Our guest is Andres Hefti, Partner at Multiplicity Partners, an investment firm specialised in providing liquidity solutions to holders of private market funds and distressed assets.
He explains how Multiplicity Partners shifted from being an advisory firm to becoming themselves an investor in PE secondaries. Mr Hefti shares his experience and enthusiasm for the secondary market and takes us through some real life examples that demonstrate why this asset class is so promising. He gives us a direct view into how his firm sources and values opportunities. And we also get some great pointers on best practices and what to avoid when pursuing a secondary deal.
Andres Hefti has over 20 years experience working in alternative investing, distressed investing and portfolio management. Prior to joining Multiplicity Partners, Andres was the Chief Risk Officer and head of Investor Relations at Active Alpha, a Swiss hedge fund. Listen on Spotify / Apple Podcast
About the secondary market and secondary transactions
Andres Hefti: “If you’re an investor investing into private equity, you need to have a long-term vision and things can change over that 10 years or, hopefully, take much more than 10 years to fully get out of that private equity fund again.
So let’s assume you’re a pension fund and that there’s a change in the CIO. And the new CIO is looking to shift more focus on liquid assets. So you may want to rebalance your portfolio at some stage before your private equity funds have matured. And, there, the secondary market offers you an exit option. This is where we come in. This is where thousands or hundreds of secondary buyers come in to basically allow investors having more flexibility with the private equity investments.
I think there were three factors that led to the massive growth in the secondary market from one billion many years ago to 10a hundred billion today. One is the basic fact of the whole private equity industry growing rapidly. So today there are much more assets in private markets than there were 20 years ago. Second thing is also the whole industry has naturally become much more mature. There are more investors that have already been in private equity for 10 years or more. So there’s more LPs that are looking at some point to get an exit. It is usual that in the first few years, after having invested into private equity, that you’re still happy with it, but after seven or 10 or 15 years, you may reconsider your strategic asset allocation. So that has grown a lot. It’s much more mature. And the third thing is the secondary market has developed a lot. So initially there was primary focus on the very largest buyout funds, the brand names that you could easily trade in the secondary market today… Now, there is a whole ecosystem of secondary players, some focusing on young funds, some focusing on tail-end funds like ourselves, some focusing on VC funds, some focusing on real estate, private equity funds, and so on. There are even investors in the secondary space that provide preferred equity solutions or similar structural solutions and so on. So it has really become a much more diverse tool set that is available to do secondaries.”
How industry players are now seeing the secondary market
AH: “I think the whole perception has changed a lot and this has also helped to grow markets. I think 10 years ago, it was almost a bit embarrassing to knock on the doors of the chief and say: ‘Sorry I signed up for 10 years, but now after seven years I want to get out. I want to inform you as the fund manager that we’re talking to secondary buyers.’ That stigma is no longer there. And that generally most GPS are very accommodating to facilitate secondary transfers.”
When sellers should hire an advisor and how that has evolved
AH: “If you look at the secondary markets, most of the sellers are more or less one-off sellers, and most of the buyers are professional secondary players who do nothing else for a living than secondaries. So I think clearly it does make sense for many LPs to take an adviser, an intermediary to launch an auction process for their interests. There are just so many more secondary players and a lot of the portfolios that are sold are split up today. There may be a large buyer interest just like for the largest buyouts funds positions in a certain portfolio, but then there are potentially also some real estate or venture funds where other buyer specialists in that area have an edge and pay you a higher price. There is much more potential to add value out as an advisor, I believe. I think if there’s a certain size of the transaction, let’s say 20 million plus or so it is certainly making sense for the seller to consider an adviser from an intermediary.”
About the team’s background and how that has influenced the investment strategy
AH: “If you look at the investment strategy that we follow here at Multiplicity, you can only really understand it if you look at our background. Multiplicity started as an advisory firm or an intermediary back in 2010 and actually our very first goal at Multiplicity was to liquidate or sell a portfolio of illiquid hedge funds. So our previous employer Horizon 21 used to be a large Fund of Fund platform, investing in those hedge funds in private equity. And after the financial crisis of 2008, we ended up having several hundred million dollars worth of hedge fund exposure that turned out to be very illiquid. The liquidation dragged on to 2009 and 2010. And eventually in 2010 and 2011, we auctioned off these hedge fund side pockets to dedicate that to hedge funds, high pocket buyers, certain private equity, secondary groups that also looked at these types of illiquid fund structures as well as certain opportunities to be like family offices. We then did similar mandates for other institutional investors, mostly around Switzerland and in certain German-speaking European countries. From then on really, we did more and more private markets, secondaries of all sorts where we usually helped the seller through the process. So we started getting a really good understanding of which secondary deals are competitive and which ones have great difficulty finding a new home. So we have really worked on numerous cases from 2010 to 2015, where we could really hardly convince anyone, or sometimes we could not convince anyone of even putting in a bid to acquire those interests.”
About the difficulties of dealing with secondaries
AH: “There’s a certain minimum size that most buyers want. We are one of the smallest players. Most of our transactions are up to five million purchase price per individual fund type we buy. So we’re running a very small stent thoroughly. I think we are a handful globally that would look at any deals below 5 million. There is much more interest for transactions above 10 million purchase value. So, most often it’s down to size. And then a second element, which makes secondary easier or harder is the name recognition. So even if it’s some $1 million position off the Blackstone fund, it may be quite easy to find a buyer – maybe a family office who just says: “you know, oh, Blackstone, can’t be so bad. Let’s pay anybody.” So if you go to more niche funds or less well-known funds, it’s getting much more difficult.
We also recognized that typically buyout is relatively a liquid part of the private markets universe. You have the vast majority of all the secondaries — we estimate about 90% is actually happening in buyouts. There are secondaries in ventures and private equity, real estate, private debt and infrastructure. But these are actually very small market segments so far. And recognizing these patterns, we really said: “Okay, there are certain deals where we know it will be very difficult to find something.” So if we are looking at a sub 5 million deal, let’s say in real estate and in a fund that is not Blackstone and it’s not very well known… it’s going to be very difficult to find any buyer.
And that’s how we developed our investment strategy. And this is what we are focusing on today. We really said: “for me to really see that there are still certain gaps in the secondary market, our investment strategy is really an actual development of our work as an intermediary.”
A deeper look at a specific secondary transaction
AH: “If you look at the majority of private equity, secondary space, I think the secondary funds are primarily looking at growth. They’re looking to buy something in a fund that has relatively good assets with good EBITDA, growth prospects and underwriting a classical buyout secondary deal is mostly coming down to corporate finance know-how and experience, and we clearly do not want to focus there. We also have quite different backgrounds. The individuals here at Multiplicity have all been for more than 20 years in financial markets and we have the classical corporate finance backgrounds in hedge fund roles in structuring and so on. We always said we do not want to compete. So we are looking primarily at the investment opportunities where the outcome is not dependent on growth or whether equity markets go up, where there are certain authors, or idiosyncratic factors and risks, really like special situations. We’re currently looking at a buyouts fund that is at the very end of its life. It’s actually in its 15th year and they have certain companies that they hold in the portfolio still. One of them needs a recap, but there is also a very large risk to this particular fund. As the fund is subject to certain potential legal claims against it because they sold the company a few years ago and now the buyer of that company is making certain claims against the fund, the seller, the reps and warranties. So if you buy this fund, you do not only need to look at the underlying companies, but you need to make an assessment of how likely it is that the claim made could wipe out all the substance of the fund. If you underwrite this, you need to read the legal opinions. You need to check with experts in those countries about the potential that these claims are successful, how long it will take and so on… but this is a very different kind of risk that we are underwriting. But we have made such investments in private market funds, mostly at the end of their lives that end up in a kind of a difficult situation. There are other situations like real estate funds that ended up being a legal dispute with one of their joint venture partners in China. They’re having to spend quite a lot of money to pursue an arbitration process.
And we were facing a seller that wasn’t a fund of fund that was at the end of its life. So they really had to sell this position. It’s not an easy position. Nobody likes this kind of legal fights or in a portfolio. It’s not a convenient investment, but this is what we are here for. We’ve got to go open minded and look at these special situations, because a lot of the risks that we take are very much diversifiable. So if one case goes against us, it is unlikely that another one will be going against us because of that. There is simply no relationship between most of the investments that we do. It is very different compared to a buyout fund where a lot of the success really depends on where equity markets go and how the economy is holding up.”
About the typical equity risks vs special situation idiosyncratic risks
AH: “We group our portfolio in three buckets, so we target about 50% of the investment should go into really idiosyncratic uncorrelated investments. So this could be like the case I mentioned where the real estate fund was in a legal dispute with a JV partner in China. All depends really on the outcome of that arbitration process and actually. Most of the money is already there in cash. So if property markets go up or down, it will not really influence the outcome much. Now, in the other case where I said, we’re looking at the buyout fund that is holding certain companies, but this fund is subject to very large potential legal claims. There we’ll have a better outcome if equity markets go up a lot. So these companies will eventually be sold at a higher price and this is helping us. So all of the downside risk is coming from an idiosyncratic factor. Whereas the upside potential is still determined by equity market beta. So this is the second group.
So I would say about 50% of our investments are clearly idiosyncratic risks and about 30-40% of the investments have some sort of equity market exposure. And then you have about 10-20% where we do have relatively large equity exposure. So most of the outcome is really depending on how those companies in these funds can be sold and nothing else.”
About sourcing secondary transactions
AH: “We do not fully rely on Palico actually! Even though I’ve logged in again on the platform this morning! So we’re currently evaluating the new deal there. If you look at Multiplicity, we started in 2010 as an advisor and actually I always say, the first five years, where we purely worked as an advisor of the secondary market and we would spend almost 80% of our time on picking up, digging out new deals and shaking trees to find sellers who want to sell something. So this is, certain strengths that we have. I would say as we start to become investors first with our own money, and then in 2016, we launched our first fund — gradually we worked more and more also with intermediaries.
We have a very good network of intermediaries and advisors globally that we work with. And usually what our key messages to them is: if you’re working on a deal, that is kind of a hairy deal and where some of the usual suspects that they would contact for such a secondary are declining the deal, then think of us. So we really want to have the last call, not the first call, and then really focus our time only on those deals that have already passed on. This is a good way of communicating what we are looking for. And then we’ve done quite a lot of marketing also on generally making ourselves known as a buyer, particularly on niche assets.
So as I said, 80 to 90% of all the secondary activity in private markets is buyout, and there are like a handful of dedicated secondary players and infrastructure, in private debt, in real estate funds, but it’s actually quite little. And if you go even more niche, if you go to illiquid private funds in litigation finance, this is such a different animal that none of the usual private equity secondary players would really look at that. And we really wanted to promote ourselves over the last year, and year and a half as a buyer for exactly those niche topics where it is only really occasional that an investor is looking to exit. So, these markets in niche alternatives are often those who are a bit younger, since the market for these is not so big yet. And there are not that many funds that are overdue and where a seller is now looking for an exit. So we have really tried to make ourselves known as the buyer for those niche funds.”
On providing quick and efficient valuations for sellers
AH: “It comes down first to managing our time carefully. So we could easily get lost in analyzing three or four potential deals every day. Now we need to make sure that we focus our time and research on those cases and do a thorough due diligence of those cases where we have a highlight of closing a deal. Now that means first we make a copt and see, let’s say: if it is somebody showing me a sub 5 million position in a Scandinavian buyout fund. This is not something I will pursue any further. Because I know the market for Scandinavian buyout funds is really efficient. There are dedicated players there who know all these companies inside out. So I’m not going to waste any time there. Now, if it is a transaction that is potentially not finding a natural home with a specialist buyer, then, I’m already getting a bit more curious. But then still I would need to check for a specific seller about their motivations and their price expectations. Quite often, we look at something and say “you don’t need to be a genius to find out, this will, in all likelihood for us require a certain discount NAV”. So we will tell the potential seller. “Are you aware we would need to have at least a 20 or 30% discount on that one?” And this shies away, another 50% or so of the potential sellers. If you’re facing a situation where there is really no natural buyer for it, and they seem to have realistic price expectations, only then we start to dig deeper and then it really comes down to being curious, open-minded and having a relatively broad background.
So with five senior investment guys here in the team, all of which have 20 years of experience across different asset classes and all of us have relatively broad networks. Last year I may have looked at a fund which was in a pastoral land fund, owning cattle farms. Now I happened to know two old colleagues of mine who have invested hundreds of millions in this niche sector in real assets and various investments in Australian capital funds. So I was quite easily getting a good reference and background check. After we have an accepted non-binding letter of intent from the seller, if you’re really clear that they’re serious about selling it to us, then at the very end be able to do external checks with expert networks, with dedicated specialized law firms to check for certain risks. And I think even if we really give our best in understanding a certain situation, a certain asset, and its risks, we’re clearly aware that in some situations, there may be a big specialist buyer who just doesn’t like to pursue such a small deal. And then we may end up actually paying a much lower price than the market would offer. And we do this because sometimes we’re just not able to get enough conviction on a certain topic. So we are aware that in some cases we need to have a larger margin of error and we have less certainty than if Blackstone buys these types of assets. They deploy 1 billion, they can easily afford to spend 2 million on due diligence. We can not if you pursue a 2 million transaction. So eventually, we also to some degree price in certain ignorance by just applying a much, much larger discount than what you would see in the wholesale market.”
About offering cash or other options when pricing deals to sellers
AH: “We often look at funds that are relatively risky, so we focus on really mature to tail-end fund interest. And in many cases, it’s maybe a fund who’s only holding one asset. So it’s quite risky. It’s different from underwriting the five-year-old buyouts fund, which has 20 different companies. It’s very diversified… not that many things can go wrong. So we would prefer to offer a lower cash price upfront and then combine it with an earnout. So let’s say you pay 40 cents on the dollar NAV upfront. And then if the recovery or the target fund recovers more than 60% of its current NAV, then we would share some of the upside with the seller. And then it’s a win-win situation. Now in 50% or more of the cases we are dealing with sellers that are looking to liquidate an entity such as a fund of fund, so they can make very little use with earn-out payments that they will receive in two, three years down the road. The whole purpose of selling something in the secondary market is that they have cleaned up the balance sheet and can wind up the company. Unfortunately, it is only in about 10 to 20% of all deals where we can employ such earn-out features.
Your free advice on selling some funds on the secondary market
AH: “We see really long common behavior in the secondary market is that sellers are very much focused on NAVs. Whereas the buyers are all concerned about cash flows and how much money they will eventually get out of this investment. Now, I think this leads to a secondary market where an excessive amount of very good funds are traded in the secondary market, because most of the sellers want to get something around NAV for their interests. And then they don’t see how much upside they’re giving up. It’s almost as if they don’t care anymore. And they leave a lot of money on the table by selling to high quality funds in the secondary market, just to make sure that they’re not getting much less than what they have it in the books for. And NAVs are not something that you can eat. So also just buying something at a deep discount to NAVs is by no means a good investment yet. So what we have seen is that by analyzing previous data from buyouts funds over the last 20 years using Preqin data, is that when you look at a mature fund being like an 8 to 9 year old fund, you look at their NAVs, how they are ranked in their performance to see that top quartile funds, mature top quartile funds will return more than 200% of their NAV over their remaining life. Whereas the bottom quartile fund that is eight to nine year old will only return about 60% of what it saysor what the account says the book value is the net asset value.
Now this means, if you would be able to sell the bottom quartile fund at 60 cents on the dollar, we’re at 40% discount, you would be much better off as a seller or an investor compared to if you buy your very best funds at NAV, because if you make it, a hundred dollars for a hundred dollar NAV about actually over the next five, six years, you would have gotten like $200 back and this is now what ends up in the secondary buyer. This is also kind of a little bit of a price of a simplistic pricing framework that we often use to start discussion with a potential seller, because this is something that many are not really aware of, how stale the pricing is in if you look at it across hundreds of funds, there is a strong tendency that pricing is relatively stale, so good funds will continue to outperform and bad funds or companies that have not performed well in funds tend to be written down over time again and again. And this is something that is underappreciated and that’s what we think is really important for us to understand for investors.”