Commentary: Private debt secondaries are resilient by design

The world is changing at an unprecedented rate and in incalculably different directions. The COVID-19 pandemic has caused historic spikes in unemployment, and protests worldwide are awakening the need to have an honest dialogue about social justice — a dialogue that may include the role of corporations as stewards of our collective well-being. We anticipate, and hope for, an authentically new normal, but that means a good deal of uncertainty in the meantime.

For investors, this tumultuous period requires expert navigation of volatility and the unexpected. Many will seek out liquidity and make large cash deposits until conditions brighten. They must manage the difficult task of preserving capital in the face of incredible uncertainty.

Private debt secondaries offer a solution, well-positioned to weather the storm and outperform over the long run. They're built with inherent downside protection and carry the potential for sizable discounts during a downturn. The consistent yield and shortened duration of private debt secondaries should help investors to derisk at this juncture.

Though private debt secondaries are indeed uniquely suited for this crisis, the asset class was already well-positioned to take off. Private credit capital under management topped $800 billion in 2019 (according to the 2020 Preqin Global Private Debt Report), with private debt secondaries deal flow reaching $5 billion to $10 billion annually, providing a robust opportunity set for buyers. There was a question as to how quickly the market would continue to grow, but increasing pressure for limited partners to sell their stakes and rebalance portfolios has provided an accelerant.

In addition to significant fundraising and LP strategy changes, corporate events at the general partner level will contribute to the development of this market in both performing and non-performing private debts.

Certain benefits of private debt secondaries existed before the crisis, but they've been spotlighted by the moment:

• With a fragmented buyer universe, few sellers and only a handful of dedicated vehicles, there is currently scarce competition in private debt secondaries. And private debt on the whole is a relatively inefficient market. This means end investors can more easily capture upside or a find a deal which fits their needs.

• Private debt secondaries benefit from diversification across vintages to mitigate single borrower and duration risk, and across geographies to mitigate geopolitical risks. Capital deployment is faster in private debt secondaries when compared with a primary vehicle, which mitigates the J-curve.

• Compared with primary strategies, there is better visibility to the underlying loans. An average secondaries deal involves funds that are 60% invested with a performance history that makes thorough analysis possible.

Private debt secondaries provide downside protection and reward investors for taking liquidity risk, while also ensuring a margin of safety against larger losses. By nature, they are built to preserve capital in uncertain times.

These benefits also highlight the importance of strong underwriting and the risk management of underlying positions. With limited blind pool risk and fragmented competition, those firms that can better synthesize underlying deal information will be able to capture differentiated returns.

In contrast to private equity secondaries, one of the key elements to private debt secondaries is their stable income stream. The underwriting investment case should be centered around the sustainability of income streams and the quality and diversification of a portfolio, all underpinned by the caliber of a specific fund and fund manager. This approach builds measurable value for investors throughout the market cycle, but especially in a low-yield environment.

As it currently stands, the secondaries market has witnessed an uptick in motivated sellers. LPs are addressing concerns around capital calls by offloading fund stakes in exchange for liquidity. And they're selling to derisk overallocated and concentrated portfolios. The denominator effect comes into play here — to counter declining value in other asset classes, LPs are turning to secondaries to rebalance their portfolio. We expect this trend to continue, meaning a sustained increase in deal flow and higher quality opportunities across the board.

We anticipate private debt secondaries to produce above market returns relative to risk. Compared with investments in "mono" strategies such as direct lending, they have the potential to outperform with better or equal levels of risk. Importantly, private debt secondaries offer regular income, further balancing the risk-return profile.

Regular income shortens duration and impacts the discount. And the "effective discount" makes a difference — there is a latent period between the bid for a deal and its close, and any extra yield generated in that time goes to the buyer, lowering the actual price. During a recession, these mechanisms are amplified as price dislocations expand to account for uncertainty.

Prior to the pandemic, a thesis of maturation for private debt secondaries was widely accepted for private debt secondaries. That hasn't changed — if anything, the timeline has been pushed up. To take advantage, private debt secondary investors need to be flexible, globally coordinated and fully aligned, and have a backbone of credit underwriting experience.

Private debt secondaries are designed to not only outperform in bad times, but also to steady a portfolio in the good. And though the market is pointing up now, other exogenous shocks may jolt investors into a sell-off. This makes the asset class a wise allocation. It's ready for a bumpy road ahead. So, when determining your path to overcoming the market's challenges, weigh the opportunity for private debt secondaries.

Olga Kosters is head of private debt secondaries at Tikehau Capital, based in New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.