Podcasts Private Credit Secondaries: Inside the $140 Billion Market

Damian Cilmi: 0:06

Welcome listeners to another series of the Premium Investment Leaders podcast. I'm your host, Damian Cilmi, and today we bring you to private market secondaries, but not as you know it. Whilst there's been a lot of discussions about equity secondary transactions, today we're going to discuss private credit secondaries with one of the world leaders in secondaries, Coller Capital, and we're lucky to have Martin Marnauza from Coller in London. But about Coller. Coller Capital was founded in 1990 as an independently owned investment firm wholly focused on private market secondaries. The business manages $55 billion in AUD exclusively in secondaries, predominantly private equity and more recently offering a dedicated solution in private credit. It manages a global footprint with nearly 300 employees across nine offices Europe, North America, Asia and Australia. And about our speaker, Martins is an investment partner responsible for origination and execution of private credit secondary investments. He's based in the firm's London office and, prior to joining Collar in 2010, he was a senior investor with Hanseatic Capital and worked with Ernst Young in the transaction advisory group. Welcome to the program, martins, and welcome to Melbourne.

Martins Marnauza: 1:25

Thank you, Damien. Good morning. Thank you for having me.

Damian Cilmi: 1:28

Thank you. First time in Australia?

Martins Marnauza: 1:30

No, the second actually, yeah, but first business trip and I'm loving every moment of it.

Damian Cilmi: 1:39

The weather's beautiful today here in Melbourne. It's been very nice.

Martins Marnauza: 1:44

It's stunning, and I mentioned to Dave earlier that I'm always very suspicious when I meet an Aussie person in London. Okay, because I can't imagine why anyone would want to leave a country like this.

Damian Cilmi: 1:59

It's beautiful, though, but London is a lot of good fun though, isn't it? We all have fun there. Yeah, all right, so we'll get into today. So, as I said, we're going to talk about private credit secondaries, but first I think that we probably should backstep a little and just kind of talk about secondary transactions in whole, and then we can delve into some specifics around private credit secondaries. So, for the benefit of the listeners, can you talk about what is a private market secondaries transaction?

Martins Marnauza: 2:34

So it's a very fundamental question and I better have a simple answer to it. Otherwise it might suggest that I don't properly understand the subject myself, which would be embarrassing after 15 years in the business.

Martins Marnauza: 2:53

In secondaries, we provide liquidity to institutional investors on long-dated private illiquid assets of private equity, private debt, real assets. So that's the synopsis, but on the basis of a conceptual example. A superannuation fund makes an investment in a private credit fund managed by the Ares or Apollo or one of the other Greek gods. It's a closed-end drawdown fund. It has a 10-year life with potentially a couple of extensions at the discretion of the manager. So it's a proper long-term commitment.

Martins Marnauza: 3:55

Five years into the life of that fund, the superannuation, depending on the nature of the underlying assets, may or not have received back much of the cash.

Martins Marnauza: 4:01

But five years in the circumstances have changed for the superannuation. So in nine out of 10 cases it has nothing to do with the performance, the quality of the underlying assets. The underlying assets are doing what they're supposed to be doing in terms of return they're generating in terms of the cash flow profile. But the idiosyncratic situation of the investor has changed and it can be as benign as the chief investment officer was replaced and there was a revamp of strategy and now they're looking to rotate out of, let's say, private credit into bonds, for example. Or it could be more consequential if you're an insurance company. The regulatory framework might have changed and the liquid assets are waiting heavily on your balance sheet, and so you're seeking early liquidity. There's no redemption mechanic in the fund that you own as a shipper annuation, and the only way for you to monetize the interest is to call someone like Collier Capital, and we're going to bid on it, and most of the times at a discount.

Damian Cilmi: 5:12

Sure, no, no, thank you for that. And so essentially what we've got is a scenario where people need to go and find their own buyer because there's no exchange, there's no other liquidity elements out of it private treaty between two parties on that there. So we've heard private equity secondary strategies have been quite popular here in Australia in the last 12 months or so, but are you able to talk through the history of, say, private credit secondary transactions? How did that all come about?

Martins Marnauza: 5:45

Sure, Coller, was one of the first, if not the first, investor to invest in private credits secondaries systematically and at scale, and we started around the time of the global financial crisis, and the way we got on to the idea was that by Coller Capital had been in the business for 20 years but investing in equity and we're a fundamental valuation mindset that we bring to any analysis, and so we would keep refreshing what we thought was the intrinsic equity value of the assets that we owned, and generally the conclusion was that, despite the market volatility at the time, that there across the board in private equity, it was money good, it's just going to take time.

Martins Marnauza: 6:51

And so, by definition, if the equity is worth something, then the debt is covered. But when we looked at where the leveraged loans so the financing outstanding to the borrowers, where we own the equity, at what levels the leveraged loans were trading, it was steep double-digit discounts, and so that was the epiphany moment for us to say, okay, this just looks like a very attractive relative and absolute risk for us to buy at the time. And so we loaded up the truck and made 60% annualized return on the first investment and never looked back. So that's the start for us.

Damian Cilmi: 7:41

Yeah, and I'll take your point there that if the equity's covered, the debt will be covered. So that's a very valid point there and I suppose you get a good lens looking at it through the equity side and then to provide you with comfort on the credit. So you talked about at that point in time. You're already like 20 years of experience in private equity transactions now, 30 years in total, and you know now you've got a dedicated program related to private credit secondary transactions, but it's a newer strategy in a sense. So what were your kind of learnings about being very active in the private equity secondary market, about embarking now on credit, that you had that experience? What things do you think are going to occur in the credit side that you observed on the equity side?

Martins Marnauza: 8:40

You're right. Private equity is the best precedent we have for what we would expect to play out on the private credit secondary side. Total transaction volume in secondaries and at the time it was 99% private equity it was less than $20 billion annualized transaction volume. Last year the comparable figure was around $140 billion. So within a decade the market on the equity side has grown exponentially and we very much expect the same dynamic to play out on the credit side, better than more accelerated pace.

Martins Marnauza: 9:38

And the reason for that is that the fundamentals for the drivers behind the transactions are the same as on the equity side the stakeholders, ie the investors that are selling, the GPs that are involved, the advisors. There's a great deal of overlap and so there's just much more familiarity and comfort with the type of transaction the second raise is and so, on that basis, as biased as you would expect us to be, but we are super bullish about the growth prospects in private credit secondaries, from a relatively standing start, growing at 30% 40% annualised rates.

Damian Cilmi: 10:48

Wow. And so when we stand here today and just using a couple of reference points about a product issuance here in Australia, I would say it's probably 10 to 1 in terms of private equity secondary strategies compared to credit. So we're expecting a big catch up there. So very interesting. And you know, would it be fair to say that a properly functioning secondary market, it provides greater resilience and confidence to private markets themselves and primary markets to grow. Are these two really interlinked? And you know you, providing maybe a backstop out of it helps people bid on primaries with more confidence.

Martins Marnauza: 11:33

Yes, absolutely. A well-functioning, performing primary market has a positive impact on secondaries and vice versa. It's fair to say that probably most investors, when they sign up to the 10-year commitments, they don't think about when they're going to have to sell and how that will practically happen, but that is a real optionality that has value for them. Having said, from our perspective, the notion of an efficient market is a dilemma of the sorts that and this is back to my opening point that secondaries, all of alternatives, remain a private and illiquid market, and illiquidity carries a price, and so the more inefficient the market is, the better returns ultimately we're able to generate.

Damian Cilmi: 12:54

So now talking about the typical participants and their motivations, you know like let's get into typical transactions. You made reference at the start to, you know, an Australian super fund, for an example, making an asset allocation change as one of your examples. But can you talk through maybe some of the other participants in there, maybe some of these vendors on that side specifically?

Martins Marnauza: 13:23

It's the law of large numbers. By now the private credit primary market has grown from a few hundred billion a decade ago to a few trillion today and it's generally performed well and that's a positive backdrop for secondaries. But it also means that literally thousands of investors have invested in this asset class by now, and it's a wide range from very small family offices to some of the world's largest, certain wealth funds, and they would have invested for different reasons and ultimately also might seek liquidity early for different reasons. But projecting the market from here, there's definitely the organic growth that we would expect to continue to drive the market.

Martins Marnauza: 14:27

Private credit probably was one of the bright spots in the last few years in terms of fundraising, to the point you could argue that there's too much capital that's been raised in private credit. But again, on the secondary side, that's good news. So it's just a matter of time when there will be sellers for those positions. But also importantly, there is a structural growth element to it. So, again, when we look at the private equity secondaries as the best precedent, the historic churn volume, ie the secondary volume relative to the primary capital outstanding. It's fluctuated but it's been around the 2% mark on the private credit side, that same percentage is well inside 1%. Okay, so at the moment there isn't enough dedicated capital that could fully cover the one year expected transaction volume in private credit secondaries. So we're constantly on a treadmill. We're not getting off it. We need to continue raising the capital to be able to service the pipeline that we're seeing. So we're long on the opportunity, we're short on the capital.

Damian Cilmi: 15:53

Yeah, fair enough, fair enough, and so you would expect probably more people to come into the market as a result of that, more competitors.

Martins Marnauza: 16:10

Definitely yes, but at this point we welcome competition as counterintuitive as it might sound because you're saying there's a lot of activity. There's a lot going on and it's a self-reinforcing cycle. So the more credible, systemic, at scale participants on the buy side there are, the more supply we're going to see. So as a case in point, they're large? State pension funds that hold gigantic private credit portfolios and we're now starting to see them come to market, as historically, on the equity side, they've been one of the most active participants in the secondary market in terms of tactically managing their exposures, but for a long time rightfully they weren't sure how deep the market is and how constructive the market is going to be, if there's a larger transaction and last year we saw for the first time a 4.5 billion single private credit portfolio that came to the market and that was constructively absorbed by the buy side.

Martins Marnauza: 17:15

So the market is in an equilibrium of sorts that just about works for the buyers and the sellers. There will be new entrants, especially on the private credit manager side, ie the institutions that do have a primary private credit business. I think a lot of those institutions are attracted by the relative value of what they're seeing. So they have their own funds and they're underwriting new assets at $0.98 on a dollar, and then they're looking at the second-rate world where Coller Capital is buying very similar assets at $0.85 or $0.90.

Martins Marnauza: 18:09

They're really intrigued, but I think inevitably we'll see some institutions that make a proper long-term commitment to the strategy and are successful, and others that will remain opportunistic and finally there will be attempts that fail inevitably.

Damian Cilmi: 18:26

Yeah, fair enough, and so let's talk about some of the motivation for a transaction as well. I mean, we talked about, you know, just a rebalancing at the start, but we haven't talked about GPs as well and their activity, you know, to motivate a transaction or some of the other factors that happens on the deal. What is the motivation for some of these things to come to your desk?

Martins Marnauza: 18:53

Yeah, let me give you maybe a couple of examples. Perhaps one on what's called the LP-led ie, where the superannuation fund is selling a fund interest, and then what would be called the GP-led ie, where the manager is proactively organizing a wholesale liquidity for the existing investors. I'm going to give you a scoop. It's not in the press yet, but we're closing on a transaction.

Martins Marnauza: 19:20

Nine nights End of next week. Don't tell anyone. It's a very large portfolio of fund interests. So there are 40 funds in the portfolio across about 20 different managers, more than 3,000 loans on a look-through basis, more than 1,500 unique borrowers unique borrowers so incredibly diversified, all senior direct lending, almost exclusively North American exposure, well-performing, marked around 98 cents cash yielding. The perfect portfolio for what is the core of our strategy.

Martins Marnauza: 20:12

The seller is a US insurance company that went through a merger a couple of years ago and this particular portfolio is no longer core for their strategy going forward. So they brought it to the market. There was a process. They picked us as the counterpart they'd like to work with on the basis that we can tailor to the size. Again, 1.5 billion. It is a large portfolio for our market, the certainty of closure that we can provide, having been in the business for a long time, and it's a reasonably complex transaction, the way it's been structured, and so we've been working on that for almost six months now and very much looking forward to closing it next week and that is going to hit the press and, Damian, you'll be able to say that you knew way ahead about this.

Damian Cilmi: 21:15

I'm sure you've already lined up the champagne on that one.

Martins Marnauza: 21:19

Yeah, it's in the cooler.

Martins Marnauza: 21:21

So that's an example of where a limited partner, an investor, is selling a portfolio of fund interest, a portfolio of fund interest, and then the other type of transaction, the GP-leds.

Martins Marnauza: 21:41

I think that we're at a very interesting point in evolution for that type of transaction and I feel last year really was the inflection point, and this is all in the public universe. There was a GP-led completed by Guggenheim, by Avery, by Vista Credit, and this is exactly what we saw on the equity side less than 10 years ago when the household named the blue chip. The high quality GPs came to the market with a GP led transaction on equity assets and that verified that type of transaction. It became acceptable for other GPs, for the LPs etc. And so I believe that's what we've gone through now on the credit side and as we look at the pipeline now for this year, there are four live transactions in the range from 500 million to 1.5 billion withchip GPs that we're working on and the motivations vary from resetting the economics. Maybe there's been a change of team and the GP needs to re-incentivize the team. The duration of the underlying assets just has been extending.

Damian Cilmi: 23:12

And that's been a big issue, hasn't it? In the recent past, there's been a very very important driver.

Martins Marnauza: 23:19

The underlying loans, when it comes to senior direct lending, until not long ago were running at a two and a half year weighted life.

Martins Marnauza: 23:29

Today who knows where it's going to settle, but it's probably closer to four years. But, as a reminder, we don't trade in loans and the investors who are selling they don't hold loans, they own fund interests and the fund interests are 10 year and if the underlying assets in those funds get extended then the weighted average life of the funds gets pushed back and there's much more structuring going on, the fund terms are longer, etc. So you're probably looking at seven to eight years weighted average life of a fund and that's the asset you own and potentially looking to sell. So the duration has been a very important driver, both for GP leads but also the LP lead transactions. But to finish off on the motivations for managers, for general partners, it could be a pivot in strategy. It could be a pivot in strategy. They might be looking to raise some additional capital to support the portfolio companies etc.

Damian Cilmi: 24:46

So ultimately quite a bespoke set of drivers and quite finely tailored transactions at the end of the day, and on that point. So when you get shown a book, it might not just all be one type of asset in the capital stack. You're going to have a number of different security types in there. So how do you pick through various forms of seniority across equity and credit and then work through that and then, I suppose, pick them apart into your various strategies.

Martins Marnauza: 25:16

We're a fundamental underwriting mindset sort of bottoms up. So the the lp transaction that I mentioned that's closing in in two weeks, we had 10 people working on the underwrite for almost two months, so it's very labor intensive, but that flashes out also the importance of having a large team, just having that capacity to be able to perform the underwrites and so and so that's the first point that we're able to tailor a solution across the range of different type of assets. So we obviously have the credit team, we have the equity team and, you're right, very often it's going to be a mixed bag and you might have some senior loan exposures, you might have junior credit and you might have equity loan exposures. You might have junior credit and you might have equity, and as a house we're able to tailor to that and provide a single stop solution to the seller and then on the back end we will allocate the assets as appropriate. So obviously the senior loans will go into the senior bucket, et cetera.

Damian Cilmi: 26:37

And just say one of your competitors doesn't have a private credit secondaries capability. Could you be brought in on the syndicate if they only do the equity side, is that something that would happen?

Martins Marnauza: 26:51

We wouldn't necessarily come in as a party to a syndicate, we'd probably just bid separately on the credit book, for example yeah, yeah, okay.

Martins Marnauza: 27:00

But you're raising a good point, which is also related to size and the way we position ourselves in the market that we are a large cap manager on the equity side and we also have the largest dedicated pool of capital for private credit secondaries. So when it comes to the large transactions, we are one of the very few parties that can provide a solution on not only on a mixed bag of type of assets, but also the size that might be required.

Damian Cilmi: 27:40

Yeah, and size counts in this market, doesn't it?

Martins Marnauza: 27:44

It does. There are efficiencies when it comes to size, but it is definitely a very relevant consideration, and it will increasingly become even more so. And that's back to the point that there has been so much capital invested in alternatives, and especially the large institutional investors. Like, a 50 million transaction doesn't really change anything for their books, and so we're increasingly seeing billion plus opportunities, which would have been shocking even four years ago, but a 500 to a billion and a half size transaction is not at all unusual today anymore and the market soaks it up, as you were saying.

Damian Cilmi: 28:50

So it's good, yeah, so talking just, I suppose, on some of the numbers around vis-a-vis performance and trade prices et cetera, I suppose one of the criticisms that have come out there that secondary discounts will get eroded away over time as you get more market participants and people price more efficiently, et cetera Do you think that there's any evidence of that?

Martins Marnauza: 29:21

It's interesting that we've been asked that question for well, for 30 years since Jeremy founded the firm is the discount going away?

Martins Marnauza: 29:33

When is this going away? Because the market is, is becoming more efficient and the truth of the answer is that it has not gone away in 30 years. Nor should it. There are obviously fluctuations depending on the market cycle, depending on a specific opportunity. The price is going to move up and down within a range over a prolonged period of time. But fundamentally, what's unchanged is that there needs to be a premium in returns for the illiquid nature of the assets. So we're buying a longer duration asset and we need to be compensated for that.

Martins Marnauza: 30:20

But oftentimes what's not necessarily obvious is that selling at a discount does not mean a loss for the seller, because the seller and again hypothetically, a superannuation fund. They would have held the asset for three, four or five years. So in terms of the money multiple they might be, they might have recorded 1.2 times money multiple already as it stands today, and then they're selling off that mark. They're selling at a discount, but since inception they're still going to make 1.1, for example, and so that's what unlocks the transaction, oftentimes on the supply side. But then there's also a comparison to the broader market, the broadly syndicated loans, for example, or equity block trades. There is a very significant portion of the public market that consistently trades at a discount. The notion of a discount is not unusual.

Martins Marnauza: 31:34

And then there's the demand side argument. Is there going to be too much capital raised on the secondary side, which is then going to flood the market and drive the prices sky high? And again, it's just not what we've seen. On equity, yes, there are more participants and it has become more efficient as a market compared to where it was 20, 30 years ago. But fundamentally the thesis would not work for any of the buy-side participants if it were to be systemically par or premium to par. There's no value proposition at that point. The market doesn't work. So I don't expect the discount to go away any time soon.

Damian Cilmi: 32:22

Because ultimately, you're providing a service for them and there's a fee for that service. And just in terms of around conditions, when this strategy probably on aggregate, tends to work well. You've seen quite a bit over your time there what's probably been some of the better periods for you performance-wise and what were some of the underpinning conditions for that?

Martins Marnauza: 32:53

Private credit. Second reason is not a momentum strategy. It is a sleep well at night through the cycle strategy if we have a great fund, we're going to deliver 15% annualized return. If we have a bad fund, we're going to deliver a 10 annualized return. We don't make timing bets, we don't make contrarian industry bets. Diversification is the ultimate characteristic of the strategy. It's meant to be boring, it's meant to be consistent. It what typically sits in the core of any institutional o r private portfolio. So, this is the strategy that you should never have to worry about at all. And paraphrasing , Jeremy Coller, secondaries is a wealth preservation strategy, it's not a wealth creation strategy.

Damian Cilmi: 34:07

How does he validate that there? Because I suppose that that's across both equity and credit as well too. So could you explain how he came to that conclusion? Let's say with the equity, let's say with the equity mindset.

Martins Marnauza: 34:18

Let's say it's the consistency of returns, it's the low volatility of returns. So both equity and credit are constructed with protection of downside in mind. So if you want to shoot for the stars, you're going to have to go and do something in venture capital or a greenfield real estate project or whatever the different options might be. But this is one of the legs that the portfolio stands on that will be delivering a consistent range of attractive absolute and relative, but middle of the range returns. So we're never going to deliver two times money multiples on the credit side, on the equity side maybe, but we should never, ever come close to impairing the principle and I suppose one of the benefits you get out of this strategy is you take away the blind pool risk issues on it.

Damian Cilmi: 35:43

You're probably buying stuff that you can see right through, correct, and you can make a decision whether you take it or not, and that's a much better situation than some of the people that need to be in primaries.

Martins Marnauza: 35:55

Exactly, and so that's again a risk mitigant. The discount obviously plays a very important role in mitigating the risk as well, and on the credit side in particular, it creates an unusual positive asymmetry for credit. So we're buying assets that are marked at $0.98. We're buying at 85 or 90 cents, and then through the rest of the loan's life we go through that pull to par, that we can capture the discount, and so that's very unusual for performing credit. And so we have a well-protected downside, a margin of safety out of the gate, because we've created the loans at a low value, but then we're able to benefit from the upside as the loans repay at par. And then the final point in terms of the key characteristics is the short remaining duration and the cash flowing nature of it. So when we acquired the loans they're already quite seasoned, mature, and so we're immediately in a runoff mode and we start receiving back a cash yield and principal repayments, and so the de-risking takes place much quicker compared to a primary strategy.

Damian Cilmi: 37:23

Yeah, no, no, it's very true, Martins. That was fantastic. We covered a lot of material there. We're really thankful for you visiting us all the way from London and also, you know, with Coller being, you know, one of the longest track records and most experienced participants in the secondaries market, so we're very grateful. So thanks for joining us.

Praemium: 37:50

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