How should pension schemes best position themselves to take advantage of portfolio secondary sales opportunities? Are there lessons to be learnt from the GFC for pension schemes selling portfolio positions during COVID-19?
Following the global financial crisis (GFC), there was a surge in portfolio secondary sales as investors, such as pension schemes, sold down their private fund holdings.
This was driven by a combination of the denominator effect and the adverse consequences of an over-commitment strategy left them unable to satisfy capital calls and craving liquidity.
The economic impact of COVID-19 is likely to lead to similar pressures and create opportunities for the well-prepared pension scheme.
While there have been some expedited portfolio sales, the volume of secondary trades is significantly down this year as a result of the pandemic. However, we expect trading to increase once valuations and pricing stabilise as some investors will look to sell down to re-balance their portfolio or manage their cash flow.
Additionally, the amount of capital secondaries fund sponsors have raised is at historic highs, meaning that buyers have abundant uninvested funds to deploy – this, combined with the pressure on sellers, means that secondaries market activity is likely to pick up dramatically.
‘Tail end’ portfolios or ‘early secondary’ portfolios?
There is a general feeling in the market that many investors accepted too significant a discount selling their interests during the GFC. Therefore, sellers should be strategic in how they market their portfolios for sale and consider alternative methods of packaging the portfolios.
“Tail end” portfolios – portfolios of fund interests that are largely fully drawn and invested – are often attractive to buyers as the portfolio companies are known and near-term liquidity is expected through distributions as the funds realise their investments.
However, in an environment where portfolio companies may struggle with the economic effects of COVID-19, it seems unlikely that many tail-end portfolios will be an easy sell.
Accordingly, pension schemes seeking liquidity may wish to defer sales of tail-end portfolios until global economic conditions stabilise, or diversify by including them alongside earlier-stage interests.
“Early secondary” portfolios could also be attractive to buyers. These are fund interests that have been recently raised and the corresponding fund is mid investment period.
The low point of the economic cycle may be the best time to deploy capital and acquire new portfolio companies, making them attractive targets for secondaries buyers, particularly those seeking to increase their exposure to sponsors with a proven track record, funds operating in a target industry or funds within a specified strategy.
For pension schemes managing their overall portfolio of investments, disposing of these early-stage portfolios will remove interests that could provide large capital calls that need to be met, thus solving short-term capital constraint concerns and enabling the pension schemes to re-allocate their investment exposure.
Similarly, sellers may wish to reduce the number of interests for sale in the portfolios as buyers may focus on consolidating their investments with a limited number of familiar managers rather than investing in extensive due diligence exercises on a large number of new managers.
Regardless, pension schemes may still have to accept larger discounts or historically lower valuations. Concerns over this may be mitigated by using “anti-embarrassment” mechanisms.
These operate to prevent the risk of a buyer acquiring a portfolio at a historic discount and swiftly selling it at a much higher price.
An example of this mechanism includes putting an overall limit on the return a buyer can make on a portfolio, with the buyer sharing the upside with the seller.
Another method involves the seller retaining the interests and using a preferred equity structure that effectively permits the seller to share in the returns after the achievement of certain hurdles.
Pension schemes should also look at preferred equity solutions. One common structure for preferred equity is for the seller to transfer the portfolio interests to a special purpose vehicle (SPV), which issues preferred equity interests to the buyer.
This structure allows the seller to release some liquidity and allow further capital calls to be funded by the buyer through a further increase of preferred equity interests. The cash flows from the portfolio held by the SPV pay down the preferred equity interests while allowing the seller to keep the upside of the portfolio.
Parties can often structure such deals as an affiliate transfer, which can avoid a lengthy transfer process and minimise tax leakage.
Pension schemes should be considering their positions in alternative investments now to take advantage of near-term opportunities to generate liquidity in the aftermath of COVID-19.
This viewpoint was co-written by Ed Harris, Jeremy Pickles, Faye Jarvis and Adam Brown, partners at law firm Hogan Lovells.