Episode 293: Private Equity Secondaries: Optimizing Through Portfolio Construction 

 

Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name's Stewart Foley, I'll be your host. Hey, welcome back. It's great to have you and thanks for listening. We've got a great podcast for you today. I want to make a little public service announcement first, we do have our ABF Real Estate Infrastructure specialty event in Philadelphia on May 7th and 8th. We have a couple of spots remaining for LPs or insurance investors. We're sitting right about 30 right now and we have a couple extra. It's an excellent opportunity for you to interact with your counterparts at other carriers. We have an over two to one ratio of LPs to GPs, and we think that that creates a really good environment for you to learn from your colleagues and share ideas and whatnot. So you can email us at events@insuranceaum.com for that. Today's podcast is on Private Equity Secondaries: Optimizing Through Portfolio Construction. This is a topic that is certainly gaining serious momentum in the institutional world and in the insurance asset management world for sure. And we're joined by our subject matter expert today is Shane Feeney, Managing Director and Global Head of Secondaries at Northleaf Capital. Shane, welcome to the program here. Thanks for taking the time.

Shane: Yeah, it's great to be with you today, Stewart.

Stewart: That's great. So, we always start with a fun one, which is where did you grow up and what was your first job? Not the fancy one.

Shane: Yeah, so I grew up in Eastern Canada, a province called New Brunswick, and for those listening in today from the US, if you haven't heard of New Brunswick, it's right above Maine, so a fairly rural part of Canada. I'm in Toronto today and take probably about 14 hours to drive from Toronto to New Brunswick, or at least Fredericton—where I'm from. My first job that actually paid me any money was working in a lumber yard. So my next-door neighbors in New Brunswick actually owned a sawmill or a lumberyard, and I worked there for several summers.

Stewart: You know, it's funny… I've ridden a motorcycle through all but three Canadian provinces. I went Key West to Halifax on a ride and I went through New Brunswick, through Fredericton that you're talking about, and there's a giant truck stop, giant truck stop out there on that road, and I was caught in the rain and I thought my jacket was waterproof, but it turns out it wasn't. And I discovered that fact at that truck stop. So, I can remember New Brunswick quite well. Talk to us a little bit about how you go from lumberyard to Global Head of Secondaries at Northleaf.

Shane: Yeah, so neither of my parents were in the finance or investment industry. My father's a dentist. My mother was a nurse. Like most Canadian kids, a big part of my life was playing ice hockey. I wasn't good enough to make it to a professional level, but fortunately, I did just have enough talent to make it to the college level. So I went down to the US, went to an East Coast liberal arts school up in New Hampshire, played hockey there, and started studying economics, piqued my curiosity broadly speaking in financial markets, finance, how the economy works, et cetera. And so from there, really just took my career in the direction of investment banking, eventually getting into private equity. And yeah, it's been a really fun ride. I've been in the private equity industry now for roughly 25 years. I actually did an MBA over in Europe and ended up staying in London afterwards. So, a lot of my formative years in finance were actually based in London, England, where I started in investment banking and then moved into the buyout industry after a couple of years and then eventually came back to Canada really for family reasons in 2010, but feel very fortunate to have spent the majority of my career and what I think is one of the most fascinating industries within investment management and finance.

Stewart: It's interesting, we have that in common, too. I was a professor of finance at a small liberal arts college in Illinois, and we had a number of Canadian hockey players who had played two years of juniors, showed up at my door at 20, had been living on their own for a couple of years, and they were all about finance. In fact, at one point half of the hockey team were finance majors and we had some phenomenal students come out of that group. I'll throw a couple of shout-outs. There's Jimmy Cassan and Davis Tocourt and several others, Louis and others who were just outstanding human beings, great athletes, super smart, dedicated, hardworking, and just great human beings. It's neat to see that you share that background and here you are. I mean, most of them, the oldest of that crew is in their late twenties now, so it's neat for me to see someone who's, I think that some of those folks will end up having a similar level of success to what you have. It would be helpful for those who don't know Northleaf Capital as well as we do, if you can give us a little bit of a framing of the firm. It's a really interesting platform, and if you can just give us the broad brush strokes and then we'll get into the market trends and evolution of secondaries.

Shane: Sure. So Northleaf Capital is a private markets investment management firm. We manage roughly $28 billion in capital commitments that we've raised since inception. We have three distinct investment strategies, although there is synergy between them, private equity, private credit and infrastructure. Private equity is actually our oldest strategy and accounts for roughly half of our capital commitments raised. A big thread across, everything we do is a focus on the mid-market. That's something we've remained very disciplined about. We think we see more genuine alpha that can be captured for our investors by focusing on the mid-market and slightly smaller transactions. The firm has a long history. It was founded back in 2002 when it was part of the Toronto Dominion Bank, here in Canada. Northleaf launched the first Canadian fund-of-funds back in 2002 with third-party capital being raised, and it spun out of TD Bank to become Northleaf in 2009.

At that point, it was still a pure-play private equity business. Infrastructure was launched in 2010 and private credit was launched in 2016. And maybe the other final point I'll make is we are a global investor, although we're headquartered here in Toronto, that's our largest office. We like to say we have strong Canadian roots. We are very much a global investor. We have 10 offices throughout the world. Really across most of what we do, our largest concentration of investments is actually in the US, but we are active globally in private equity. We're very active in Europe. We're also active here in Canada, obviously. And our three investment strategies all have slightly different geographic compositions, but broadly speaking, the US, which is the largest obviously private market in the world, is where most of our capital is invested.

Stewart: And just for the sake of our audience, when you talk about the mid-market, can you define that? Because I have a feeling that not everybody is talking about the same thing when they use that term.

Shane: Yeah, great question and one we frequently get. And what's funny, one thing I'd mention is I go around the world and meet investors. One of the things I've found is the definition of the mid-market. There's been a lot of, I'll call it size creep where you now have some pretty large funds that would define themselves as mid-market, but maybe the different ways to define it, we can use underlying EBITDA. The companies we're focused on investing in would range typically from $10 million at the low end to $150 million at the high end. I'd say most of what we do in the private equity side is going to be in that $25 to $100 million range. We also often define it by underlying fund size, so the size of the fund that a private equity manager is managing, and there our definition would sort of be between, fund size is between $500 million and $7.5 billion.

Again, most of our focus would be kind of in the $500 million to $3 billion range. So the one thing I'd say is oftentimes when people hear mid-market, they think really small companies, micro-cap companies. These are still pretty sizable businesses we're investing in and they have deep management teams. They've grown out of that point where there's a lot of key person risk around one individual, a CEO, a founder. They do provide quite a lot of resiliency, but still at that kind of sweet spot where they're not so large that there's a lot of value creation opportunity, oftentimes through M&A, actually. In the segment we focus on, we see a lot of buy-and-builds growth through M&A as well as organic initiatives.

Stewart: That's super helpful. I am familiar with the concept of key person risk myself in a business. Absolutely. Let's just flip over to market trends and evolution of secondaries. I mean, you've had a front row seat to global private equity for a couple of decades. What has changed in the secondary space and why is it getting more attention from institutional, particularly insurance investors today?

Shane: Yeah, so it's been really interesting. I mentioned I've been in the industry now for over 25 years, and maybe just for context, I mean a lot of that time certainly when I was in London, was sort of a deal person sitting in a buyout fund focused on specific industries. And then when I came back to Canada in 2010, I joined an organization called the Canada Pension Plan Investment Board, which is actually the largest investor in private equity globally, about a CAD$150 billion private equity program. And so when I was at CPPIB and my various roles there, but running the Global Private Equity Program was the last role I took there and was doing that the last four years I was there, really had an unbelievable perch to kind of see what was happening really across private markets, but specifically within private equity. And when I joined CPPIB in 2010, on the direct investing side, we did have an in-house secondaries business.

CPPIB remains probably one of the only global pension funds or sovereign wealth funds that has actually developed its own in-house capabilities to execute secondary transactions. So CPPIB had a very well-developed secondaries program, and it was really interesting to kind of see how it evolved over the years from that perch. It really started very much a tertiary almost market within private equity. No one paid a lot of attention to it. It was very niche. I think a lot of people struggled to understand how can you really make money or generate attractive returns, buying up what some might call “used” private equity funds that were five, six years old. I think there was a lot of confusion around what secondaries was and that has changed markedly to where we sit today. I love to tell the story of one of the well-known intermediaries in this space, who, he's been doing it a long time and has a great franchise.

And he was once telling me how he used to go to conferences, private equity conferences, and no one would want to talk to him. And he was kind at the back of the room and now he's the keynote speaker at all these conferences. So it's grown tremendously. I think people now recognize the advantages and the attractive returns that can be earned in secondaries. And it's really evolved from the early days when investors would turn to the secondaries market for almost more, I'll call it a distress management tool. It was almost like someone's messed up internally at a pension fund, a family office, an endowment, whatever, and needs to turn to the secondaries market to sell some exposure. And now I think what's much more mainstream, it's used very routinely by large, sophisticated investors to rebalance their portfolios for general portfolio management capabilities. So it's just evolved hugely from where it started.

Stewart: It's super helpful, that context. I've heard it said that return per unit of risk is the core value prop in secondaries. Do you agree with that, first of all, and can you unpack it for us for how that compares with other private market strategies, like primaries or directs?

Shane: I always like to ground things in facts and numbers, and when you look at the data and benchmark secondary funds against buyout funds, venture capital, growth, et cetera, the picture that emerges is very attractive. Certainly from an IRR perspective, what you see is secondaries, typically even fourth quartile funds, don't lose money. They're still generating a positive return. Median returns among secondary funds tend to be in line with buyouts. But when you look at top quartile returns, they tend to actually outperform buyouts in terms of top 25% returns you see from secondary funds. So, put differently, there's an opportunity to earn very attractive risk-adjusted returns or, as you put it, more return per unit of risk in secondaries. And I guess the question then becomes why. And there I'll probably get a little more subjective in my answer, which is I think one, it's a fairly inefficient market.

I'm not going to say it's not competitive, but I'd say it wouldn't be overcrowded. It's still competitive but not overcrowded. The other point is when you think about what a secondaries fund is doing, it's basically buying up exposure to an existing private equity asset or company where there's no change of control. So the underlying company is not moving from one existing owner to a new owner. You have stable ownership across the transaction that the secondary fund executes. So we're really able, I think, to look into the underlying risk characteristics of what we're acquiring. The companies, to some extent, have already been de-risked because they're typically through the first two, three years of ownership. Leverage levels have typically come down a bit. So you're able to assess the performance of the businesses in more detail prior to deciding what you want to pay for them. I think it lends itself for an ability to price with a greater appreciation for the underlying risk an investor is taking on. And as a result, I think what we've seen is some very attractive risk-adjusted returns being generated by the industry over time.

Stewart: That's super helpful. I want to turn my attention here to portfolio construction and my notes talk about something called the Northleaf way, which sounds like it's going to be a differentiator. So I want to kind of dig in there and say, what is Northleaf’s specific approach to building a secondary portfolio? And in particular, how do you think about LP-led versus GP-led deals and what are your key levers for risk management diversification?

Shane: I mentioned the mid-market focus before. Our strategy is very grounded in a couple of principles. We are focused on trying to invest into high-quality companies, managed by high-quality GPs, typically first and second quartile, mid-market GPs. So quality, it all kind of starts there. The second point is when we think about what we're really doing, and we're often asked about, probably the most frequent question I get from investors is around discounts. What discount are you buying funds at? Because typically the secondaries industry is associated with paying discounts to net asset value, often a stale net asset value that can be up to six months old, in some cases, So, although discounts are clearly helpful and it's always a good thing to buy things that discount to reference net asset value in the underlying fund you're acquiring. We're really, I'd say almost embedded value hunters.

We're really trying to identify where can we deliver embedded value to our investors, and sometimes that means a very significant discount to the net asset value. Sometimes that can mean a less significant discount to the net asset value in terms of the optical price we're paying. But it really is trying to identify companies and portfolios that have a lot of embedded value that our investors are going to be able to reap the rewards up. Beyond that, when we think about portfolio construction and how we're building our secondaries fund, diversification is extremely important. We're big believers in diversification to mitigate risk. Just as an aside, with everything going on right now, I think that is more important than ever. It's very difficult to know what sectors are going to get rerated going forward, et cetera, face headwinds. We're typically ensuring our fund is very diversified across many dimensions, Industry, vintage year, we're buying into underlying private equity fund manager or GP exposure we're taking when we buy portfolios. So diversification is something we monitor very carefully.

And we have a dedicated team here at Northleaf called Portfolio Strategy and Analytics. They play a very important part of our investment process, advising the investment committee, working alongside our deal teams, monitoring fund-level metrics like the ones I just described, pacing, et cetera. And really, it's all about, trying to build portfolios and a fund that will perform well in different market scenarios, in different environments. A lot of thoughtfulness goes into how we construct our portfolio and portfolio construction. And the secondaries industry is one that lends itself to that because there are so many different deal types that have slightly different cashflow and slightly different risk profiles to them. You can be very thoughtful around how you're layering in different transactions at different points in time to deliver that investor objective.

You asked on the GP-led, LP-ed split. To level set, because I understand maybe the audience may not have heard of some of these terms historically. When we talk about an LP portfolio transaction, that is a more traditional type of secondary, that's really where the industry started. So this is where one investor into a fund, for whatever reason, after 3, 4, 5 years, decides it would like to sell its position in that fund. When an investor makes a commitment to a private equity fund, a closed-end fund, that is a long-term commitment. There is no public exchange an investor can turn to to sell its position if, for whatever reason, it decides it needs liquidity after a few years. So the investor will turn to what is called the secondaries market, where a secondaries fund will effectively acquire that fund position and step into the fund as a limited partner.

When we talk about a GP-led transaction, that's where the private equity manager is really initiating the secondary transaction. So a private equity manager or fund takes an asset, as oftentimes a single company or sometimes a couple of companies, out of an older fund and moves it into a new what the industry terms “continuation vehicle” or “value extension vehicle” to really reset their ownership timeline on that asset or assets. The private equity industry has grown up around this 10-year closed and limited partnership fund model. And one of the issues with that is it does make it harder for private equity managers to hold assets longer term. And so when a private equity manager sees a company that it feels it can continue to generate value creation and outsized returns for a longer period of time than what the traditional fund model allows, it will sometimes move an asset into these value extension or continuation vehicles. And that's become a pretty significant part, roughly half of the secondaries market actually, over the last few years has grown very strongly. So we're active across both. We do tilt a bit more to the LP-led segment, but we do also invest in GP-led continuation vehicle transactions. They have complementary return profiles and cashflow profiles. So we think having a fund that mixes or a strategy that mixes both strategies can be very powerful. Albeit we do tilt a bit more to the LP-led segment.

Stewart: That's super helpful and a really thorough answer, and I appreciate that. I've learned, I'm learning and taking notes as we go here. This is the part of the program where we ask you to dust off your crystal ball, and that's looking ahead, right? So as you look forward, what do you think the future is for secondaries? Are there any supply-demand dynamics to be concerned about? And do you see, or how do you see, co-investments playing a role here?

Shane: Again, at the risk of maybe providing a bit of a long-winded answer and a bit of a historical context. So the private equity industry has grown as an industry very strongly, certainly coming out of the GFC, we've seen AUM growing double digits over that period of time. And specifically, if you look between 2018 and 2022, the industry grew very strongly. Fundraising was very robust, particularly in 2020, 2021, we really saw what consultants would sometimes refer to as hyper-scaling in terms of the AUM that was sort of managed by the private equity industry, obviously the buyout industry being the largest component of that. When interest rates increased significantly, what we saw was underlying deal activity really ground to a halt, bid-ask spreads appeared. And this wasn't caused by underlying company performance so much as it was just a rates issue. And so the private equity industry has historically seen distributions as a percent of net asset value in the 20% to 25% range per annum.

And what we've seen the last couple of years with very subdued exit activity and deal activity is that ratio basically halving, falling to 11%, 12%. So we've had two years where investors into private equity funds, limited partners, have received very subdued distributions back to them from their private equity managers. That's created a lot of pressure in the industry. I think illiquidity is generally a very big theme right now, and that's where the secondaries market, as basically a liquidity provider to an illiquid industry, can step in and play a really important role. When you look back at 2024, the secondaries market hit an all-time record: $160 billion of transaction value, it was up almost 40% year-on-year, as it really stepped in to take advantage of this market dislocation we were seeing following the interest rate increases. If you wind forward to today, I think the expectation was that 2025 was going to see the flywheel start to really spin again in terms of deal activity and distributions coming back to investors through sales of underlying portfolio companies.

And as you can imagine, just given what's transpiring in the world today, that hasn't happened. The illiquidity freeze continues. How long that will continue, that's where my crystal ball may be as hazy as anyone's. But I think most experts, if you follow the daily publications, seem to be getting more and more negative on where we're heading from an underlying growth perspective and inflation perspective, et cetera. So I think this is where the secondaries industry can be a very effective countercyclical strategy. When we see periods of disruption and volatility like this, it can lead to a lot of opportunity for the secondaries market. And I think generally people are very optimistic on the secondaries industry for the foreseeable future. And I would just mention that everything I just talked about is more of a cyclical tailwind for secondaries. This industry is not only driven by those sort of cyclical tailwinds, there are some very attractive underlying secular tailwinds driving secondaries, which I've largely touched on in terms of increased portfolio management on the part of investors in the private equity asset class, the rise of continuation vehicles, which we're seeing private equity managers now use much more frequently to hang on to star assets.

And then of course, just the underlying increase in private equity net asset value is positive for secondaries because it's effectively a kind of first-order derivative of the amount of net asset value in the ground and across the industry.

Stewart: So occasionally, Shane, my CIO friends, allow me to put that, let me borrow one of their hats. I'm going to put that hat on and ask this question. If I'm an insurance CIO, thinking about getting into this part of the market, what's one piece of advice that you'd give me?

Shane: I think generally when we get in periods like this…look, your core asset that you're investing behind is the team and the people. It's a judgment industry at the end of the day. So certainly when it comes to private markets, I think it's all about trying to ensure you're partnering or backing cycle-tested teams where you see a lot of continuity. And that's not to say you're not going to see a team having made some mistakes. It's very difficult to bat a thousand in this industry. But generally speaking, you want to see over time that kind of asymmetric batting percentage and where mistakes have been made, what are the lessons learned? What were the changes made as a result of that? I think it really may be a bit of a cliche, but it's all about the people, the team. So really trying to ensure you're backing teams that have seen cycles before, been through periods of volatility, I think becomes more important than ever when you're getting periods like this.

Stewart: So one of the questions that I've been asking of late is what are the characteristics that you look for when you're adding members to your team? And not so much school or skillset, but characteristics.

Shane: It's a great question, Stewart. And I would say in our business, it is a people business. Our most valuable asset is, frankly, our team and our culture. And here at Northleaf, when I joined the firm about three and a half years ago, I've been really impressed by the amount of emphasis we place on culture and our people here. I think it is one of our differentiators, and I also think when people get to know Northleaf or interview with us, it's one of the reasons they really want to come, and it frankly leads to very low turnover. And I would describe maybe, before I talk about individual characteristics, at the firm level, I often like to use this expression that it's a really nice combination of high performance and collaboration. So people who bring that to the table will do well in the Northleaf culture and organization.

And so I think when hire and interview people and meet people, I mean, you mentioned the academic credentials, and I think for the most part, everyone that we're interviewing when we post a new role or look to bring someone in the team is going to be coming from a great school, have great academics, et cetera. So beyond that, really, I think it's really about looking for people who want to win, who are hungry, if I can use that expression. So that really goes to the high-performance part of what I mentioned earlier, combined with people who are very team-oriented, very collaborative, and have really strong communication skills. We're not a kind of star culture here where it's all about one individual, really its about the team. So I think people who bring that team orientation, are very collaborative. Having great communication skills is the other formula that works really well here.

Stewart: A former hockey player doesn't hurt anything either. That's super helpful. Last question. It's a fun one. You can have lunch or dinner with up to three guests. Who would you most like to have dinner with? Alive or dead?

Shane: I should probably give a more intellectual answer to this, but honestly, I'm still such a big fan of the game of hockey, and it had such a big part of my life, was such a big part of my life growing up. I'd certainly had my father there because he's also a huge hockey fan. And then I'd probably pick one of my childhood idols. I'm going to go with maybe Wayne Gretzky.

Stewart: What about Ovechkin? Would you have Ovechkin and Gretzky there at the same time? I mean, that would be interesting.

Shane: Yeah, I think if I were going to pick another one, honestly, I'd probably go with a guy named Steve Yzerman, who played in Detroit for many years. He was also an idol of mine growing up on the hockey side.

Stewart: That would be quite a dinner. I really appreciate you taking the time. We've had a tremendous education today, Shane, thanks for being on.

Shane: Thank you so much for having me.

Stewart: We've been joined today by Shane Feeney, managing director, Global Head of Secondaries at Northleaf Capital. Thanks for listening. If you have ideas for a podcast, please shoot me a note at Stewart@insuranceaum.com. Please rate us like us and review us on Amazon, Apple, Spotify, or wherever you listen to your favorite shows. My name's Stewart Foley. We are the home of the world's smartest money at InsuranceAUM.com.