Last year saw a record 12 months for secondaries transactions – Ares Management sized the market at $12.4 billion of deals in 2022, up 17 percent on 2021.
However, it was very much a year of two halves. Most activity happened in H1, and could generally be attributed to a handful of large fund recapitalizations, but movement ground to a halt as interest rate rises led to a questioning of valuations. A stand-off emerged as buyers refused to accept sellers’ over-optimistic pricing.
Against this background, there are underlying changes in the shape of the secondaries private real estate market. There is a small but growing cohort of managers successfully raising billion-dollar funds, which leads to questions as to whether their influence is healthy for market dynamics.
Key players in the space are not concerned, however. In fact, recurring sentiment is that these developments are positively exciting rather than being a problem.
The small group of large players in the market is led by Ares and Goldman Sachs. Scott Koenig, head of the real estate secondaries business at Neuberger Berman, is clear that the big players’ influence is healthy for market dynamics. “We believe a deeper buyside in real estate could… help to draw new sellers to the marketplace, which could significantly grow volume in the space.”
An evolving area
David Kamo, secondaries and M&A partner at Goldman Sachs, argues: “It is no secret that the secondaries market is capital constrained. In our view, there is a lot of available supply, and the more capital that flows into the space, the better.” According to Kamo, any narrowing of the supply-demand gap would be good and “part of the market’s maturation – just like in primary private equity.
“There will eventually be funds for every flavor of investing – mega-cap down to small deals. These are different risk profiles and require different underwriting skills. LPs will benefit from greater dispersion and proliferation of fund strategies within the real estate secondaries space.”
This perspective is shared by other market players, regardless of size. Jeffrey Cho, managing director, real estate secondaries at Portfolio Advisors, applauds the “healthy growth in market participant numbers… [which] demonstrates that a diverse pool of experienced investors with different expertise and cost of capital are recognizing the opportunity. As the market continues to grow and mature, it is an exciting time for all involved.”
Michelle Creed, partner and co-head of secondaries in Ares’ secondaries business, thinks the smaller players can carve out niches, something Cho very much agrees with. He says: “We are able to leverage our two decades of experience and relationships in the primary real estate investing arena to create a unique competitive advantage in the opaque secondary market.
“We are not just a ‘financial buyer’ to sponsors, which gives us access to fund interests managed by restrictive sponsors, and the most up-to-date information when underwriting.”
BGO Strategic Capital Partners’ second secondaries program raised $1.2 billion. Sarah Schwarzschild, managing director and co-head at the multi-manager platform of BentallGreenOak, says: “We have a middle-market focus. There is space for all the players in the market, including those who raise smaller funds.”
Some market commentators make the valid point that the very largest players tend not to wish to disclose their portfolio details to rivals and rely on smaller specialist secondaries operators to provide liquidity.
According to Creed and Schwarzschild, it is also important that the nature of the deal has changed. As Schwarzschild says: “The kind of deals have expanded – whereas it used to be mainly LP stakes, we now see more GP-led deals. Secondaries have become liquidity solutions to LPs and GPs alike.”
Josef Menasche, vice-president in the secondaries advisory team at Goldman Sachs, believes there was a significant increase in the number of GPs exploring continuation funds and other secondaries transactions. “Without access to debt financing and a challenging public market environment, routes to liquidity to LPs were limited.”
Secondaries investors realized that they were one of the only sources of capital available to potential sellers, and leveraged their position of strength accordingly, Menasche says. “As a result, pricing came down in the second half and while we were fortunate to not experience this in any of our transactions, we saw an increase in the number of failed processes across the market.”
But Menasche again ties this into the changing shape of the market. “It is really a natural development in the market as it matures.” GP-led transactions allow secondaries investors to generate more alpha by backing sponsors who have high conviction in specific assets.
There is of course a greater level of risk with more concentration, especially when compared with a diversified portfolio of LP interests. Menasche says: “We believe that move up the risk-return curve is why you will see more dedicated GP-led funds raised on a standalone basis or alongside flagship secondaries programs with a broader remit.”
The 10 largest real estate secondaries funds to close between 2013 and 2022 (Source: PERE) Click to enlarge.
Rising interest rates and SVB
Rising interest rates have brought about a liquidity crunch in the market for real estate in general. But as Schwarzschild notes: “Secondary players are providers of liquidity and therefore this current situation provides us with a lot of opportunities.”
She sees several factors that could drive dealflow. “It could be, for example, where a GP has an LP that needs to exit, and the manager may not want to sell at this time. There will also be areas of opportunity driven by refinancing given that the cost of finance is so much higher today than it was. Borrowing levels have come down and the amount of debt capital is increasingly limited, so it may be also that managers might need to inject new equity.”
It is too early to be sure of the exact effect of Silicon Valley Bank, but in general terms, Schwarzschild thinks it will further exacerbate the liquidity crunch. “It is likely to mean that banks are lending less once more, helping the secondaries environment.”
“There is space for all the players in the market, including those who raise smaller funds”
Sarah Schwarzschild, BGO Strategic Capital Partners
Cho agrees. “In this current market climate, we are seeing investors increasingly turning to the secondaries markets in search for liquidity. This is an understandable result from the volatility in rates and the regional banking crisis, reducing much-needed liquidity from the capital markets.”
Higher rates are leading to a bid-ask spread on real estate secondaries transactions. According to Cho, it is taking some time for the seller’s pricing expectations to adjust to today’s new yield environment. “We think that is normal for any markets, and we think fourth quarter valuations will help in bridging the bid ask spread,” he says.
This appears to be happening now. “Buyers and sellers today seem to be aligning more than they were at the end of 2022,” according to Kamo. There is a general appreciation from sellers that we are in a new valuation environment and that it is unrealistic in most circumstances to expect to receive 2020-21 valuations today.
Kamo laments that “a lot of time was spent on broken deals last year,” but adds: “What we are hearing is an understanding from buyers that few sellers are truly ‘price takers’ and that the deep discounts offered in some deals were not sufficient to generate interest from LPs in selling. Buyers are adjusting their pricing accordingly.”
The outlook is complex, depending on time horizon. In the near term, Koenig recognizes the “cyclical opportunity.”
Kamo says: “Overall, it feels like the market is in a good place right now. There is capital out there for deals with high-quality assets and sponsors where there is a clear rationale for the GP remaining in control, and price expectations are settling at levels that generate a fair return for both existing and new investors.”
Looking out to the medium-term, as the real estate secondaries market continues to mature, Cho is “excited about the potential to use GP-led transactions to execute on our thematic investment approach while opportunistically taking advantage of the discounts available in the LP secondary market.”
Longer term, that optimism rises further. Koenig believes “there could be a secular, long-term opportunity, as the private real estate asset class continues its growth, and the secondaries marketplace gains even greater awareness and acceptance among investors.”
Schwarzschild is also of the opinion that the future will be an exciting time for real estate secondaries. “That $12 billion of transactions last year could rise to $20 billion, considering the overall value of the industry. Currently, turnover is just 1 percent that amount in the secondaries, and 2 percent will be quite possible, taking us above $20 billion.”