. At the time of the GFC, there were some proto-GP transactions in the form of spinouts and carve-outs; however, GP-led deals hadn’t yet entered into the secondaries market tool kit. Coming into the COVID-19 crisis, GPs had begun to routinely use the secondaries market to address a variety of strategic and tactical issues. We believe that this trend will continue unabated in the post-crisis environment as secondary investors work closely with GPs to funnel capital to individual companies and funds with capital requirements.

We believe that the best opportunities and performance in the secondaries market will go to the most discerning in selecting assets and structuring deals (the best stock-pickers rather than the best indexers). This dynamic favors specialist investors with direct underwriting skills, the ability to calibrate concentration risk, and the willingness to assume it when conviction warrants.

In the final analysis, the secondaries investors who’ll lead in the post-COVID-19 environment will be those who are the nimblest and most innovative. They’ll be the first to turn on the spigot, the fastest to deploy capital, and the most creative in structuring deals. They’ll embrace new capital market solutions while at the same time demonstrate superior ability to conduct deep-dive fundamental analysis. They’re also likely to be able to invest with dexterity up and down the capital stack, embracing credit and equity opportunities in creative, customized ways.

 

 

 

Editor’s note: Much of this material originally appeared in Secondaries Investor on May, 6, 2020.

A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment

Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.

The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.

This material, intended for the exclusive use by the recipients who are allowable to receive this document under the applicable laws and regulations of the relevant jurisdictions, was produced by, and the opinions expressed are those of, Manulife Investment Management as of the date of this publication and are subject to change based on market and other conditions. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only as current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.

Neither Manulife Investment Management or its affiliates, nor any of their directors, officers, or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment, or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment, or legal advice. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer, or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against a loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.

Manulife Investment Management

Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than 150 years of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams, along with access to specialized, unaffiliated asset managers from around the world through our multimanager model. 

These materials have not been reviewed by and are not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at  manulifeim.com/institutional.

Australia: Hancock Natural Resource Group Australasia Pty Limited, Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area and United Kingdom: Manulife Investment Management (Europe) Ltd.which is authorized and regulated by the Financial Conduct AuthorityManulife Investment Management (Ireland) Ltd., which is authorized and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad (formerly known as Manulife Asset Management Services Berhad) 200801033087 (834424-U). Philippines: Manulife Asset Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G). South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC, and Hancock Natural Resource Group, Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.

Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates, under license.

515309

Jeff Hammer

Jeff Hammer, 

Global Co-Head of Secondaries

Read bio
Paul Sanabria

Paul Sanabria, 

Global Co-Head of Secondaries

Read bio