Competition in the private-equity secondary market is creating some unusual bedfellows.
As the balance of supply and demand for secondhand stakes in private-equity assets tilts in favor of sellers, some buyers are turning to co-investing with independent, or fundless, sponsors in their quest for attractive returns, according to market participants.
Secondary investors have not typically been a big source of co-investment capital for independent sponsors, a term that refers to investment managers that raise capital for each individual deal they back rather than investing out of a commingled fund. Many buyers were more focused on acquiring stakes in funds or, to a lesser extent, older stakes in companies within funds.
But a large volume of unspent capital held by secondary investors and a steady influx of participants into the market have intensified competition for deals. Investors in secondhand stakes of private-equity assets were sitting on a record $107.4 billion of unspent capital as of September 2020, according to data provider Preqin Ltd.
Added to that is the growing popularity of secondary deals driven by private-equity firms themselves, including ones involving a single company and a smaller pool of fund portfolios available for sale. Those forces have prompted some buyers to seek less heavily trafficked investment niches, including in the fundless sponsor market, according to Sunaina Sinha, managing partner at secondary advisory firm Cebile Capital.
“As a buyer you can get into one of the several adviser-led processes for single-asset deals and compete with dozens of your peers and kill each other and try to bid up the price,” Ms. Sinha said. “Or you can try to do something different, less competitive.”
Recently, for example, Cebile advised Seattle-based independent sponsor Westward Partners on its acquisition of insole manufacturer Superfeet Worldwide LLC, which the firm funded partly with co-investments from secondary firms Headway Capital Partners and Montana Capital Partners.
“There were actually several other secondary groups also interested in looking at this [deal] seriously, which I think is the advent of something very new in the market for [secondary buyers],” Ms. Sinha said.
Headway Capital has executed co-investments alongside several independent sponsors including Astara Capital Partners and Archimedes Health Investors, according to Cliff Meijer, managing director of the London-based firm’s U.S. subsidiary.
Co-investing in deals alongside independent sponsors can heighten returns in a secondary fund, said Peter Martenson, partner and global head of GP advisory, secondaries and direct deals at placement firm Eaton Partners.
“You are typically underwriting a three-to-five times return on invested capital,” he said.
But those returns may come with a different cash flow and risk profile than an investment in an older asset or diversified portfolio of assets, which often start producing cash soon after a secondary buyer invests. Because they tend to hold investments for shorter periods, secondary buyers typically look for co-investments that have potential to generate cash sooner, Ms. Sinha said.
Secondary buyers often are better equipped than more traditional co-investors such as pension funds to execute on co-investment deals, which makes them attractive to independent sponsors.
“They are used to tight timelines, they have the skill set to underwrite the assets and can move quickly,” said Gerald Cooper, partner at secondary intermediary Campbell Lutyens & Co.
But as more secondary buyers look to independent sponsors for deals, they could weaken the supply and demand dynamics that currently make this part of the market so attractive.
Mr. Meijer of Headway Capital said his firm has already witnessed increased interest in independent sponsor deals from other secondary groups.
“Nature abhors a vacuum and when there [are] opportunities capital tends to follow that. So I think with the continued growth of the independent sponsor [market], you’ll see a lot of other secondary players come in,” he said.
But he added that he believes some of the more recent interest from secondary firms in this corner of the market will be relatively short-lived.
“Once the supply of traditional LP interests returns to prior levels, many secondary groups will focus back on their core competencies, and likely reduce or abandon entirely their focus on independent sponsor-led transactions,” Mr. Meijer said.