Show V/O:
This is Alternative Allocations, a monthly podcast where we share practical, relatable advice and discuss new investment ideas with leaders in the field. Please subscribe on Apple, Spotify or wherever you get your podcast to make sure you don’t miss an episode. Here is your host, Tony Davidow.
Tony:
Welcome to the Alternative Allocations podcast series. I'm thrilled to be joined today by Taylor Robinson, partner at Lexington Partners. Taylor, welcome. Thanks for joining us.
Taylor:
Tony, thank you for having me.
Tony:
So, Lexington Partners, you guys have been in the secondary market for quite some time. Maybe just give us a little bit of the background of the firm and then I'd like to delve a little deeper into what are secondaries.
Taylor:
So Lexington Partners is really a blue chip name within the alternatives universe, probably less well known outside that. And with RIAs and individual investors, we really are one of the pioneers of what is today a growing secondary market for private equity. And when I say private equity, I also mean all of the alternatives. So it's private equity, it's venture capital, it's growth, it's infrastructure, mezzanine, private credit, anything that resides within a fund structure where LPs need liquidity at a time of their choosing. That is what secondary is for. And so we've been around independently as a firm for 30 years. The origin of the firm goes back farther than that. We were actually the New York office of another secondary firm. But we became Lexington Partners 30 years ago. Pretty exciting. And we are today one of the largest, oldest blue chip firms in that market.
Tony:
And as you mentioned, secondaries were once considered a niche, sort of part of the private equity ecosystem. But clearly there's been incredible growth. I actually just wrote a blog on the growth and diversity of opportunities in the secondary market. Maybe for the listeners here who may not be familiar, what is a secondary and how does it work? And why have we seen such incredible growth over the last several years?
Taylor:
I spent time over the last couple of days with our interns, and it's sort of the perfect way to test how you describe what is secondary. Look, I take everything we do in our market back to this archaic legal structure of the private equity fund. So if you think about the alternatives, everything we do in our market sits within a fund structure. And a fund is just an agreement between the limited partners, the investors, and the GP, the firm who is managing the capital. What it does is lock up capital for ten or 15 or even 20 years. And the agreement is that the LP commits money in this legal construct. The GP has the ability to call that capital as they make investments over a period of time. And then after that, there is a harvest period. Now, the dirty secret of private equity is that though these funds are ten year life with two or three extensions at either the GP or the investor's discretion, the funds have a much longer tail than that. And so you have this legal structure that governs how the capital is committed and how the GP is invested. But the investors in the asset class, the companies that are ultimately purchased by these funds, and the investors, have different time horizons. And I think that's what creates this incredible ecosystem of opportunity for our market, which is the only way LPs, Limited Partners, the investors in the asset class, can get liquidity at a time of their choosing, right? Otherwise, they have to wait for the GP to sell an asset and distribute that capital back to them. That is what is a secondary. It is in the most simple form, we, Lexington Partners, become a replacement limited partner when a pension fund, let's say, says, I've committed capital to this fund, I did that five years ago. For some reason, I need liquidity, I need to divest that commitment. What we Lexington do is price, we underwrite the assets in the portfolio. We decide what we're willing to pay for that. We negotiate with the seller as well as with the GP who has the right to transfer that asset or that fund, commitment or not, to us. So it's a three party negotiation. And then we become the replacement limited partner, and we take on, therefore, any unfunded commitment that remains with that fund commitment that we purchase. I'm making it sound maybe more complicated than it is, but we become a replacement limited partner.
Tony:
And I think that's a perfect way of describing it. And if we think of 2022, you see a slowdown of exits or what happened most recently with SVB, at least in the marketplace, I'm certainly hearing that there's an opportunity for secondaries because, as you point out, a lot of big institutions who have committed capital haven't necessarily deployed it, but they've committed capital to private equity. They're often looking for diversification. And at least what I've been hearing in the industry, and I'd love for you to opine on it, is it really provides the secondary manager the opportunity to select them on premium assets at a good price, where maybe that was a little bit more challenging at the peak of the market. So I'm hearing this is a really attractive opportunity for the secondary market. Is that what you're seeing?
Taylor:
Yes. I mean, we describe it for people as what we see as a historic opportunity. I'm always careful to say that because we will ultimately come someday and raise our next fund. And people say, well, did that opportunity pass? The reality is the market has grown every year, basically for all of its history. When I started at Lexington 15 years ago, it was called a nine or $10 billion a year market. In 2021, it was 130. I think the only thing constraining the growth of our market, candidly, is the availability of capital to our market, right? So we, Lexington Partners raise money from all the same institutions and people who are the ones selling. So, no surprise, the greatest investment opportunity comes when capital is hardest to find. That's just the way markets function. When I think about what is driving all of the sales in this market. And what is creating this opportunity today? It is for the last 13 years, coming out of the financial crisis, allocators of capital had a decision to make, which was, where do I place my money to earn excess return above the public markets? Well, for the last 13 years, until last year, interest rates were basically zero. And so more and more money, obviously not on a cumulative basis, but on a relative basis, went to private markets and alternatives. And so what we saw was bigger commitments being made by allocators of capital to private equity and alternatives generally, faster and faster. And they were comfortable making those commitments faster and faster because we had highly liquid markets. So there were a lot of distributions coming out of these portfolios. Busy M&A markets IPOs, valuations went up and to the right, capital was available, everything was liquid, everyone looked smart. And then what happened last year in 2022, I don't know if it was tied to it, but after Russia invaded the Ukraine, the music stopped and the capital markets got choppier and interest rates started to rise. And all of a sudden, the liquidity seemed to come out of the system. And for the first time in over a decade, the alternatives were not a self funding asset class. And so what that creates for the biggest allocators, if you're the CIO of a pension fund and you're sitting there and you're looking at your portfolio and gosh, your equity portfolio is down 20 or 25%, right? Your fixed income portfolio on a mark to market basis is also down. It's starting to earn something which becomes interesting. And you have this structural overallocation to alternatives because those assets have not been marked down in the same way your public portfolio has. So if you had a 10% allocation to private equity, you might have woken up and found out that it looked more like 15 or 20%. The separate part of that is because it was no longer self funding and you have a funding commitment to these funds, you then need to decide how you fund capital calls, right? And so if you're the CIO, you might say, well, I don't really want to sell out of my equity portfolio that's down 20 or 25%. I don't want to take away from my fixed income portfolio, right. Because it's finally earning me something and it's also down on a mark to market basis. So what we have seen is some of the biggest allocators say, well, maybe what I should do is sell a portion of my private equity portfolio to redeploy that capital into new fund commitments and to meet capital calls. And that is the driver. I think it's less people worried about where valuations are going, because I think most allocators agree that private equity over the long term is an asset class they want to be in. So it's not a rotation out of private equity into other stuff. It is, it's just an understanding that maybe I need to take a little profit or I need to reallocate within the alternative bucket to meet those funding requirements. And so that's the driver of what we're seeing today.
Tony:
And I think that makes a lot of intuitive sense, especially if you understand how the private markets work. Let's talk a little bit about the benefits. So somebody obviously needs liquidity. They're thinking about diversification. I know one of the benefits of secondaries is mitigating the J curve effect. Not to get too technical in nature, but maybe list for some of the advisors on the phone that may not be familiar with secondaries, what are some of the built in benefits of the secondary market?
Taylor:
One of the things that it provides is an immediately diversified portfolio, not only by strategy, by asset type, by underlying industry and sector, but also by vintage diversification. So you have the ability to very quickly get exposure to a broad swath of private equity that has been put to work in the underlying assets across a long period of time. So we Lexington typically buy private equity funds in year four or five, but some of them are older, so you get access to deals and funds from years before that point of your investment. So you get that diversification. We are buying in at discounts. So to be clear, we are as a team, we spend a lot of time, majority of what I do and our team does is underwrite the assets in the portfolios we are purchasing. We are making a decision at a point in time what we think the terminal value of those assets will be within the hold period of the funds we're acquiring. And so there was this great analogy. The founder of our firm used to say it's like betting on a horse race after the final turn, right? So we may get to buy a fund in year five. The investments have been made. At that point in time, you know which companies are performing really well and maybe they've been written up and you're going to buy in above the GP's cost basis, but at a discount to where it's held today. The assets that are clearly going to underperform have been written way down. So you're not really paying for them. So you get that advantage of building a private equity portfolio with the benefit of hindsight. Right? That is an awesome thing to be able to do. And then as you point out, the mitigation of the J curve comes because we are buying broadly diversified portfolios, but right about at the point where they reach their harvest stage.
Tony:
And it's interesting, I think as you describe this sounds very common sense, right? You got the built in diversification. I like the vintage diversification. You're mitigating the J curve because you're buying more mature companies. They tend to be more liquid, they're more established. It sounds really appealing to an advisor. An advisor is not familiar with secondaries. I think they certainly will be. There's been a lot of financial press about it. How should they think about it in the larger private equity ecosystem? You talked earlier about VC and growth and buyout or even private debt. How should they think about secondaries? It's a piece of the pie. It cuts across the pie.
Taylor:
I would describe it as what should be the ballast of an individual's alternative portfolio. Secondaries historically have been accretive to private equity returns on an annual basis with very attractive risk adjusted returns. So because of the broad diversification and the discounts, really attractive on a risk adjusted basis. But it turns out it's also adding alpha to private equity portfolios. I think in terms of the risk spectrum of alternatives, I have heard that people think about secondary as sitting somewhere between a private credit portfolio and a private equity portfolio. Because there's more concentration risk in private equity, you have the downside protection of credit. It would sit somewhere between that. Candidly, most of our capital gets raised from institutions and I think we as an asset class have not done a great job of describing how important we are as our own asset class. So I would make the case for anyone listening that I think of secondaries as a strategy that should have its own allocation. And I think there's no reason why secondary shouldn't grow to be maybe the largest asset class within alternatives. When you think about technically it can never be bigger than the primary markets for private equity. But there's no reason why secondary funds individually shouldn't be the biggest funds out there because what you're doing is acquiring exposure to many different funds. Just to be clear, it sits somewhere on the risk spectrum between credit and private equity.
Tony:
And you mentioned institutions, maybe the last question here, and that is that I think a lot of institutions and family offices been allocating to private markets for decades and decades. This is still relatively new for a lot of advisors out there. What have you seen from institutions as they're allocating? We've certainly shared in past podcasts and things that we've written the large allocations to private markets by institutions and family offices. But are there different sort of ways that they think about it? And maybe more specifically when they think about allocating to private markets, are they often taking it from their public equity exposure? Or are there things that maybe advisors should start to think about when they think about that tough decision about where do I allocate from and where do I allocate to.
Taylor:
Though it has a yield and a yield like feel to it to be clear, it is equity. So I would expect that anyone is taking capital out of their equity allocation to make investments in the private markets, certainly private equity, which this is, and it is locked up capital, right? So they expect to earn a premium return versus a liquid public portfolio when you're investing in a secondary fund., So I look at it generally from what the institutional investors are doing, and what we have seen over time, is many of the biggest institutional investors, all the way up to sovereign wealth funds, they begin their private equity portfolios, their alternatives portfolios with secondary. Because they get broad diversification, consistent cash flow and access to information on many, many managers. And that's one of the interesting things we haven't talked about. In our typical funds, we will have hundreds of underlying fund interests with hundreds of managers. In a typical Lexington Global Fund, we'll do 120 to 150 deals. Each one of those is diversified. And so what our LPs get when they come to our annual meeting is they hear the stories on a lot of these different GPs and the assets that are underlying in those portfolios. And so from an information gathering perspective, it's really attractive. So not only are you getting private equity returns in a really attractive, risk adjusted model, but you're also getting access to information that then allows you to go out and make future commitments to the asset class with a little more information. I think one of the hard things, even if you're a family office who's been committing to private equity for years, maybe you have one or two people who do that for you. Even the biggest public pensions have a private equity team of five or ten people. We Lexington, we've been doing this for 30 years. We have 160 something people in eight offices around the world. It's all we do is manage relationships with hundreds and hundreds of GPs. And so we have history with these GPs information, access all of the stuff that our LPs can benefit from as they see the reporting on a quarterly basis from our portfolio. So that's sort of an intangible. It's not a return attribute, but it's something that people look for.
Tony:
And I think that's a huge advantage that you have, the visibility into what's happening in the entire ecosystem. Taylor thank you so much. I think we've covered a lot of ground here. Hopefully we've demystified a little bit what secondaries are. Talked about the relative attractiveness in this market environment, the built in benefits of diversification by geography, industry and vintage. Vintage, of course, diversification critical importance and that shortening up of the J curve over time. So a lot of really great information. I would just say that I hope this isn't the last time that we talk about secondaries. I hope it is a larger and growing portion of the entire private equity ecosystem. So thank you so much for your time, and I hope that our listeners get a lot out of this. Thank you.
Taylor:
Thank you for the time. It's my pleasure.
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