Lazard: Secondaries hype yet to bear fruit

Increasing interest from institutional investors in secondaries has not yet materialized in transaction volumes, writes James Jacobs, head of real estate for Lazard’s private capital advisory group.

In April, there was an uptick in investor appetite to explore the secondary market. This desire to discuss, gain exposure to and participate in secondaries transactions is consistent with observations from earlier in the year. However, despite the conversations and general interest, transaction volumes have yet to catch up. The bid-ask spread has not yet closed enough to the required levels to transact.

James Jacobs

Many investors are exploring the potential to tap the secondary market in response to pressures to rebalance portfolios, access liquidity or simply to reallocate to different strategies in a changing market. However, it remains challenging to execute transactions given the continued high interest rate environment, equity market volatility and the broader economic outlook.

The bid-ask spread remains stubbornly wide for three reasons. Firstly, buyers have reverted to more conservative underwriting in the wake of the recent bank failures – this has reduced the ‘bid.’

Secondly, the pressure on sellers has alleviated for the time being, given the optimism resulting from the strength of the equity market rally earlier in the year – this has held the ‘ask’ relatively constant.

Finally, valuations have not adjusted significantly enough to help bridge the gap and bring expectations together. Existing owners point to the quality of their assets, the lack of precedent transactional evidence and the robustness of their current valuations; rental growth and operational performance have generally offset softening yields. Secondaries buyers, meanwhile, go to their investment committees underwriting steep discounts.

Secondaries buyers are becoming more creative to try to bridge the pricing gap. Preferred equity, deferred payment and earnout structures are frequently introduced to prospective sellers. These structures either enhance returns or augment the risk associated with a particular transaction. For example, preferred equity structures are less reliant on the valuation and pricing of an asset, given a significant part of the return is fixed and buyers have the equity subordinated to their position.

Notwithstanding the lag, we expect the requirement for liquidity and for creativity from secondaries buyers to continue, leading secondaries transaction volumes to pick up in the second half of 2023 once we get through the valuation cycle and pricing expectations adjust.