Private credit’s growth into a more than $1 trillion asset class has fueled an increasingly active secondary market for private debt stakes. The secondary market is poised to grow faster as institutional investors, hit by markdowns in equities and other assets, face pressure to unload private holdings that have become disproportionately large segments of their portfolios, investors interviewed by Reorg said.
Institutional investors such as pension funds and endowments are typically restricted from exceeding certain allocation percentages to various asset classes. An institution might be barred, for example, from allocating more than 40% of its total portfolio to private equity and 30% to hedge funds. When other areas of a portfolio lose value, the institution can become overexposed to certain assets and exceed those thresholds, leaving it in violation of mandates.
Secondary trading can offer a solution. An investor overexposed to private equity or private credit may tap a broker or its own network to help find a buyer - and in so doing come back into balance with allocation rules. Changes in leadership at funds have also helped drive the market, as new investment officers impose different strategies and tailor their exposures accordingly.
“You’re seeing [limited partners] taking more active management of their private-credit portfolios in particular, selling all sorts of private exposures,” said Rick Jain, global head of private debt at Pantheon. “When you historically have had a lot of different parties coming into an illiquid asset class, you’re going to have a need for liquidity.”
Private credit, or direct lending, offers small and midsize borrowers an alternative to bank lending, and as a global market it’s expected to grow to $2.69 trillion by 2026 from roughly $1.25 trillion today, according to Preqin, a data provider. Regulatory changes enacted in the wake of the Great Financial Crisis of 2008 tightened underwriting standards for banks, creating opportunities for nonbank lending by private equity firms and business development companies. Private credit typically offers investors higher returns because of the risks of lending to less capitalized companies.
For prospective buyers, the private credit secondary market offers a way to access funded private debt paying yield that has matured beyond that “J-curve or drawdown period of private credit,” Jain said. Pantheon’s deal flow this year is on track to be up 10% over 2021, when it saw deal flow of about $18 billion.
Secondary-market buyers also have the benefit of being able to choose debt that has improved in credit quality and to negotiate prices with sellers. They can weigh the advantages of potentially higher-yielding instruments against the risks of more defaults in a tougher rate environment, treating private credit in much the same way as other types of assets.
“We have pretty good transparency in terms of what’s in the portfolio, and we can do our work as to what we think of those assets and what price we’re willing to pay,” said John Kyles, managing director at Portfolio Advisors.
General partners are also increasingly interested in using the secondary market as a way to extend the life of funds or gain access to new capital, Jain and Kyles said. It can help managers secure returns and fees, too: A GP may initiate the sale of legacy credit assets in a fund that has performed well to a secondary buyer in order to “crystallize performance, carry or fees and accelerate the return of liquidity to that account,” Jain said.
The space is drawing strong demand from investors. Secondaries player Coller Capital earlier this year raised $1.4 billion for its first credit secondary fund, the “world’s largest pool of LP capital dedicated to private credit secondaries,” it said in a statement.
“If you buy a book of four, five, six LP positions, you’re potentially collecting anywhere from 300 to 1,000 line items,” said Ed Goldstein, chief investment officer for Coller Credit Secondaries. “You can get a pool of attractive names at a discount with diversification.”
For investors in the secondary market, a tougher rate environment might complicate the process of finding good opportunities in private debt. But the benefit of higher yields on floating-rate instruments will probably offset the increased risk of defaults, Goldstein said.
Investors say they expect private debt secondary trading to mature in a similar manner as secondary markets in private equity. There, volume has grown from $24 billion in 2011 to $130 billion last year, according to Coller. Changes in funds’ investment strategies and in their leadership ranks that have helped fuel the growth of the secondary market in private equity will also spur private debt trading, investors said.
“Whatever is happening in the private equity secondary market is going to happen eventually in some form or fashion in the private credit secondary market,” Kyles said.
–Alex Wittenberg