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Private Credit 

Sami Vukelj

The illiquidity premium is central to the private credit offering. When investors buy into private credit they trade liquidity for yield.

At least that was the old formula. Today, credit secondaries investors look to alter that equation, by offering exits to LPs, whether they need to rebalance their portfolio, or require immediate cash.

Brian Laureano, CIO of the credit secondary specialist, FoxPath Capital Partners, spoke to 9fin about some of the misconceptions about credit secondaries, why he expects more GP-led deals, and the key distinctions between credit and PE secondaries.

1. FoxPath’s launch was announced in November of last year – what about the current state of the market prompted you and your team to enter into credit secondaries?

Prior to being a credit secondary investor, I was a direct investor in both the senior and opportunistic credit markets. The Covid-19 pandemic was a wake-up call for many investors in private credit — including myself. It was tough to predict the future state of the market environment and when the pandemic was going to end. Credit funds were getting hit with unexpected R/C draws and potential mark downs in their holdings. LPs were over-allocated due to the denominator effect. Private credit needed liquidity…and the development of a more robust secondary market.

Our team has been navigating the credit secondary market since its early development back in 2020. In just the last twelve months, we’ve seen deal flow in excess of $25bn with a limited pool of capital for the opportunity set. In addition to market-related events, we’ve witnessed a trend in active portfolio management across the private markets. We have conviction on the current and future state of the market, deciding to launch FoxPath as a purpose-built platform dedicated to capitalize on the tailwinds and need for liquidity across the private credit ecosystem. We’ve leveraged our experience and responded to feedback received from market participants — LPs, credit GPs, and secondary advisors — to structure a firm that is purpose-built for the opportunity.

2. What are some of the factors that you anticipate will be driving secondaries activity this year?

As a baseline, we believe there are natural factors that will drive a heightened velocity of credit secondary opportunities over the next several years. Out of the $1.2trn of unrealized NAV across the private credit markets today, over $700bn sits in 2018-2021 fund vintages. These seasoned credit portfolios are ripe for secondary transactions, where sellers await realizations on illiquid fund holdings and buyers look to uncover value in predominately funded exposures. Market estimates have private credit growing up to $3.5trn in AUM (from $1.7trn currently) by 2028, which we expect will create a sustainable flow of secondary investment opportunities. According to the Lazard 2023 Secondary Market Report, around 83% of LP-led secondaries result from liquidity-oriented or active portfolio management objectives. Liquidity needs and active portfolio management are foundational elements of being an investor, which are unlikely to go away.

Secondly, market awareness is increasing, but still there is work to be done. Given private credit secondaries are relatively nascent in comparison to the private equity secondaries market, spending additional time discussing transaction structuring, secondary processes and pricing is critical to originate transactions. It is on us, and the broader market, to drive further awareness of our product and its benefits. Though the fund turnover ratio for credit has significantly increased over the past few years, it is still far from the 2%-4% of unrealized NAV seen in other areas of the private markets. As this gap narrows, we expect volumes to increase.

3. Direct lending funds have been a popular source for stake sales and purchases, but are you seeing opportunities in other private credit strategies?

Given the rise in direct lending over the last several years, we’ve seen a heightened level of those funds trade in the secondary market. Despite its growth, the private credit market is still relatively evenly split in terms of AUM in traditional direct lending and opportunistic credit fund strategies. Our team sees investors in special situations, distressed, and asset-backed finance funds frequently tap the secondary market for liquidity. Given the heightened level of complexity associated with these fund strategies, they do tend to trade at wider discounts than senior secured direct lending funds.

FoxPath invests on both ends of the credit spectrum. We believe having the ability to navigate across the private credit markets, where we identify value, is crucial in maximizing the credit secondary market opportunity. Sellers (and brokers who manage the secondary sales process) often look for multi-fund liquidity solutions across both senior secured and opportunistic strategies. By providing a holistic liquidity solution, we are often able to capture enhanced value on the blended transaction and gain preferred partner status on secondary transactions where ease of execution is a key factor.

4. People often point to the rise of the PE secondaries market as an example of the potential for the growth of credit secondaries, and draw parallels, but what are some of the biggest distinctions between equity and credit secondaries that investors should know about?

In addition to cost of capital considerations, private credit is self-liquidating. As such, understanding transaction rationale is key to ensure there is a clear motivation for a secondary transaction and no inherent bias on quality. Despite the self-liquidating nature of the asset class, hold periods can be nearly as long as private equity holds — direct lending is largely a derivative of private equity-backed leveraged buyouts and are typically structured with a term of five to seven years. Liquidity, on the other hand, is a daily consideration, so although the asset class does have contractual maturities, there are idiosyncratic, but recurring, liquidity needs of private markets investors.

Separately, valuations for private credit and private equity are vastly different. There is less subjectivity to private credit since your principal upside is par value. Many valuations utilize a cost and accretion to par approach (absent material underperformance). As such, we believe precision in underwriting credit secondary transactions is crucial to ensure an attractive risk-adjusted and downside protected investment. We take a bottom-up approach to investing, focusing on asset-level due diligence first and foremost.

5. What is the breakdown between opportunities that are LP-led and GP-led in the market these days? Do you anticipate either one becoming more or less popular in the coming quarters?

In terms of pipeline, GP-led secondary opportunities are picking up in pace. Historically GP-leds have made up just 15%-20% of closed transaction volume. In the $4bn of opportunities our team has seen in the last few months, roughly 40% of volume is coming through GP-led secondary processes. These often take the form of strip sales to help GPs bolster their capacity for deployment, but can also resemble continuation funds to solve issues driven by regulatory changes, need for distributions or catalysts such as strategy shifts or spin-outs. As we saw in the PE secondary market, we believe the market adoption of GP-leds will contribute significantly to market growth in the coming years.

6. We’ve seen several large firms launch credit secondaries strategies in recent years. What is the key way to differentiate yourself in the space?

We are 100% aligned with the market opportunity, providing liquidity to investors in both traditional direct lending and opportunistic credit funds. We specifically tailored our platform to leverage our team’s direct underwriting experience in the private credit markets, in a secondary investment construct. We take the merits of each transaction, without bias, and are able to move quickly with a team and investment committee that is trained and solely focused to invest in credit secondaries. With that, we are able to manage expectations appropriately with our counterparties and provide ease of execution, navigating the complexities of each transaction. As the sole independent firm focused on the space, FoxPath is free of conflicts or impediments to receiving full diligence information on the portfolios we underwrite.

7. Does there remain an education process about the asset class as it begins to become more mainstream?

Absolutely — particularly with credit GPs. We have taken note that the private credit markets are increasingly becoming competitive, so a partnership with a secondary firm is accretive for GPs and their LPs. Lenders are still able to get the illiquidity premium on yield, but now have flexibility to effectuate strategic transactions with secondary market participants that are mutually beneficial.

For example, to lead transactions directly, credit GPs have to speak in size. Over time, that creates concentration issues in terms of portfolio construction. GP-led strip sales to secondary buyers allows GPs to actively manage their portfolio while still maintaining their sponsor relationships. For us, we get access to a funded diversified portfolio of performing, yielding credit investments that we can underwrite with the benefit of historical performance data. A win-win for both parties.

On the LP front, we feel that we and our peers have done a great job at educating the market on the favorable investment attributes of credit secondaries: A value-oriented avenue to invest in private credit with a mitigated J-curve, reduced blind pool, and increased level of diversification. For investors who are under-allocated in the private credit asset class, the credit secondary strategy is an efficient means to access exposure to a multitude of fund managers, strategies, and vintages with a shorter duration.

8. What are some of the biggest misconceptions about the secondaries market?

“So you are buying stuff that others don’t want?”

This is a question we often get from investors, and it’s understandable. Yes, there are some “tail-end” credit funds that have a degree of selectivity bias. It is on us to navigate the market and avoid these equity-like, concentrated fund exposures. It is not core to the FoxPath strategy. That being said, liquidity needs are recurring and investors actively manage their private markets exposures. Focusing on the rationale of transaction first, helps us understand seller objectives contextually and is an important consideration. Often times, it is not an LP bringing a select few credit funds to market, it’s typically a broader rebalancing exercise across their alternatives exposures. Our specialization and independence enables us to partner with other asset class focused secondary buyers to create a holistic liquidity solution on LP-led transactions.

9. What do you like to do in your free time?

As a Long Island native, it pains me to say this, but my wife convinced me to move to New Jersey. And it’s actually not that bad. Fine, it’s great…there is a catch though, the property is a farm, which came with a herd of alpacas that we now care for. My wife manages our farm, where we host field trips, farm tours, and charity events — it’s rewarding to see the impact nature can have on people. Suffice to say, I like the outdoors. Feel free to reach out and ask more…or if you’d like warm alpaca socks.

But as a credit secondary investor, liquidity and returns first and foremost!

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9Questions — Brian Laureano, FoxPath — Bringing liquidity to private credit

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