Five misconceptions about the GP-led secondaries market

Adam Le:                 

Welcome to the latest episode of Spotlight, a PEI Group podcast that delves into the very latest in private markets investing. I’m Adam Le, Senior Editor based in London.                                   

There aren’t many people in the secondaries industry for whom you can say they have seen it all. Jeff Hammer is certainly someone who, if he hasn’t seen it all, he certainly comes close.

 Jeff began his career at Goldman Sachs, has worked at Morgan Stanley, and was working at Bear Stearns up until December 2008, which must have been interesting, to say the least. He then spent a decade at Houlihan Lokey as an investment banker advising on illiquid financial assets trades, and today is Global Co-Head of Secondaries at Manulife Investment Management, one of the largest asset managers in the world.

 Jeff, in today’s discussion, we are going to be discussing the biggest opportunities in secondaries and I thought we’d make it a little spicy and do this by examining five controversial statements about the secondaries market. Because when people talk about the biggest opportunities, you know, continuation funds, staple deals to help with fundraising, et cetera, these are not black-and-white topics. There is controversy to these ideas. So I’d love to discuss these with you. And if listeners stick around until the end, we’ll end with a little lighthearted lightning round where I ask for your quick-fire take on some fun topics.                                   

But first, to jump off, Jeff, welcome to Second Thoughts.

Jeff Hammer:           

Adam, thank you very much and thank you for your kind words. I don’t know if having seen it all means you’re just old, but I am young at heart so I look forward to this interesting round we’re going to have.

Adam Le:                 

I think you’re younger than I am at heart. From LinkedIn, I think I can tell that you’re pretty active and you’ve run in a couple of marathons as well, which I have never done myself, so I wholeheartedly agree with you there.

Let’s jump right into the first controversial topic, and I’m just going to read out this statement. This is designed to kind of push buttons. It reads, “Continuation funds create a moral hazard for GPs because they are disincentivized from maximizing value for original LPs.” In other words, they kind of provide a safety net for GPs who may not have made carry or have delivered the returns that they expected for their LPs. What do you make of this sentence?

Jeff Hammer:           

Well, Adam, you have pushed a lot of buttons for me because this is just not true. And by asserting this fallacy, we obscure the primary driver of CVs, which is liquidity.

So, here’s the story. Fundamentally, there’s a flaw in the private equity infrastructure. Partnerships, by their nature, do not create liquidity. Yet, most people agree that liquidity should not be a punitive afterthought. It needs to be a right, and CVs really have enshrined that right. CVs are a surgically precise liquidity option for limited partners.

Let me explain how that works. Secondary transactions have historically been about liquidity. So traditional secondaries create liquidity as trades between LPs. But they’re a blunt instrument and that liquidity usually comes at a discount, which creates ample headroom for investors who do not underwrite deeply.

But GP-led secondaries, and CVs in particular, create liquidity that’s introduced by the sponsor and they’re more like a surgeon’s scalpel, Adam, not like a woodman’s axe. And so there’s really, at a top level, no moral hazard here.

Adam Le:                 

But, I mean, can I just push you a little bit on this?

Jeff Hammer:           

Push as much as you want.

Adam Le:                 

Okay. I mean, eight years ago, as a journalist, I would never receive a press release about a continuation fund. It was almost something very, very hush-hush. People didn’t want to talk about them. Today, we receive press releases, it feels like, every three days about continuation funds. So they are clearly becoming a lot more commonplace in the market. And I really get the sense that GPs are using these as a kind of fourth exit route.

Now, if they have this kind of safety net by which, if they can’t IPO, or they don’t get a trade sale or strategic or some other exit like that, they can just continue to hold on to the asset and potentially generate carry, which they then reinvest into the continuation fund. Surely that can lead to a little bit of complacency among the GPs.

Jeff Hammer:           

Well, Adam, you do bring a good point. Not all CVs are attempted for the best reasons. But let’s keep our eye on the ball here. The long-term goal of general partners is to maximize value. And that value can come today or it can come tomorrow. LPs can take advantage of these transactions also, by the way, because they get to maximize value and create customized liquidity. And when they go back into these transactions, they’re investing alongside capable secondary investors.

So, if you look at the goal and keep your eye on the ball of sponsor-generated secondary deals, you know that you’re going to get into good investments. And if you make sure you keep your eye on how to structure your good investments, you know that the sponsor’s going to be fully aligned with you.

So, the short story is that if you can determine that a sponsor is a net investor in a deal, that they’re not taking money out, that they’re reinvesting in the deal, you create the proverbial win-win-win.

LPs can de-risk their investment, yet they have the opportunity to stay invested. Sponsors can hold their best assets for longer, and they can reinvest in them. And secondary investors do what secondary investors do, which is provide liquidity and set up a good investment for their investors and for their capital.

So not all sponsor-generated liquidity are done for the best reasons, but if you invest in the right ones, they can be phenomenally good investments.

Adam Le:                 

Yes, we’ve had some research recently on our Secondaries Investor publication, which shows that a select sort of example of continuation fund returns have delivered sort of 2, 2.5, even higher X for those investors who have invested in the continuation fund. So there’s starting to be, it seems, a little bit of evidence that these vehicles can really work for their investors.

But I mean, just backtracking a second, Jeff, I mean, are you sort of saying that the market will decide and the processes that are not done for the right reasons will clearly simply not get over the line? The ones that do get over the line clearly have been done for the right reasons? And it’s kind of natural selection in that sense?

Jeff Hammer:           

Well, there is natural selection. And, of course, not everything goes either at zero or 100%. So there are some transactions that might get across the line, which could have been done for the wrong reasons. But the vast majority of transactions between a willing seller and a willing buyer are done because both are going in with full information and making a rational and economic decision.

So I would say, Adam, that yes, your point is correct, that most of the continuation vehicles that get done are done for the right reasons and are good transactions, or they’re setting up to be good transactions. We can’t forecast the future, but they’re setting up to be good transactions for both the incoming capital and the outgoing capital.

Adam Le:                 

Fair enough. Okay. That makes sense. All right. Let’s move on to controversial topic number two. So this one reads, “The continuation fund market takes direct and co-investment deal flow away from institutional investors, such as pension funds and sovereign wealth funds.”

So what this means is GPs in the market typically sell assets in secondary buyouts or just to strategic sellers. And in those exits, institutional investors can often get access to direct co-investment deal flow. The advent of the continuation fund market means that more of these assets are being held within the same sponsor, and institutional investors cannot get as much access to this co-investment deal flow as they previously would have.

Jeff Hammer:           

Adam, this is a complete misperception. GP-led deal flow has actually doubled the volume in the secondary market. So it hasn’t eroded any volume in the secondary market. And other transaction volume has not been impacted whatsoever by CV deal flow.

As with similar innovations in other worlds, when people, for example, created email, did it erase the fax machine? No, people still used the fax machine for a while. And perhaps that’s not the best analogy because the fax machine is becoming an older technology, but the point of the matter is when innovation comes, it usually builds the pie; it doesn’t simply cut into the pie.

So CV deal flow has actually created an additional deal flow for institutional investors, and sponsors are creating action on companies and assets that would not be subject to transactions at the point in which they’re occurring. So it’s created an entirely new sub market and we call it interim liquidity. And that’s what these transactions are delivering. Interim liquidity, which never would have been attempted in the past were it not for the CV market.

Adam Le:                 

And can we just dig in specifically, Jeff? I mean, you said that actually, the advent of the CV, so the continuation vehicle market, has provided more opportunities for institutional investors. What do you specifically mean by that?

Jeff Hammer:           

Well, for example, in the past, a traditional secondary investment had been an investment into a partnership which had multiple positions. And there really had been no liquidity around one or two companies within a sponsor’s portfolio. The sponsor’s choice was to either sell the company in a process to another sponsor, or to a strategic, or to take it public. Or to hold the company. And at this point, we are now seeing the advent of liquidity that’s partial in nature at a point in which the sponsor doesn’t want to realize full liquidity.

So CVs are exactly what they are called, continuation vehicles, which means that the sponsor and the limited partner want some liquidity around particular assets at a point in time, but it’s partial liquidity. So, if certain investors want to stay in the asset for the full duration of the sponsor’s hold, they get to do that. But if they want to take cash and realize proceeds, for whatever reason at this interim stage, they get to do that as well.

What this innovation in the secondary market has done is create more choice at a point where it never existed. So that is really my argument of why it’s increased the pie of transactional opportunities for institutional investors.

Adam Le:                 

Okay. I see what you’re saying there. So, if you’re an LP in a fund and the fund is subject to a continuation fund process, then you are given the optionality to the choice to potentially retain or increase even or decrease your exposure to a particular asset or set of assets. And that’s what you kind of mean by providing more opportunities for institutional investors. Okay. I think that makes sense.

I guess, I mean, just to even play devil’s advocate even more, if you’re a sovereign wealth fund, for example, and typically you see a lot of deal flow, co-investment deal flow, or just direct deal flow, I guess, in the market, and suddenly a lot of these assets are being held in continuation vehicles, and you don’t have the opportunity to buy a direct stake in that asset. For that particular LP, isn’t the market sort of shrinking?

Jeff Hammer:           

Well, I wouldn’t say it’s shrinking, Adam, because there are a very large universe of transactable assets out there. And what sponsors are now doing is they’re making assets in their portfolio, which had previously not been transactable at a point of time transactable.

The opportunity to invest in a particular company in a sponsor’s portfolio as a co-investment will come about again when the sponsor creates full realization and sells it on perhaps to another sponsor who then marshals co-investment to go into that asset. So again, it’s a question of a point in time.

There is now opportunities to invest at different points in time. The analogue might be the venture market, where you’ve seen companies grow up from very small companies to very large companies through A, B, C, D, and E rounds with different sponsors coming and going at those rounds.

If you take that framing and drop it now into the buyout market, you’re beginning to see the same thing. Sponsors have identified companies that they want to hold for longer. And in doing that, at certain points, you need to create liquidity for some of your investors.

So that same framing of different points in time, liquidity is coming about with more mature companies as the sponsor shepherds that company to an ultimate realization, if that makes sense.

Adam Le:                 

Okay. So you’re saying it’s not like that deal flow just completely dries up and disappears. It’s just kind of perhaps at a later point in time that an institutional investor might get access to that particular asset. It just kind of extends the time frame in some cases, I suppose.

Let’s move to the third controversial topic. And this is slightly related to what we’ve just been talking about in terms of continuation funds, but it’s a question about pricing. And the statement is that “The biggest conflict in GP-led processes is the fact that the sponsor wants to maximize value for LPs, but not too much value because it still wants to kind of leave enough room for that asset to grow post transaction so that it can essentially exit that asset at a later date and still make a decent return.” What do you make of this?

Jeff Hammer:           

Well, Adam, I’m beginning to sound like a broken record or a bit of a curmudgeon, but I would say this is also a myth. Sponsors frequently in transactions push values that we see as high onto the secondary market investors in these continuation processes. And at the end of the day, why sponsors use CVs as an exit, and an exit tracks into their track record. So they will be measured by a CV as an exit, as they would by an exit to another sponsor or to a strategic investor. So, frankly, they don’t compromise on value.

Now, again, there are exceptions. There are some sponsors who may try to moderate value because they have a good asset in a poorly performing fund. But this is the smallest of exceptions, falls under the category of what I mentioned earlier as bad reasons for doing these deals. But at the end of the day, the sponsors want to hold their good assets for longer and they want to get capital into the hands of their limited partners. They want to enhance their track record, their DPI. They want to enhance their fundraising and [their] story, their own economics.

So all of that evidence leads you to conclude that sponsors are not going to sandbag values in these continuation processes. The benefit of the relatively small economics that they might make on that particular asset by acting that way are far outweighed by the franchise risk they undertake if they mistreat their limited partners.

Adam Le:                 

I mean, I get that. That makes sense. And obviously, franchise risk is something to be very wary of. I mean, at the end of the day, private equity is a people business and it’s one run on reputation and LP/GP dynamics are very, very important.

But just to be a little bit more provocative then, if the GP is really incentivized to maximize value for its LPs, why are we not seeing GP-led transactions and continuation fund transactions closing at significant premiums to net asset value? The average pricing seems to be in the single digit kind of discount. Why aren’t we seeing sort of 110%, 120%, 150% pricing as it relates to NAV in continuation fund deals?

Jeff Hammer:           

Well, Adam, that leads us to have a discussion as to what is net asset value. And net asset value is determined by the sponsor based upon guidance from the accounting boards and based upon specific policies. So GPs influence value, but they don’t control it. Prior period marks matter.

And beyond all that, Adam, the market speaks. You’ve heard people mention that term. Interested secondary parties will go into these processes and they will express a view on value. So it’s really the process that controls value, not the general partner.

Secondary investors are looking to make a good return. So they are going to be very restrained on so-called overpaying just so that they can get invested. You might see that restraint to be a little less in the world of strategic companies who are looking to add on companies to their platforms and to be able to realize synergies, strategic investors, not financial investors.

So, by virtue of the fact that these processes are really focused on financial investors and not strategic investors, you are not going to see that outlier premium that you would normally see in a full-blown M&A process.

But that’s not because of sponsor manipulation of values, Adam. That’s just because of the nature of the process. And again, getting back to what we discussed earlier, when you’re creating interim liquidity, that’s not the penultimate realization event that will get that reach value. And I think all parties realize it.

And limited partners, they take a view on it. But if they want to stay in the asset because they feel they ultimately want that penultimate value, well, they can stay in the asset. And in the meantime, other limited partners are going to say, hey, I realized two, three, four times my cost on this particular asset. I’m happy with that return and I’m going away. It’s an option for everybody and everybody gets to vote with their feet, so to speak.

Adam Le:                 

Okay. So there are specific dynamics and I guess nuances to GP-led secondaries trades that don’t make, I guess, the answer to this question sort of so black and white. And we’re bringing in the whole thorny issue of valuations, which has been a huge topic of debate, I guess, in private markets over the past sort of 18 months, I feel.

I would love to hear from listeners as to what they think about this particular controversial statement. I’m sure, Jeff, you would love to hear their thoughts too. Maybe we can get people to contact us and let us know their thoughts.

But let’s move to the second last controversial topic, which is about staple deals. And these are deals, for any listeners who are not familiar, where a secondaries buyer will acquire stakes in a fund, or fund of a manager, and at the same time, pledge a commitment or commit to that manager’s current or next fund in market. And some blue chip firms have used staple deals over the last 12 months to kind of help with fundraising, because as we all know, it’s one of the most difficult fundraising environments out there right now.

So the controversial statement here is, “Are staple deals really the best use of buy-side capital,” so secondaries’ buyer’s capital, “or are they simply sweeteners to help get a secondary’s deal over the line?”

Jeff Hammer:           

So, Adam, this is a complicated one. There are really two schools of thought on staple deals. First is the thought that staple deals exemplify the creativity and innovation of the secondary market. And that the prevailing rationale for staple deals is that all opportunities can be underwritten. So primary, secondary, co-investment, direct can be underwritten by specialists, and that all capital has a price or a cost or an assigned return.

And in this world, using a staple is pretty clearly a manifestation of the solution orientation of the secondary market and is an appropriate tool for allowing a deal to get done.

The alternative view is that specialization matters, and that the best investors focused on each of these distinct domains, whether it’s primary, secondary, co-investment, what have you, have specific skills that should be utilized. And the distinctive competence of a fund investor is different from that of a co-investor, or different from that of a secondary investor, or even a GP-led secondary investor. Specialization matters.

So, if you believe this, then a generalist buy-side investor in the secondary market engaging in staple deals could lead to some questions. And, again, that’s the alternative view.

Adam Le:                 

Yeah. Yeah. I was just going to jump in and say, you’re saying that it could lead to some questions, and that’s the alternative view, because at the end of the day, the secondaries fund has said to its LPs, we are going out there and underwriting to a certain return, investing in secondaries, buying exposure on a secondhand basis. The LPs are not paying the funds to invest primary capital on a primary basis. Otherwise, they would be investing in a different strategy, a primary fund of funds or a different manager or something like that. And therefore, the argument there is that if you’re a nonspecialist investor, then it’s valid, I guess, to raise questions about are you using your LP’s capital to the best ability.

Jeff Hammer:           

Yes. And what I would say is secondary investors create a lot of headroom for themselves in the form of a discount or a lower return expectation to compensate for perhaps their less polished skills of investing in a de novo fund. I mean, effectively, those assumptions get baked into models.

And so this is often what you find in staple transactions, lots of headroom created for achieving return.

So, Adam, my view is that staples are indeed sweeteners to get a deal done, but they are important to the secondary market solution-oriented ecosystem. And they’ll always be a part of the secondary landscape and demand for them will ebb and flow with market dynamics.

Adam Le:                 

Interesting. So you’re sort of saying—you’re agreeing with the statement, but you’re saying that it’s not necessarily a negative thing.

Jeff Hammer:           

No, it’s not a negative thing. Because again, secondary capital is flexible, pliable solution-orientation capital. That’s what’s created the multiple innovations of the secondary market and it’s allowed liquidity to come about.

I mean, we’re in a time right now when M&A volume is down, when realizations, I think in your publication, you noticed in the third quarter, they were the lowest ebb in 10 years, IPO volume continues to be down. Where do people go for liquidity these days? They go to the secondary market. But when you show up to the secondary market, it’s not necessarily just a single transaction. You’re saying, hey, I have this situation, I have these assets, I’m looking to do this, I’m looking to do that. And so you need in your secondary market toolkit as an investor, these various tools, such as stapling, to be able to get deals done and create the liquidity that people want.

Adam Le:                 

Absolutely fascinating, Jeff. I think this is the first of all the questions we’ve got to where you don’t disagree, I guess, with the premise. But I like your take on it in terms of saying that it’s actually a necessary part of the market.

Jeff Hammer:           

Well, I didn’t say they were simply sweeteners, Adam, because I think you mentioned they were simply sweeteners. I think they are sweeteners, but in important instances, can be important sweeteners.

Adam Le:                 

Very, very interesting. Okay. Let’s see where we land on the last question. Okay. So this is a huge one, actually. So this is, “The biggest barrier to the growth of the secondaries market isn’t the lack of capital,” so the lack of money to invest in secondaries deals, “it’s actually a lack of human resources, and people with secondaries expertise.” What do you make of this?

Jeff Hammer:           

Adam, I’m sorry to be objectionable again, but this is a complete fallacy. And feel free to challenge me on that. Capital is still the primary constraint.

I would say that skill sets are available for executing in the secondary market, but they are misaligned currently. And part of the reason they’re misaligned is because there’s not enough capital to support the secondary investment ecosystem that needs to come about, and would come about were there enough capital. Let me pause there and see if you want to challenge me on that.

Adam Le:                 

Okay. So firstly, it’s not that you’re saying that a lack of people isn’t a big issue. You’re saying that the biggest issue isn’t that, it is actually the fact that we don’t have enough capital to invest in the opportunities out there and grow the secondaries market.

Jeff Hammer:           

That is absolutely correct. We lack capital for the secondaries market in general, and for the GP market in particular.

If you look at some of the metrics, and I don’t have them on the tip of my tongue, but in the buyout market, it’s generally looked at to say there’s about three to five years of dry powder depending upon the cycle. In the secondary market, in totality, for both traditional LP- and GP-led, we have oscillated between one and two years of dry powder. And I think we’re actually at a low ebb right now where there’s perhaps one or less than a year of dry powder available to invest in secondary transactions.

In particular, in the GP-led market, we are seeing at Manulife four to five deals a week. And you can add those up across the years. Since we set up at the beginning of 2020, we’ve seen over 700 transactions, really credible transactions, mostly brought by credible banking organizations.

And I would maintain to you, Adam, that very few of them—well, let me put it this way, one-half to perhaps two-thirds of them have gotten done over that time frame. It’s something that you all should validate through your ability to peer into different portfolios and organizations.

But the primary reason is not because the deals aren’t compelling. And, of course, not all the deals are compelling. But because there is so little capital to address this need for interim liquidity, that the large majority of transactions that have not been completed have been for that reason, not for the reason because they were poorly conceptualized, or were brought about for the wrong reasons.

Adam Le:                 

Okay. So you’re saying that buyers maybe want to back a lot more deals, but they can’t because they have to be selective with the types of deals that they back and where they spend their LP’s capital.

Jeff Hammer:           

Yes, you have two sets of buyers. You have those buyers who are what we call hybrid, who invest in traditional LP transactions, meaning limited partnership interests and portfolios of limited partnership interest, and those who are pure play GP-led investors. The primary difference, if you’re a pure play GP-led investor, you’re really investing in concentration. And you’re doing what’s the equivalent of sponsor-like diligence on a single asset or potentially two or three assets. You’re embracing concentration.

And that skill set draws often from an M&A background, it draws from a direct sponsor background. And as part of the evidence that skills can be brought into the market, you’re seeing some direct sponsors with two feet forward into the GP continuation world and drawing upon their direct investors to make this investment.

So were there to be more capital in that part of the market, there is a ready pool of capable investors to draw upon. But the pool of capital hasn’t materialized just yet.

Adam Le:                 

As always, time is against us. We’ve come to the end of the five controversial topics. I said that we would end this discussion with a lightning round. Lightning round, as the name suggests, is where I’m going to ask you a couple of questions and you should answer them as quickly as possible. So no need to think too long and hard about them.

I have to admit, I stole this from another podcast that I listened to. It’s not a finance-related podcast, but I just think it’s a great way to kind of get a bit of levity at the end of a discussion, which has been pretty interesting and heavy about continuation funds and secondaries.

So let’s start with the questions and you have to answer as quickly as you can. The first question is coffee or tea?

Jeff Hammer:           

Coffee.

Adam Le:                 

Burrito or pizza?

Jeff Hammer:           

Pizza.

Adam Le:                 

What was the last book you read?

Jeff Hammer:           

Truman by David McCulloch.

Adam Le:                 

Best film ever?

Jeff Hammer:           

The Sting with Robert Redford and Paul Newman.

Adam Le:                 

Ah, an oldie but a goodie. How long did it take you to run the Berlin Marathon?

Jeff Hammer:           

Three hours and forty minutes.

Adam Le:                 

That is pretty good. Who is the best person to sit next to on an airplane after a private equity conference?

Jeff Hammer:           

I would say, without thinking about that too much, it would be a reporter from PEI.

Adam Le:                 

Very good to hear. Very good to hear.

Jeff Hammer:           

And the reasoning being that, what better way to understand what actually occurred at that conference than to sit next to someone from PEI for eight hours.

Adam Le:                 

For eight hours. Wow. I mean, that would be a long time for the journalist as well. But I wonder if that leads into the next question, which is who’s the worst person to sit next to on a plane after a private equity conference?

Jeff Hammer:           

Oh, that’s easy. A reporter from PEI. That would be a painfully long eight hours, Adam.

Adam Le:                 

It would be very much so. But, Jeff, if it was you that I was sitting next to on a plane for eight hours, I think we’d have a lot of fun. I think that would be a great way to spend eight hours. So I love your answer.

Okay. Last question. Finish this sentence. The thing I find most fascinating about the secondaries market is… ?

Jeff Hammer:           

That we don’t know what the future is going to hold in store in five years. We don’t know what the volumes will be. We don’t know what additional innovations will be. But we do know that it will be a great place in which to spend a career and a great place in which to invest.

I apologize, Adam. I speak in paragraphs. So, therefore, telling me to complete a sentence invites me to complete a paragraph.

Adam Le:                 

No, no, no. I love your answer, Jeff. And hopefully, us at PEI and Secondaries Investor will be there to cover whatever surprises and interesting developments we have in store in five or ten years’ time or even longer.

So Jeff Hammer from Manual Life Investment Management, thank you so much for your time. Thank you for sharing your insight on what is arguably private markets’ most dynamic sector. And I look forward to speaking with you again, Jeff.

Jeff Hammer:           

Adam, thank you very much. This was a pleasure. And thank you and your fellow reporters for all the good work you do on covering the market. It’s really helped us see what’s going on in the secondary market in totality. Thank you again.

Adam Le:                 

Likewise. Thank you.

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