Show V/O:
This is Alternative Allocations by Franklin Templeton, 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 latest episode of the Alternative Allocations podcast series. I'm thrilled to be joined today by Taylor Robinson from Lexington Partners. Welcome again.
Taylor:
Thank you, Tony. Great to be back.
Tony:
Yeah. Yeah. And what's interesting, we talked a little over a year ago and we talked about this incredible growth in the secondary market. It certainly has come a long way. Why don't you remind our audience about who you are and your role at Lexington and then we'll get into kind of the opportunities.
Taylor:
Sure. Well, again, my name is Taylor Robinson. Pleasure to be here. I'm one of the investment partners on the secondary side of our business. For those who haven't heard of us before, Lexington is a specialist firm within the private equity world. We do just two things. We do secondary private equity, which is our big business that we are well known for. In that side of the house, we are providing liquidity to the investors in private assets, generally through funds.
And then our other business that we've had for almost 27 years is equity coinvesting alongside sponsors. So direct private equity in a diversified way. Both of those are non control strategies. And what we aim to provide is a broadly diversified portfolio of private equity, growth, venture, exposure to investors in an attractive, diversified way. That's the mission.
Tony:
And there's a lot there. And again, maybe for the audience who isn't as familiar, maybe we should dig in a little bit on what are secondaries. And Taylor, you've heard me say a lot over the last couple of years. I really feel like secondaries have emerged from a niche sort of strategy to a vital cog in the overall private equity ecosystem. So maybe just for those who may be newer to the space, what are secondaries and what value did they provide in the overall ecosystem?
Taylor:
Yeah, so if you think about the investment experience for a limited partner in these funds, what they are doing is providing a general partner committed capital, generally for 10 to 15 plus years, and they give that general partner the ability, the general partner being the firm who's investing the money, the ability to invest that capital. Generally, over five years, and as the capital is drawn down, investments are made, and then the expectation is that that capital is returned to the investors as assets are sold in the following years, generally years five through 10, 12, even 15.
And so what we are doing, because that capital is locked up, and the LP, the limited partner, doesn't control the exit or the timing of that liquidity, what we do is provide the service of liquidity for those investors. at a time of their choosing. And so that has become an increasingly important service within the private equity world.
And when I say private equity, I mean private equity. Again, I mean growth capital. I mean, venture capital, all of the alternatives where capital is locked up and someone else controls the timing. We are giving the investors the sometimes needed pressure release valve if they need liquidity at a time of their choosing. So what we do as a firm is we underwrite the exposure in those funds. We underwrite the assets. We price that set of cash flows effectively to a return level of our choosing. And we typically buy into private equity funds later in their life. So it is important because it has allowed the original investors in this asset class, who we Lexington replace by these transactions, the ability to get out when, and if they need to.
Now that's a traditional, partnership, portfolio secondary deal and I suspect we'll get into that here. The other type of deal that has become an increasingly large part of our market over time has been what we call GP-led deals. And that is where a private equity firm themselves comes to Lexington and says we have one or two or a number of assets that we absolutely love, but the investors in those assets in that fund that owns them, they've been in for four or five or six or seven years, and we don't think the time is right to sell that asset, but we really see a tremendous amount of upside.
And what they look to someone like Lexington for is for us to price that asset, to create a set of terms that align both Lexington and our investors, the general partner and the sellers in the transaction around the next phase of growth for that company or a series of companies. So this secondary market has become a very important part of the provision of liquidity for the investors.
Tony:
Yeah, and maybe we'll pick up on that a little bit and if we roll back the clock, even just a few years, we saw in ‘21 kind of peak valuations, a ton of money going into the private equity space and institutions woke up in the middle of the disruption of ‘22 and realized they're over allocated to private equity. They're outside the barriers in their investment policy statement and there was that need for liquidity. So maybe just to provide a little bit finer point of that to the folks who may not be familiar, you are absolutely providing a service in the sense that you're helping to take those assets off the institutionals’ books, which then frees them up to allocate to future.
So it seemed like that ability to provide the liquidity and the diversification is something that's here to stay, even though it might have been a trigger or the catalyst might have been some of the experiences we had over the last couple of years. It doesn't seem like that's going to go away. Once somebody has started down that journey of having a secondary program in place, it seems like that's a recurring sort of theme.
Taylor:
Yeah, I mean, we really think there is a persistent structural need for liquidity in the private markets. And if you look at what's happened, really in the last two and a half years, two and three quarter years, since there was a reset in rates and the IPO market slowed and corporate M&A slowed, there was a reset in the cost of capital.
And sponsors are holding assets that are performing very well through that period. But the traditional sources of liquidity, sale to another sponsor, IPOs, sale to a strategic, even dividend recaps to get some cash back to the limited partners. None of that really existed over the last couple years, or it certainly existed at about a third of where it was in the years preceding.
And so that distribution activity, as you point out, is sort of the flywheel lifeblood of private equity. And it is the sort of basis upon which allocators to this asset class made their commitments in the decade plus preceding. And so you're right, distribution slowed down. They sit today, whether or not they feel over allocated, they certainly feel as if they don't get the cash flow back from the portfolio that allows it to be self-funding.
And so we as a market are providing that service and it is a service and to be clear, we do get paid for that service and our investors expect a return. But that's become really important. I would just take it a step back maybe and say, I think the success of private equity has created tremendous growth for these firms, the direct investment firms, the companies are doing very well.
And you have a growing amount of net asset value equity that sits within these funds. The problem is probably getting worse. And by problem, I mean, trapped NAV is getting worse, not better. And I suspect it will get worse, not better, even if markets and liquidity come back. So private equity, at least in the short and medium term, may have outgrown its traditional sources of liquidity.
That's great for the equity holders, but they can't get their money back when they choose. And so I think there is going to just be, again, a structural and persistent need for a way for that equity to change hands beneath the funds and the assets themselves.
Tony:
And I like that flywheel analogy because I think that's exactly right. And one of the things that we've been writing about is why this is a good time for secondaries. Part of what you've described, the slowing exits, the amount of money that's been invested or committed, but yet you want to make sure you see that next deal coming along the way. And I think you partly answered the question, but I'll ask it anyways, because it's something I hear a lot from advisors out in the field. And that is, if exits go back to their normal activity level, do we think that secondaries still have a vital role? I think I know the answer to that. And then related to that, one of the phenomenas recently is the discount that's available on the market. The supply demand imbalance creates discounts on the market. Do we think that discounts go away or get muted?
Taylor:
Let me start with the last part first. I always say to people, we at Lexington don't wake up in the morning and think about discounts. We think about buying assets we know well, managed by sponsors we know well and trust at prices and return levels that make sense.
The discount is really a reflection of what we think the go forward and terminal value is for the assets we're purchasing and the return we want to earn to take on that exposure. Now part of that analysis is the underlying owner of those assets charges a set of economics. We as a firm charge our own set of economics, and so the discount generally reflects, again, not just the value of that asset in the future, but also who's being paid between now and then.
So generally we buy things at discounts. The discount moves as markets do. The secondary market tends to transact pretty efficiently between 10 and 20 percent closing discounts. Now the question is always a discount to what, right? So, our deals price off a record date or a quarterly valuation date in the past, generally one, two or three quarters.
So people talk about discounts. We focus on what the closing discount is. You can have a deal that is a 5 percent discount as of the record date, but a 15 or 20 percent discount at close if the assets are appreciating during that period between the record date and the closing.
I think that the crux of the question is, it seems like there's a lot of capital being raised for this strategy. Do we think with those capital inflows, pricing will generally stay the way it has been for our market historically? I personally think the answer is yes. There are periods of time where we have higher discount, but generally that's a reflection of market disruption. And then there are periods of lower discount, and that reflects higher liquidity, very stable markets, inexpensive financing for those who use it.
But I think there will always be a discount just because the service we provide and the way in which we get paid, and the underlying sponsor gets paid, oftentimes requires that. You need to buy at a discount later in the life of a private equity fund to earn the returns that we want. Now, that has to work for the seller.
And these deals are pretty complex. Sellers typically have in mind a dollar quantum of liquidity they want to create and generally have a price at which they're willing to do it. Most have been advised to accept that there will be a discount. Some want prices that are par, and then the question is, what assets can we buy to achieve their goal and achieve ours in terms of return?
And so, I sort of take it back to, we don't wake up in the morning and think about discount. We think about earning the return we want to create a diversified portfolio of private equity. But, historically, this market has always been at a discount, and that has more to do with the age at which we purchase these assets and the underwritten upside for those assets.
Tony:
: So I wanted to kind of pick up on that a little bit. You mentioned a couple of times the persistent structural advantage, and I agree with you a hundred percent. And just maybe for the audience who hasn't really delved into secondaries, I typically think of shortening the J curve, getting those distributions back sooner, as you've talked about, and the built in diversification.
But imagine you're an advisor listening to this and they're thinking about allocating to secondaries. What are the advantages that they should think about communicating to the clients? And why is this structure, the secondary fund structure, an advantageous way of starting to get the exposure to private equity?
Taylor:
What I've said to people in the past is I think in a perfect world, you want the asset classes through which you're invested to earn the returns they're supposed to earn. And then you as the advisor can pick and choose which asset classes make sense for which clients and in what ratio, right? Secondary should, and has always, scored very highly on the predictability of returns. And that is because of the diversification of these portfolios we're putting together where we Lexington, our funds, can have five, 10 plus thousand underlying assets when they're fully assembled. And you're doing that across many transactions and doing that across multiple years.
And so, besides just the mitigation of the J curve, the frequent and regular cash flows that secondary is known for, I think the most important thing, as I said at the beginning, it is a way to deliver private market exposure in a client's portfolio, and not surprisingly for many large institutions around the world – pensions, endowments, sovereign wealth funds – that are just building portfolios and coming online. They like to start with secondary as a centering ballast within an early portfolio around which you can create additional exposure that is alpha generating. And so I could go into more merits, but I'm not sure we want to complicate it more than that.
Tony:
Yeah, no, I think that's great, and I think it's a perfect segue to my next question. We've had multiple guests on recently, primarily in the family office space, who've talked about secondaries and primaries, of how they use those as one is a complement to the other. So you started that as kind of an on ramp, but how do institutions think about allocating to secondaries, and as they mature, are they still using secondaries?
Taylor:
The answer to the last question is yes, they are still using secondaries, and I think there are some, and I won't name names, who began their portfolios with secondary. Then they started to pick managers. Picking managers is great if you can always be in the top performing, highest quartile manager, but it turns out it's very hard to always pick top quartile managers.
And I think some are coming full circle and selling broad parts of their portfolio and sort of coming home to secondary and saying, Okay, maybe that should have been the biggest part of the portfolio all along. It would have been accretive to my performance within the private equity bucket over the life of my private equity program. So, again, this is an asset class that irrespective of the practitioner, has always scored very highly on that predictability scale.
Tony:
And again, it's not an either or, it could be both, or as you suggest, maybe that's the core, and private equity, the primary investment, is the satellite.
Taylor:
I think we as a market, and this market's been around over 30 years, we Lexington were one of the pioneers in the secondary market. It has grown significantly in recent years alongside the private markets generally. I think we as GPs or managers of these funds, the firms, have probably not done a good enough job explaining to and convincing allocators of capital that secondary is sort of an asset class unto itself and deserves its own allocation.
And if you're the CIO of a pension fund or you're a senior allocator somewhere and you have a private equity mandate and you have a team of people, it's very easy to say, let's go pick direct managers because they should earn a higher return because they have higher concentration levels. They're taking more risk than a secondary manager and you chase that strategy for a while.
Secondary sits somewhere between direct private equity and credit in the risk spectrum because it's an equity strategy, but it has broad diversification. You have the benefit of buying assets later in their life, and you can see performance when we buy these portfolios in the companies. And so I think the market is just waking up today and it's saying, boy, there really is this big structural opportunity and maybe we should have a dedicated allocation to secondary. And we don't have to compare that to the performance on a multiple basis. You certainly can on an IRR basis, but on a multiple basis of our direct private equity program, which by the way should earn a higher return. And so it's, I think to your point, which is a good one, it's not either or, it can be both.
Tony:
And Taylor, as you know, we have spent a lot of time thinking about the opportunities in the secondary market. We're coming out with our 2025 private market outlook and we're very, very constructive on secondaries largely because of what you've talked about, which is the structural advantages and the fact that they become such an important part of the overall ecosystem.We think that will persist in the future. I did want to ask you about two macro themes that we've identified and we've been talking about for a while. And one of them is, I think, kind of a direct corollary to where you were. One is which we have historically seen a larger dispersion of return with private markets relative to traditional markets. And part of it, I think, is driven by the fact that it's a very specialized market. The tops tend to stay at the top and the bottoms tend to be at the bottom and they’re going to be there for a while.
I'd love for you to kind of comment maybe on the differences in the managers without getting into your fund versus somebody else, but why size and scale is important. And then secondary, if you could, we also talk about this macro theme, what's the difference in putting capital to work today versus ‘21 with those high valuations and so much money flooding into the marketplace. Is this a better time to be putting capital to work? So if you could just maybe touch on those two points.
Taylor:
I never want to describe secondary as an opportunistic strategy. We think of this as an all-weather investment strategy, and we've been investing these funds at Lexington for over 30 years. And we pace the deployment of those funds very evenly.
This is an attractive time to invest because I think we are buying really great assets at reasonable valuations. I certainly think that's the case in some of the strategies you wouldn't expect, growth and venture. We're buying those at big discounts, and we have the benefit of looking at companies that have been in, let's say, a venture fund for a five, six, seven years, and they're well known and they're cashflow positive.
And then on the buyout side, we're seeing the same thing. We're seeing the best asset quality we've ever seen coming into the secondary market because the sellers of these assets, whether they're through portfolio deals or through deals with one general partner, where someone ultimately has to be the seller into these deals, they need liquidity and they want to create liquidity at a reasonable price. And so that might mean the discount is low, but the asset quality is very high. So it just strikes us that the asset quality is really high. The need for liquidity is really high and it allows all of us in this market to be extremely selective in what we purchase.
Now just going to the first part of the question. As this secondary market grows and as more entrants come in, and they will, more capital's being raised. Firms are going to start to try to differentiate and create niche strategies within secondary. That's part of the maturation of a market. We, Lexington, again, we're one of the biggest. We today have the largest fund ever raised in this market as of the recording of this podcast and we go back and forth with some of our competitors and then that will change over time.
But look, we're one of the biggest on the traditional partnership portfolio where we go buy from a pension fund, a portfolio of private equity fund commitments. It is well known that scale really matters. If you can show up and underwrite a couple billion dollars of exposure and create an experience for the seller where they deal with one highly reputable, credible counterparty, and we can create a solution for them, they're generally a little less sensitive to price. They're looking for certainty of execution. And so that's what we deliver there.
On the GP led side of the business, that is a huge and growing part of the market. It is also starved for capital. There are a lot of new entrants there in that segment of the market. Because those deals typically have one or two or three lead buyers, but then there's a long tail of syndication that has to happen, there's room for new entrants. And so you're going to have small firms that do syndicate pieces of GP-led deals. You're going to have small firms that do syndicate pieces of other types of deals. It's normal. And then you have some buyers on the partnership portfolio side who use leverage in their deals.
Now, leverage can work both ways. I've been saying for a long time, we will have probably a wider dispersion of outcomes in the secondary market, if you look back 10 years from now at the performance, then if you look at the performance today back 10 years. I think that the dispersion of outcomes will widen.
Again, that's part of the maturation of the market. I don't want to sound like a Lexington commercial, but our goal is to do the same thing over and over, because it's been really successful.
Tony:
Taylor, this has been fantastic. Thank you for enlightening us about the opportunities in secondaries. Thank you for walking us through some of the structural advantages. Thanking you for sharing how institutions think about this as these strategies have become much more generally accepted in the wealth channel. It's always good to listen to the biggest and the best and how they allocate capital. And there's a lot of lessons that we can learn there. I thank you for your time, I congratulate you on your success, and we'll see how this all plays out. We'll have to have you back in the not-so-distant future.
Taylor:
Tony, thank you and thank you to all the listeners, and I think what you're doing to educate people is really important, so we appreciate that.
Tony:
Thank you.
Show V/O:
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