M&A drought spurs nascent private credit secondaries market forward

Slower M&A activity is a thorn in the side of private equity investors: It's stymying plans to exit investments and limiting new investment activity.

One beneficiary may be private credit secondaries.

Investors are increasingly turning to this nascent, but growing, market. Not only can it provide liquidity to lenders, investors can gain exposure to loan portfolios, potentially at a discount, while bypassing the loan origination process.

What are private credit secondaries?
Private credit loans, which lack ratings and up-to-date mark-to-market pricing, are not known for secondary trading. Private loans have bespoke structures and terms, and are typically held by a single lender, or a small group of lenders. Lenders generally view them as buy-and-hold investments.

Private credit secondaries are a relatively recent market solution for trading private credit loans and investor commitments of closed-end private credit funds, typically halfway, or later, through a loan’s lifetime. 

Within the private credit secondaries market, there are options for general partners and limited partners. 

GP-led transactions are initiated by the GP, often to restructure an asset’s ownership within a fund, while providing a liquidity event to existing LPs. The owner may sell off a loan entirely, or borrow against it via a net asset value (NAV) loan, sometimes at a sizeable discount.

In the larger LP-led market, known as the “conventional” secondaries market, LPs sell their stakes in a fund, or a collection of fund interests, with the GP's approval. The secondary buyer will take the LP’s place, inheriting any future commitments to the fund, in addition to the transferred interests.

The growing private credit secondaries market follows the development of active secondaries markets for venture capital, real estate, and, particularly, private equity. Between 2008 and 2022, annual global secondaries fundraising activity grew from $13.9 billion to $57.6 billion across all markets, with private equity and general secondaries making up roughly three quarters of fundraising activity in any given year, according to PitchBook. In the first nine months of 2023, secondaries funds raised an additional $68.1 billion.

The private credit secondaries market is likely to evolve along a similar trajectory, according to Atalaya partner Josh Ufberg, who is responsible for the firm’s Corporate and Opportunistic Investing Strategies+. 

“What you're seeing is, private credit — similar to private equity — has had a significant amount of additional capital formation,” said Ufberg. “And there are defined maturity dates in private credit. Actually, it's more defined than private equity, where the maturity dates come about through the structure of the fund, as opposed to the underlying asset.”

“These private credit managers have longer-dated investments that they need to revisit to extend the life of their funds, or restructure their funds to create a longer duration,” he added.

The solution, in many cases, is to dive into the secondaries market.

From the smallest acorn
When Tikehau Capital opened its private credit secondaries division, the market was still in a primitive stage.

“It’s not that private credit secondaries transactions didn’t exist, or never happened before,” said Tikehau Capital’s head of private debt secondaries Pierpaolo Casamento. “But they were mostly done opportunistically out of a fund of funds, private equity secondaries funds, or hedge funds that do credit.”

According to secondaries specialist Coller Capital, the trade in secondhand stakes of private debt funds hit $17 billion in 2022 — more than 30 times the total volume in 2012. At the current rate, the value of secondary deals is expected to reach $50 billion by 2026, the firm estimated.

The market is poised to continue growing alongside the primary private credit market, the latter of which is expected to double in size by 2028, to $3.5 trillion, according to BlackRock. However, the subset of LPs seeking liquidity will likely remain a small minority of market participants.

Casamento estimates that the LP turnover for private credit assets into the secondaries market is one percent or less. By comparison, the private equity market experiences turnover of as much as three percent.

Atalaya and Tikehau aren’t the only players in the secondaries space, of course. Other participants include J.P. Morgan, Pantheon, Apollo, Ares, and Coller Capital.

Happy to lend a hand
As the market provides liquidity for investors cashing in their chips and exiting private debt investments, it can also offer attractive opportunities for those picking them up.

“You don't have the three months of diligence that you typically have with a single loan in the direct lending process,” Casamento points out. “But you have the benefit of having seen how the company has performed that long after the loan has been originated.”

In the secondaries market, investors are able to assess a portfolio company’s ability to repay lenders after a loan has been outstanding for some time.

“You're able to see these underlying loans perform, and to measure their performance, before you're underwriting them in a secondary market,” said Ufberg. “So, it's less about targeting the performance of the secondary market — we're targeting the position of the original underwriting.” 

“I think of our portfolio as an index of private credit,” said Casamento. “Our goal is to offer investors access to the index at a discount, with selectivity around GPs, portfolios and pricing. But we’re not trying to cherry-pick what we hope will be the best funds or loans, as you would expect to see on the primary side.”

Exits for sale
On the smaller, GP-led side of the secondaries market, investors looking to exit positions in 2023 found themselves constrained by a drop-off in M&A activity.

M&A activity lagged in the first three quarters of 2023, according to PitchBook, reaching its lowest mark in Q3 since the Covid-impacted depths of Q2 2020.

“Investments that private credit and private equity investors are making are both dependent on M&A,” said Ufberg. “In order for those transactions to turn over, to exit those deals, you need that M&A to happen. And there's been a significant lack of M&A in 2023, due to the tightening of capital markets, retrenchment of alternative lenders, and the cost of capital with interest rates rising.”

Sponsor-backed M&A was the most severely affected by the downturn in the first half of 2023, according to a report by Lazard’s Private Capital Advisory — a trend the group attributed to heightened financing costs and wider bid/ask valuation spreads.

Economic conditions have also spurred exit activity in the larger LP-led secondaries market in recent quarters. Some investors may be correcting for overexposure to private debt assets due to the “denominator effect,” when one asset class generates outsized returns and moves a portfolio out of line with an investor’s preferred allocations. Others may be reallocating investments among strategies, managers, and assets.

“There are many reasons for selling in the secondary market, and it can be very idiosyncratic,” said Casamento. “It's probably even more understandable when you think of the fact that only 1% of the primary market either trades on the secondary market, or even looks for a price check in the secondary market.”