Virus fallout putting secondary markets into chaotic tumble

The specter of evaporating liquidity and rising capital calls in light of the COVID-19 crisis may cause some asset owners to consider or even launch a sale in the alternative investment secondary markets.

The big question is how to set a price.

Extreme market volatility makes Dec. 31 valuations seem so long ago — and irrelevant, industry insiders say. Some asset owners also are starting to see an increase in capital calls. Many managers are using the capital to pay down subscription lines of credit as well as to shore up existing investments, although there is disagreement among industry experts on whether there will be a large increase in capital calls until later in the year or in 2021.

Meanwhile, secondary market buyers have little interest in portfolios exposed to certain industries such as hospitality, consumer-related, energy and transportation that had been attracting investor capital since the global financial crisis. Due to uncertainty about value, secondary market buyers are only interested in portfolios that are heavily discounted.

"We are seeing more LPs starting to ask for a sense of price for their funds, as they look to optimize their post-corona portfolios," said Cecilia Banares, Toronto-based administrative director of secondary market broker Setter Capital Inc. "That said, we expect the number of inquiries from LPs to increase markedly in the coming months, given many are still putting out fires elsewhere in their portfolios."

Some industry insiders say they have already seen some smaller portfolios and credit fund limited partnership interests being marketed on the alternative investment secondary markets.

There's been a major uptick in offers to sell real estate limited partnership interests on the secondary market," said Christy Gahr, Boston-based principal and real estate consultant at consulting firm Meketa Investment Group Inc.

"Thus far, sellers have largely been pension funds and foundations as they navigate the denominator effect and liquidity issues," Ms. Gahr said. "Activity has been across core and non-core real estate funds as many open-end core funds have gated redemption requests or offered low partial redemptions."

Institutional investors right now are pruning real estate investments deemed mature, said Charles Hewlett, Washington-based director of strategic planning at real estate consultant RCLCO Real Estate Advisors. Investors are selling positions in open-end funds and even some closed-end funds and separate accounts they consider at peak value to shore up liquidity and preserve cash, and to have dry powder to invest in opportunities that may arise.

While over the past several years, very large portfolios — worth $1 billion or more — pushed up secondary market volume, the portfolios put up for sale since the COVID-19 crisis descended on the world have been much smaller.

"We're seeing a bigger uptick of smaller groups that want to manage their capital and look to unwind LP interests," said Mike Bego, Greenwich, Conn.-based managing partner of secondary market manager Kline Hill Partners. "They are open to bigger discounts and are looking to unload unfunded capital commitments."

The fear of some of these smaller institutions and family offices is that their "cash sources have largely dried up because distributions from private equity funds have gone down a fair bit in the last few months," Mr. Bego said.

Some institutions agreed that capital calls have increased recently but they have sufficient liquidity so far to meet these capital calls.

"We have been receiving more capital calls and less distributions, as we expected and are prepared for," said Bob Jacksha, chief investment officer of the $13.7 billion New Mexico Educational Retirement Board, Santa Fe. Some of the capital calls have been from general partners seeking to pay down or pay off subscription lines of credit, he said. However, that's not something that pension fund officials are tracking and not all managers say what the capital calls are for, Mr. Jacksha added.

The $17.3 billion Orange County Employees Retirement System, Santa Ana, Calif., has also seen an increase in capital calls. OCERS has had 26 capital calls since its March 25 investment committee meeting from private equity, private credit, real estate, energy and infrastructure managers, spokesman Robert Kinsler said in an email. Of those, nine managers noted that part or all of the capital would be used to reduce credit facilities.

"OCERS does have sufficient liquidity for all current and future capital calls and was conservatively positioned with cash going into these markets," he said.

Robert Kohn, partner at real estate placement agent and secondary market adviser Park Madison Partners LLC, said that many real estate managers are maxing out their lines of credit.

"Cash is king right now," Mr. Kohn said. "(Managers) are worried about banks' ability to make good on what they promised."

For their part, some investors are concerned with getting hit with a barrage of capital calls.

"A few investors have called GPs and asked then not to call capital right now," Mr. Kohn said. However, most investors will likely refrain from selling limited partnership interests on the secondary markets for the next 30 to 60 days because they will have to take serious discounts on the portfolio's net asset value, in part, because of the lack of clarity on value, he added.

Any big discounts potential sellers would have to take in the secondary market would be off prices that were already trending downward before the coronavirus crisis. The average high bid for all strategies on the secondary market in 2019 was 88% of net asset value, 400 basis points lower than the prior year, according to investment bank Greenhill & Co. Inc.'s latest Secondary Market Trends & Outlook report.

Even so, this same lack of vision on what a portfolio is worth could result in an increase in non-traditional secondary deals including fund restructurings and recapitalizations of single-asset funds, joint ventures and other non-fund structures, said Warren Kotzas, New York-based capital adviser in charge of Park Madison's recapitalization advisory business. Mr. Kotzas is also managing partner of C6 Real Estate, a firm focusing on recapitalizations. In restructurings and recapitalizations, a secondary market buyer spins the assets into a new structure, giving LPs the choice of exiting the fund or remaining in a new vehicle, sometimes with an additional capital commitment.

For the time being, investors are exploring their options, said Claire Commons, Paris-based head of strategy at secondary market trading platform Palico. She said that her call volume from potential buyers and sellers on the secondary markets had doubled in a few days.

In this kind of environment, Ms. Commons said that buyers are throwing the traditional method of evaluating secondary market deals based on net asset values out the window.

"NAV pricing is not valuable anymore," she said. "The buyers we're talking to are doing stress testing of underlying companies and understanding capital structure of the businesses to make sure the underlying businesses can weather this recession."

Much of the deals investment bank Campbell Lutyens executives are seeing were transactions signed before the coronavirus outbreak, said Gerald Cooper, New York-based partner.

"When we speak to the different constituents, we don't get the sense there's a lot of activity right now," he said.

Some smaller transactions are getting done, mainly by retail, smaller pension funds and family offices in a liquidity crunch at significant discounts, Mr. Cooper said.

The deals that are getting done have some level of downside protection in that they are in what are now considered resilient industries such as telecommunication companies, especially companies that are supplying internet connectivity, like fiber companies, as well as health-care companies, Mr. Cooper said.