Reopening the secondaries market for illiquid assets

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The Monetary Control Act of 1980 was a watershed piece of legislation that removed controls on bank interest rates and repealed federal usury laws.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 In 1999 the U.S. government repealed portions of the Glass-Steagall Act that separated retail banking from investment banking.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.

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.

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.

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.

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.