Primary private credit now encompasses far more than senior or stretched senior strategies. Is this the same with secondaries?

If you look at the secondary market as a ‘release valve’ for private credit investors seeking liquidity, I’d say two thirds of that liquidity need is in senior focused private debt funds, but the other third is in opportunistic credit funds. What do I mean by opportunistic credit? Funds focusing on strategies such as distressed, special situations, asset-based lending, growth lending and structured credit.

What’s the investment case for opportunistic credit?

You have all of the benefits of credit secondaries: value, as you’re buying at a discount to the reference fair market value of a portfolio; visibility, as funds are three or four years into their investment period; immediate cash yield because funds will be outside of their investment periods. But there are also some notable extra benefits related to these factors that are specific to credit opportunities.

Which are?

Visibility is key. Three or four years into a fund, you can see if deals have de-levered as promised, if performance is in line with the initial business plan, and you’re past the initial period where there are often meaningful EBITDA adjustments. Essentially, the fund is seasoned. In an opportunistic fund, you can start to see if restructurings and workouts are delivering as promised and that the companies are on the right track.

Can you tell me about how you underwrite a distressed debt secondary transaction?

Distressed debt funds generally acquire direct loan positions on the secondary market either with a pull to par strategy, or loan to own strategy. They may also provide new capital injections to businesses impacted by the economic cycle or in need of a management transition. Investments in debt instruments in these types of situations can pose a more binary risk at inception, based on uncertainties arising within restructuring or work-out processes.

Entering via a secondary transaction into one of these distressed debt funds, you can better identify whether the restructuring is going to be successful, and identify value in portfolios where the current fair market value held by managers in their funds is truly reflective of operating performance. Managers are generally conservative in terms of reflecting business recoveries and uplifts in these types of situations. A secondary buyer can spot value inflection points given the visibility of what we are buying.

What are the ways secondary managers can add incremental returns to the investments they make?

There are a few levers that secondaries investment managers can pull to create value for their investors. The first is the discount to acquired fund net asset value, which both drives return and provides downside protection. There could also be the benefit of the ‘pull-to-par’ element for those loans marked below par.

Modest and prudent use of leverage and fund management techniques is another angle. Most managers will have a short-term fund facility backed by investor unfunded commitments. Some secondary managers use SPV-level debt, adding anything from 25-50% of the transaction’s size in leverage to enhance returns.

We’re very conservative on leverage in our funds and in terms of leverage on a look-through basis through to the funds we purchase. The beauty of secondaries is that levered funds are already paying down their leverage at the end of the term of their vehicles and you can identify the health of the portfolio, avoiding acquiring levered funds with substantial credit concerns.

Are there any blockers to scale in private credit secondaries?

In one sense, the adoption curve in private credit secondaries has been steeper than its predecessor, private equity secondaries, precisely because PE secondaries have been active 20 years and laid the investment case down. GP-solution secondaries - a fast-growing segment of private credit secondaries - are more complex, highly negotiated and require scale. The challenge here is therefore lack of capital and skills.

Why is the demand for GP-solution secondaries growing?

With a slower pace of refinancing activity in the market, several funds are getting to the end of their seven-year term, with higher-than-anticipated levels of investments remaining in the fund. While there are potential fund extensions, GPs are coming under increased pressure to generate liquidity, which is driving managers to look to the secondary market to find a solution for their LPs. They can either facilitate a sale of the LPs’ remaining exposure in an older vintage fund to a buyer such as Pantheon, or alternatively propose a continuation vehicle to transfer the remaining assets of a vehicle to a new vehicle where the manager stays in situ. The result is a structure with a more appropriate time horizon to enable value maximisation for the portfolio.

All the above requires strong GP relationships, manager skill and sufficient capital. GP-solution secondaries can be quite a visible process with a lot at stake for the GP so they want to ensure that they are partnering with a knowledgeable counterparty with the ability to structure a transaction that can enhance that reputation. In this regard, GPs are also keen to ensure that the secondary buyer is a strong institutional investor with a long-term partnership approach.

Does this skills gap work in your favour?

For credit opportunities, given the additional difficulty of pricing and understanding these more specialist strategies, investing successfully requires a specialised team, a track record of executing similar transactions and a strong GP network. These are the foundations of a successful secondaries business and typically take a significant amount of time to build. However, once established, it’s an area where secondary buyers can identify highly attractive credit opportunities with the potential to generate equity-like returns.

You’ve closed the Pantheon Credit Opportunities Fund II at $590m. Can you tell me more?

It specifically focuses on secondary fund investments in high-quality credit portfolios, primarily in the US and Europe, with a focus on downside protection, targeting a mix of both senior and junior debt strategies and assets, as well as opportunistic exposures including distressed, special situations, growth lending, specialty- and asset-backed finance.