Secondaries: The benefits of preferred equity
When Pierre-Antoine de Selancy attended a Zurich secondaries conference in February 2006 he noticed something strange. A panel discussing an overview of the secondaries industry had a representative from a bank sitting on the left and three secondaries participants sitting to the right.
“You had three equity investors, Adams Street, Greenpark, Pomona, and one lender, RBS,” de Selancy tells Private Equity International. That there was no one sitting in between struck the secondaries professional, at the time working with AGF Private Equity, now Idinvest Partners, as odd.
“There was no one occupying that space in the secondaries industry or on how private equity funds are funded,” he says. “I thought it doesn't make sense – the level of sophistication should be higher.”
Since then, de Selancy’s firm 17Capital has raised three preferred equity funds, each vehicle more than doubling in size from its predecessor, and the London-based specialist launched its fourth fund in June seeking north of €500 million, as sister publication Secondaries Investor reported in August.
Today, preferred equity in the secondaries market is no longer an unknown, little understood strategy in a market with zero competitors. In the last 12 months, the entrance of several new – and big name – players to this niche segment of the secondaries market has suggested the strategy is one worth paying attention to.
Last year, Yann Robard, who spent almost 14 years at the Canada Pension Plan Investment Board and established its secondaries and co-investment platform, left the pension to start his own firm, Whitehorse Liquidity Partners, focusing on the strategy. Vision Capital, which pioneered direct seconda-ries, is the most recent player to enter the space, announcing in July its principal finance strategy that focuses on preferred equity.
The recent emergence of new players begs the question: what do these players see in this market that others haven’t? The answer: huge potential.
“If you look at the secondaries market back in the late 1990s, people would have told you it shouldn’t exist. Now it’s commonplace,” Robard says. “Then you go to 2005 and you ask players, are you ever going to use leverage to do your seconda-ries? I’m pretty sure buyers would have said absolutely not.
“The next evolution is preferred equity financing, which today is in its infancy but has significant growth opportunity. I do think in 10 years from now it will be fairly commonplace.”
Preferred equity as a financial tool is not new. What 17Capital pioneered was the use of preferred equity financing for portfolios to address a gap in the market between debt providers and secondaries buyers. Portfolio holders could take on preferred equity – a tranche that sits between debt and equity in the capital structure – instead of selling stakes in their portfolios, thus keeping exposure to any potential upside while benefiting from liquidity.
The benefits of preferred equity are many, according to its proponents, who say the tool is more cost efficient and flexible than debt and a useful way for funds to create value that is aligned between the managers and LPs.
“It’s cheaper and more flexible than borrowing, and enables value creation that otherwise couldn’t be done,” says Vision Capital founder and chief executive Julian Mash.Vision plans to focus on providing preferred equity to GPs who want to invest more in their portfolio companies but who are restrained by their amount of available follow-on capital or for whom financing is too expensive.
For its part, Vision believes its long track record of working with portfolio companies gives it a competitive edge when it comes to its financing strategy. “Our equity skillset means that we are able to evaluate concentrated portfolios efficiently,” Mash says. “We think about how companies are valued, their individual prospects, how they are financed, who else might buy them one day.”
Vision’s focus on GPs illustrates the market’s evolution from a problem-solving tool to one that helps create value. Today, a wider range of industry participants are starting to see its benefits, including funds of funds, evergreen managers and listed private equity firms to either solve problems or fund growth.
Should secondaries buyers be worried about whether preferred equity will eat into their potential dealflow? Robard thinks not. He says the strategy opens up the market to sellers who may otherwise walk away from a secondaries sale because of an issue such as pricing. In a market where high pricing has eroded buyers’ returns, the tool can be used by traditional secondaries buyers for acquisition financing.
“Utilising preferred equity in their transactions enables them to continue to deploy capital while retaining their target returns, rather than avoiding it and deploying capital at lower returns,” Robard says. “You can embrace preferred equity and be at the forefront of the evolution of the private equity secondaries market, or you can resist it and five years down the line you’re going to get dragged into it.”
Whether the preferred equity market itself is becoming a more crowded space remains to be seen, but increasing competition isn’t something firms active in the space are worried about. They say the more participants there are helps to grow the market, and this will in turn help secondaries participants.
“I would be worried if it was the opposite,” says de Selancy. “We’ve been developing our strategy for eight years now. It’s actually good news that other people agree that what we do makes sense.”
For Whitehorse, which launched its debut fund in March, more competition may just lead to a larger market, something that may be just around the corner.
“Markets can evolve pretty quickly,” Robard says. “There needs to be a few of these transactions and more people will get educated about it. The more people see the benefits of it the more the market will open up.”