Episode 42 | Private Credit Secondaries: Growth, Liquidity and Opportunity

CJ Doherty Welcome to the Lending Lowdown. I'm CJ Doherty, Director of Market Analysis at LSEG LPC. Today, we're going to focus on a familiar topic, private credit, but look at it through a different lens as we explore private credit secondaries for the first time. We'll aim to discuss the growth of the market, what's driving activity, investment strategies and where opportunities are emerging. Joining me today to share his expertise is Greg Ciesielski, Head of Credit Secondaries at HarbourVest Partners. Greg, it's great to have you join me. Greg Ciesielski CJ, it's great to be here. CJ Doherty Greg, so to set the stage for our conversation, tell us a little bit about yourself and your role at HarbourVest. Greg Ciesielski Sure, happy to. HarbourVest is what's known as a multi-asset private markets platform. It has more than $150 billion of AUM, and it's been around for over 40 years with 15 offices globally. In terms of what we do, principally, we back general partners. So we do that across private equity, private credit and infrastructure and real assets. And we do that by investing directly in the general partners’ funds, by co-investing alongside those same general partners into their companies and also by doing secondary transactions with those general partners, either GP led or LP led transactions. I've been with HarbourVest for going on 19 years, I think next week. And I've been part of the secondaries business. And over the last couple years, I've become a leader of our credit secondaries business. CJ Doherty And now can you begin by talking about the growth you've seen in the private credit secondaries market, and if possible, quantify it for us? And also, why now? What are the main factors driving that growth? Greg Ciesielski Yes. So the market's grown quite rapidly. It's been doubling year over year over the last four years. So it's gone from basically $5 billion to $10 billion to $20 billion last year of total transaction volume. And this year through the first half, it's been $20 billion, so the same size as the market last year. So we're on pace to double or more than double again. So it's been one of the fastest growing parts of private markets. And what I put that down to, essentially, if I had to point to one thing, is the duration extension of private credit. If you think about the way that a lot of these private credit funds were raised, they were raised in the closed end fund format. And that really took off kind of in the 2018 timeframe. And people really thought of these as being a six-year vehicle. So three years to invest, three years to harvest, and then two-years extensions to wrap up the funds. The reality for investors has been that it's been much longer duration. So the median private credit fund actually hits a DPI of one times. So that means if you give them a dollar, you get that $1 back on a median basis 10 years into the life of the fund. So while the performance has actually been quite strong, the duration of the underlying funds has been very long, and that's led to the requirement to have a liquidity solution for an illiquid market. So that market existed in private equity secondaries. It's grown to a $200 billion plus market over the last 20 years. And that same technology has now been applied to private credit, which has led to the rapid growth and adoption in that market. CJ Doherty And following up on that, then what are the types of private credit secondary transactions you're seeing today? And how do they differ from those seen in the private equity secondaries market? Greg Ciesielski Yeah, so very broadly speaking, there's two key kinds of secondary transaction. There's what's known as a GP led and what's known as an LP led. So an LP led deal is someone selling their stake in a private equity fund. Usually it could be a pension or another person selling a large basket of stakes in a private equity fund to the market. The other transaction is a GP led. That's when a general partner seeks to move one or more assets from one fund to another fund and switch their underlying limited partners. So provide their limited partners liquidity within that transaction. That GP led deal is what really has driven the private credit secondaries market to date. But it's a little bit different than what you see in the equity side. In the equity side, the GP led market's really about chasing winners. You know, when a fund that could have 10 to 15 assets, you would do a single asset, maybe two or three assets in a transaction, come out of the fund and go into a new fund. In the credit market, the use case is really to wrap up a fund. So when you're seeing a GP led transaction in private credit, it'll have often 100 plus line items in it. It'll be in years five, six, seven of a fund's life. And it'll be used to provide the limited underlying limited partners liquidity within that vehicle. But it's a whole fund solution as opposed to just a couple underlying credits. So that's what really drove the adoption of the secondary market, was the need for that liquidity. That was about 80% of deal flow last year. But as that developed the market, the right cost of capital, so credit targeting cost of capital came into this market. And that's really driven the LP led side of the market because now you can sell your private credit interest at relatively strong pricing. So we've seen a rapid growth of that side of the market over really the last year, year and a half. And now we're seeing, you know, multiple billion dollar, billion dollar plus LP led trades. So both sides of the market are coming and it's been the result of the correct cost of capital coming and targeting this market. CJ Doherty Okay, great. Yeah, thanks for the nuances there. Next question is in what attracts investors to credit secondaries relative to putting capital into newly originated senior direct loans? You know, how does the risk return proposition differ? Greg Ciesielski So secondaries become a very accepted part of private markets. Most large-scale institutional investors will have an allocation to secondaries. And it's also become a very strong entry point into private markets for new investors. So that's applied to emerging investors as well. And why is that? Essentially, when you're doing a secondary deal, you're buying a fund that's fully ramped and you have visibility on the assets that are in the fund. So that has become a very attractive dynamic. When you think about what that means in a private equity context, that would mean that, you know, you have you have a lower downside risk because you have knowledge and visibility on what the portfolio is and you have a higher diversity. So when you apply that to credit markets, it actually becomes a very attractive dynamic because what you're buying is a fully yielding portfolio, so it's fully ramped, there's no J-curve or investment period. You have to come through. It's hyper-diversified, so you're really eliminating a lot of the esoteric risk, and you get full visibility onto what's in the portfolio. So from the risk side of the equation, you're able to dramatically lower your risk, and you also get what I call kind of the time traveler benefit. So if you're coming into a new private credit fund today, one example I use is you're taking a lot of, you know, AI data center risk because you're seeing, you're investing into that new market. And, you know, no one knows quite how that will turn out. But what we do know is that in three years, when that comes into the secondary market, we'll have more information on how that trade turned out, so you have a lower risk from that side. In addition to that, you get the diversification, you get the full yielding portfolio, and you often get some level of discount within these transactions. So the returns here also exceed what you're able to get in an underlying private credit fund. So it's a very powerful combination of a lower risk opportunity with potential to have higher reward on that side. So I think that's what's been very interesting to limited partners investing into the space. CJ Doherty There have been a lot of headlines and negative sentiment around private credit this year, particularly centered on software exposure. What's your view on the underlying fundamentals of the market? You know, is there a disconnect between investor sentiment and the actual credit performance of the asset class? Greg Ciesielski So I've been doing secondaries, as I said, for going on 20 years. And my overall sentiment is that things are never as good or as bad as people think they are. So I think just a couple of years ago, we were in the golden age of private credit. And then, you know, for the first, call it 100, 150 days of the year, I think there was a daily article in a major publication about how you know, private credit apocalypse and everything's going to zero. And I don't think either of those things were true. So on a fundamental basis, we believe the fundamentals of this market are quite strong. And we really like to do, I think it's become trade at this point, but kind of that baby with the bathwater trade of when the sentiment runs out, it's usually an attractive time for secondary market to come in and provide liquidity and stabilize that market, and it's driven a lot of deal flow. That being said, there are, you know, real stresses within the market. The rising rate environment does affect the companies, and we are seeing that come through, probably less so in software, but in other areas in consumer and discretionary. So I think both things can be true at once. I don't think anything even approaching the more dire scenarios was ever true or fundamental to the market and was a pretty big disconnect. But at the same time, we're going from what was a very benign credit environment to a more normalized cycle, and there will be, you know, further headlines and further issues within there, and the need to be able to do fundamental analysis. CJ Doherty And so given the amount of potential supply coming to market, how attractive is the pricing environment for buyers today? How much dispersion are you seeing in pricing between higher quality assets and more challenged or complex situations? And where are you finding the most compelling opportunities? Greg Ciesielski Yeah, so I would say if you found any credit secondaries pitch book over the last four years, even the most optimistic scenarios that you would see portrayed in terms of market growth have been outpaced. I don't think anyone was quite ready for how quickly this adopted, how a set of several factors came together, and this market came together very quickly. So I think today, you know, with the market run rating towards $40 or $50 billion, it's substantially outpacing the ability to form capital to acquire in it. So it's created a very attractive buying environment as supply has outstripped demand. Which, by the way, was, if you look at the analog of the private equity secondary market, was a dynamic that existed for, you know, well over a decade. So it can be a long-term dynamic in a market that's growing extremely quickly, which this one is. And that's led to a wider discount environment as you can imagine when that dynamic occurs. So I think we're in a very interesting place in terms of ability to buy well in this market and capture those discounts. When you asked the question about high quality versus challenged or more complex situations, I think within a secondary market, not everyone's the same. Different people do different things. The HarbourVest kind of house style is we focus much more on the higher quality end and alignment with the general partners we're investing in. And that's been a very strong risk return for us throughout our history. So I think we find that incredibly compelling. And as I said, when people are willing to sell some of the highest quality managers and the highest quality assets at attractive discounts, it's a very interesting time to come into the market and buy. CJ Doherty And final question before we wrap up. Looking ahead, what is your outlook for private credit secondaries and how do you see the market evolving from here? Greg Ciesielski I think even by the most pessimistic scenarios, just given the size of the private credit market, I don't think I've ever seen an asset class there's more disagreement about what the size of it is. But you know, if you look at whatever number you pick, $2 trillion, $3 trillion, and applying, you know, the secondary market turnover of 2, 3, 4%, so even just making the most conservative estimations you could, the scale for growth here is very large. And I think the persistent secular trend here is very clear. When you ask about where the market's going to evolve, my inclination is that today we're really taking tools from the private equity secondary market and applying them to credit. As I go out there, I think there are very specific use cases within private credit where new transaction types and new solutions are going to start to emerge from the frontier players in this space. And you're going to see a further unlock as we create more targeted technologies beyond just the plain vanilla LP led, the GP-led that apply to this market. I think that could really spur further growth. So I expect further growth and further innovation through the coming years in what's a very nascent market and emerging market. CJ Doherty And with that, we'll bring today's conversation to a close. Greg, thanks very much for taking the time to join me. It's been great to hear your thoughts. Greg Ciesielski Thank you very much, CJ. Appreciate your time. CJ Doherty And thank you all for tuning in. As always, I invite you to check out our private credit news, data and analysis on Loan Connector and BDC Collateral. And a quick reminder to join us at the LSEG LPC Annual Loans Conference here in New York on October 29th, where we'll have a full day of discussions on the latest trends across the private credit and syndicated loan markets. I'm CJ Doherty. Thanks for listening. 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