Private credit secondaries: A market to watch?
Demand for liquidity is driving growth in secondaries deals across private markets, so how is this relatively nascent market developing?
Not that long ago, private credit secondaries transactions were unusual – not only were there few dedicated buyers, but the shorter duration of debt investments (than, for example, private equity) meant that portfolio sales were less likely to happen.
Yet demand for liquidity over recent times has changed all this. “Volume in private credit secondaries is increasing,” says Sebastien Burdel, Partner in the Secondaries Group at Ares Management. “One reason for this is the extended duration of credit assets. Until recently, investors enjoyed a two to two and a half year average duration for the underlying loans in a portfolio. That has now extended to three or four years and some loans will definitely run to maturity. The perception of private credit as a self-liquidating asset class has changed.”
Indeed, some LPs are examining their private credit portfolio more closely as a potential source of liquidity than their private equity assets. “When CIOs are deciding what to sell, some of them prefer to keep their private equity holdings to retain the potential upside,” says Toni Vainio, Partner in the Global Private Credit team at Pantheon.
“So they’re selling funds that typically have a more moderate risk-return profile, such as private credit, even if that happens at a discount.”
“Volume in private credit secondaries is increasing. One reason for this is the extended duration of credit assets. Until recently, investors enjoyed a two to two and a half year average duration for the underlying loans in a portfolio. That has now extended to three or four years and some loans will definitely run to maturity. The perception of private credit as a self-liquidating asset class has changed.”
Private credit secondaries remain a relatively small corner of the secondaries market – they accounted for just 5% of overall LP-led volume in 2023, according to Jefferies Global Secondary Market Review for full year 2023. But many believe that volume in absolute numbers will rise sharply over the coming few years, and not just because of the growth of the underlying primary private credit market.
“Two years ago, there was relatively little subjectivity when it came to valuing direct lending portfolios,” says John Bohill, Partner at StepStone Group. “That’s one of the reasons there was very little activity on the secondaries market. Yet in the intervening period, we’ve seen dislocation in the wider market that has created a liquidity gap for LPs. They are looking across their portfolios to see how they can solve this and credit secondaries can look like a good option for them.”
“Five years ago, there was around $5bn of liquidity need in the market,” adds Vainio. “Last year, we originated over $24bn of private credit secondary market deal flow. In our estimate, what ended up transacting across the market was about $10bn due to a limited pool of buyers, combined with buyer-seller bid-ask price expectations not aligning.”
Yet the buyer pool looks set to expand as LPs increasingly look to add private credit secondaries investments to their portfolios. Over the next 12 months, 21% of LPs plan to commit to private credit secondaries funds, according to a recent survey by Private Debt Investor, up from 17% the previous year and just 12% in 2019.
For LPs, the prospect of strong returns is one of the attractions. “There are some great value opportunities in private credit currently,” says Marco Busca, Head of Indirect Private Debt at Generali Asset Management. “One of these is secondaries, where we can get double-digit returns.”
Yet there are other attractive features. Similar to secondaries in other private markets, investors can gain access to rapid diversification by vintage year, geography, managers and assets, and in private credit, aspects such as increased maturity can shift the risk profile of the investment. “Private credit assets are generally de-risked by the time they transact in the secondaries market,” explains Burdel. “Leverage may have come down a turn or a turn and half and this may lead to some form of liquidity discount.”
Vainio agrees. “Secondaries can be lower risk,” he says. “EBITDA adjustments have usually worked through, portfolio companies feature lower leverage, the portfolios are seasoned and highly funded – and the private debt and private equity backers may be three years into a deal and are getting closer an exit or refinancing event.”
LPs need to be aware of the risks that do exist, however. One is exposure to documentation that may not be suitable to today’s more difficult market. “Documents are the one thing you will inherit in a pool of assets in the private credit secondaries market, so diligence is critical,” warns Burdel.
One way of mitigating this is for buyers to target certain parts of the market. “Cov-lite terms are prevalent in the broadly syndicated loan and large cap market,” says Vainio. “So you need to be careful in that segment. We typically prefer acquiring middle-market focused assets where there is a single lender or small group of lenders and where there are generally several maintenance covenants.”
Another is really understanding how different managers have behaved over the past few years. “On LP-led deals, we tend to have access to the managers in the process to gain an understanding of their perspective on the portfolio,” says Burdel. “In these deals, there may be 300 to 500 underlying portfolio companies and so we don’t get access to the credit documentation. Yet we do have insight into how different managers underwrite, the quality of their documents, whether they have used cov-lite and how aggressive they have been – this knowledge is critical in informing our investment decisions.”
A deep knowledge of the market can also give investors other information, says Bohill. “When a deal comes across our desk, there is very little uncertainty which LP portfolios will trade the best,” he says. “That’s because of our level of understanding of individual managers’ documentation, but also how concentrated or diverse the portfolio is and how much is fully invested. That can create a bifurcated market where there are hotly contested portfolios and those where some of us may even be unable to price a transaction.”
There are some great value opportunities in private credit currently. One of these is secondaries, where we can get double-digit returns.”
Much as in private equity secondaries, GP-led deals in private credit are gaining in popularity. “The GP-led market has appeared in private credit much earlier in the development of a secondaries market than it did in private equity or real estate,” says Burdel. “The technology has been embraced quickly and around half of deals in the market today are GP-leds. That said, only a small population of that gets transacted because there is a lot of complexity here.”
That’s because there are fundamental differences between GP-leds in private credit from those in private equity. “Where in private equity today GP-leds are typically single-asset deals, in private credit they’re more likely to be transactions comprising a diversified portfolio of loans,” says Vainio. “They tend to offer a broad set of opportunities and some of them can be quite large – around $500m to $1bn+. There aren’t many buyers who can speak for scale and have the experience to complete these types of transactions, which often involve significant legal and transactional complexity given the multiple counterparties involved in these types of transactions.”
They do, however, come with a distinct advantage to LP-led deals. “You get access to all the information you need in a GP-led situation,” says Burdel. “You can have access to documentation on each underlying credit if you want it.”
Private credit secondaries may currently be small beer relative to their other private markets peers, but the coming period looks set to be a busy one, with more capital flowing to the market and a rise in available deals. It’s a trend that Shelley Morrison, Head of Fund Finance at abrdn, notes. “Private credit secondaries could be a sub-asset class to watch this year,” she says. “We expect to see a rise in fundraising, which will be instrumental in maintaining the health and track record of the asset class.”
