Jon Madorsky – Navigating the Evolution of Private Equity Secondaries (EP.448)

Jon Madorsky is Managing Partner and Co-Portfolio manager of the secondaries strategy at RCP Advisors, one of the largest managers focused exclusively on North American lower middle market buyouts. Jon joined the firm 21 years ago and has participated in the growth of the secondaries business from its earliest stages. His partner, Alex Abell, joined me on the show last year and that conversation is replayed in the feed. Our conversation covers the history and maturation of the secondaries market from a red-headed stepchild to a modern portfolio tool. We discuss the use cases, transaction types, and capital sources in secondaries, RCP's investment strategy, levers of value creation, portfolio construction, and exit strategy. Jon also shares his perspective on secondary market pricing, growth, risks, and the future of the industry. If you'd like to learn more, reach out to Jon directly at [email protected] mailto:[email protected]. Learn More Follow Ted on Twitter at @tseides https://twitter.com/tseides?lang=en or LinkedIn https://www.linkedin.com/in/tedseides/ Subscribe to the mailing list https://capitalallocators.com/ Access Transcript with Premium Membership https://capitalallocators.com/signup Editing and post-production work for this episode was provided by The Podcast Consultant (https://thepodcastconsultant.com https://thepodcastconsultant.com/)

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:05Ted Seides?

  Hello, I'm Ted Seides and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at capitalallocators.com.

• 0:32Speaker 01

  All opinions expressed by TED and podcast guests are solely their own opinions and do not reflect the opinion of Capital Allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Capital Allocators or podcast guests may maintain positions in securities discussed on this podcast.

• 0:51Ted Seides?

  My guest on today's Sponsored Insight is John Madorsky, Managing Partner and Co-Portfolio Manager of the Secondary Strategy at RCP Advisors, one of the largest managers focused exclusively on North American lower middle market buyouts. John joined the firm 21 years ago and has participated in the growth of the secondaries business from its earliest stages. His partner, Alex Sabell, joined me on the show last year, and that conversation is replayed in the feed. Our conversation covers the history and maturation of the secondaries market from a redheaded stepchild to a modern portfolio tool. We discuss the use cases, transaction types, and capital sources in secondaries, RCP's

• 1:36Ted Seides?

  investment strategy, levers of value creation, portfolio construction, and exit strategy. John also shares his perspective on secondary market pricing, growth, risks, and the future of the industry.

• 1:51Speaker 02

  Before we get to the interview, we're excited to share a new opportunity to join the Capital Allocators team. We're hiring a head of content to lead everything we create and share with you, our listeners and followers. That includes our flagship podcasts, our newsletters and written content, our website and social channels, and our new video content. We're looking for someone who's excited to roll up their sleeves, get into the weeds, and own our content processes from start to finish. Most importantly, we're looking for a fan of the show. Someone who's jazzed about long-form interviews with leaders in the institutional investment industry. Someone who brings energy, pride, and a sense of purpose to our mission of compounding knowledge and relationships among asset owners and investment managers.

• 2:36Speaker 02

  This person should be detail-oriented, organized, experienced in project management, and ideally have a background in media or podcast production. The job posting is in the show notes and on our site at capitalallocators.com/about. Thanks so much for spreading the word about our head of content job opening. Please enjoy my conversation with John Mendorzky.

• 3:01Speaker 02

  John, great to see you.

• 3:02Speaker 03

  Thank you very much for having me.

• 3:03Speaker 02

  I would love you to take me back to your growing up, eventually leading into being in this business.

• 3:11Speaker 03

  Yeah, I grew up in Miami, Florida, which is a very different animal. It's a melting pot of many different cultures. From a community-wise, in the 80s, Miami was a very interesting place to be. And then, lastly, as I was an up-and-coming pre-teen, being in that space gave me a lot of interesting opportunities that I wouldn't have had elsewhere. So, I was thinking, one of your questions, what was your first job? We lived in what was then a fairly rural area of Miami. Today, it's the center of it, but it was a old mangrove farm. It was just parceled out, and our house just happened to be on one of the acres of the mangrove farm. We had, let's call it, eight or 10 trees. As a seven or eight-year-old,

• 3:55Speaker 03

  I would cut mangoes down and then walk them to the natural food store and sell them. An entrepreneurial spirit has always been embedded in my system. That same entrepreneurial voyage for me continued. When I got too old to be a mangrove salesman, I started walking dogs. I still have a business card in one of our bathrooms that says Walkin' John's Pet Services. It was a dollar a walk. And then I started sea dogs with one of my good friends and we would wash boats. So before I had even graduated high school, I had all of this little side hustle, but all very Miami. Boat washing, mangoes, everything in between. It was a really unique place to be and it's still very much part of my soul.

• 4:38Ted Seides?

  As you went through your education, how did you think about that in the context of either the business world or where you would go after college?

• 4:45Speaker 03

  I always assumed and thought I would go into something entrepreneurial. Today, if you say, John, are you in an entrepreneurial environment? In finance, I would say 100%, absolutely. But entrepreneurism today takes a different look and shape. Back then, it was just doing something on a smaller basis and not as institutional. When I was in college, my parents didn't push me to do anything. They just said, follow what you like. And I graduated a history major, which is a funny degree to have. But the reality is you can spin it into saying it's the foundation for making all investments.

• 5:24Speaker 03

  As a history major, we take a primary hypothesis and we use primary and secondary information to validate that hypothesis. Ted, that sounds a lot like a investment. So there I was, I was a history major and I started working in strategy consulting at PricewaterhouseCoopers, largely because I didn't really have a deep level of mentorship to know what I wanted to do. I just took a job and off I went. My dad's a doctor, so he just said, don't be a doctor. After I left PricewaterhouseCoopers, I did an entrepreneurial startup and then I went to business school. And I've been at the same job since I graduated business school, 21 years. It's pretty amazing. I think that duration is rooted in that entrepreneurial spirit.

• 6:08Speaker 03

  I joined RCP when they were raising their first fund. We had $86 million under management, which in fund-to-fund construct is very, very small.

• 6:19Speaker 03

  Our first office, two of my partners shared the conference room as their office and I had a cube outside. It was tiny. Being entrepreneurial and being lucky and us being complimentary and successful allowed us to build a really big organization. Today, I have to take a step back and be really grateful with the fact that we built one of the largest managers focused on North American lower middle market buyouts. Pretty wild.

• 6:45Ted Seides?

  A lot of your focus been in the secondary space. And I'd love you to take me through over the last two decades, how it's evolved to where we are today.

• 6:54Speaker 03

  Yeah, it's a good question from somebody who has a history major. Let's start at the beginning of private equity in the early 90s when you had no secondary players at all. And a limited partner that would invest in a private equity firm was in that manager until it had full liquidity. And there was no exit out. The secondary market was really birthed in 1990. You had two managers, Coller and Lex, 90 and 93. And they were started because you had the 87 crash and then the early 90s recession. So people needed and wanted to sell their private equity positions and they were buying

• 7:36Speaker 03

  limited partnership interests. But it was still very much a cottage industry and there was not really intermediation in it. It was a market that was very much underground. We didn't see any of those transactions occurring. GPs would use a secondary as almost like a scarlet letter to think that something's wrong with their portfolio. This real largely continued probably until, let's call it, the early 2000s.

• 8:02Ted Seides?

  So in those early years, if somebody wanted to sell or had to sell, if there's no intermediation, how did you even find a Coller or Lexington at the time?

• 8:12Speaker 03

  It was difficult. There was two elements to that question. One is, how did they find them? And then secondly, how did they even know what these assets were worth? In terms of finding them, the landscape of limited partners was so much smaller. If you think about the total amount of NAV, the total number of investors in the space, it was still a very cottage industry. In 1995 or 2000, KKR's fund might have been a billion dollars. I'm going to be wrong in that number, but it's at least directionally accurate. So it just speaks to the fact that the market was small. Within the market, there was like known pockets, and I think that's the way a lot of people were finding the transactions.

• 8:52Speaker 03

  The other piece of it was that prior to 2007, there was not a mark-to-market valuation methodology universally adopted. The NAV, the value of the position, was the lower of cost or market, lower of the cost of market. The FASB rule of 157 drove to a more mark-to-market situation. So at that point, 2006, that's when secondary buyers would have to price the positions because there was a real market value to them.

• 9:27Ted Seides?

  What caused that scarlet letter to change?

• 9:32Speaker 03

  The point of maturation, almost immaculate conception, was global financial crisis. In 2010, everybody awoke to the fact that private equity positions could be sold. When you look at the 2010 volume, it was right around $20 billion. So let's mark our growth of the industry with the volume size. A lot of LPs recognized this is a market that they can use to get liquidity. It was at that point still very much of a distressed market, distressed sellers. But also, a lot of entrants started, moved into the market, and we were one of them. GPs went from, we've never had a secondary in our portfolio, to, will you help us out

• 10:16Speaker 03

  and buy this secondary position from this limited partner? It was a real eye-opening opportunity. For me, it was a real career inflection point. We went out and thought about hiring somebody to be the portfolio manager. We were looking for two key attributes. One was going to be secondary capabilities, transaction capabilities. And the other piece was knowledge of our market because our lower-middle market space is very unique. My partners tapped me and said, you should think about doing this. So this is when I joined the secondary landscape. And I feel really fortunate because it's grown exponentially since then. So $20 billion in 2010, 170 or 80 billion dollars in 2024.

• 10:59Speaker 03

  We went from a cottage industry to like a professionalized or at least acknowledged industry in 2010. The next major point that I think is important is when people started identifying leverage in the market, specifically asset-based leverage to buy portfolios and put a loan on those specific portfolios. This was in the 2014, 15 timeframe. A lot of the larger players started consuming the entire portfolio versus the portfolios being sold in a one-off basis.

• 11:31Ted Seides?

  Joe, at what point in time did the transactions move from LP-led, so an LP needing liquidity, to the GPs using it as a technology that was useful for them to say, wrap up a fun life, or what's become with continuation vehicles?

• 11:50Speaker 03

  Beginning in 2012 and 13, there were some early deals and the language they would use would be like zombie funds or GP restructurings. Those were largely tougher assets or tougher manager quality. And that continued largely, but in a very small percentage through 2017. For me, there was a watershed moment when one of our best GPs decided to do a GP-led transaction. And immediately, the market changed the name of a restructuring to a recapitalization. A recapitalization has all those positive connotations versus a restructuring, which has the negative connotations.

• 12:33Speaker 03

  The market shifted wholesale in 2017, 2018, and you can see that with the volume. By 2020, about half the volume was GP-led transactions and half the volume was LP transactions. Juxtapose that versus 2010, it was all LP transactions. And it fundamentally changed the way that the market approached secondaries.

• 12:58Speaker 03

  The next thing that happened was COVID. And in COVID, managers realized that they would need more time on their portfolios. So we renamed GP LEDs and started calling them continuation funds. Same mechanics, same structure, same assets, but we just changed the name because that was how they were going to behave. This is when GPs needed a little bit more time. We needed the COVID metrics to flow through the financials. And nothing was really selling in 2019 or 2020. I think the next major milestone is really 24 with these 40 act funds or a lot of the retail capital flowing into the market.

• 13:41Speaker 03

  I think when that capital comes into the market, there's pressure on those managers to invest it quickly. So therefore, secondaries is a natural avenue for that. I think a natural question is, well, that was a great history of the last 25 years. Where do you think it's going to go?

• 13:57Ted Seides?

  Very recently, we've had these announcements of some of the longest standing LPs putting big portfolios up for secondaries, most notably Yale and Harvard. How do you think about that as a potential next inflection in the history of what might come in the industry?

• 14:14Speaker 03

  I was looking at a industry report and the survey was how many people have not used the secondary market historically? That number keeps shrinking every year. So although we see in the market that Yale and Harvard are selling, this is not their first sale. It's just actually a return to them selling. A different way to think about it is how much more volume will they sell? How often will they come back to market to sell? The secondary market started as a market for liquidity.

• 14:49Speaker 03

  And in today's world, liquidity is harder and harder to obtain. So we're seeing limited partners come back in a quicker and quicker way. On the demand side, there's a lot of demand for those limited partnership positions. So the sellers feel like they're going to get a fair price.

• 15:07Ted Seides?

  How do you think about the secondary market as one of the tools that is needed to provide liquidity to a primary market that's a bit stuck?

• 15:16Speaker 03

  The secondary market is the tool to provide that liquidity. We see it manifesting two ways. On the GP LED side, we have an incremental transparent perspective on deal flow because we also have a very large co-investment portfolio and we also have a very large primary portfolio. The amount of failed transactions that occurred in 2022 and 23, primary managers trying to sell their assets was astonishing. Effectively, unless it was a perfect asset, it wasn't going to trade. Or they could go to the secondary market. And so many of the deals that we see in the secondary market, there's a little bit of noise on them. Maybe that's why they're not pricing at a premium like the open market might not get

• 15:59Speaker 03

  or collect, but that's the fair value. So GP is using the secondary market as a tool to get liquidity because in one ear, the limited partners are saying, we want maximum value. In the other ear, they're screaming, we want liquidity. So GPs are recognizing this is a great opportunity for us to do a GP LED and give the liquidity that LPs are screaming for. On the limited partner side of the secondary market, we are with less liquidity coming out, with less realizations occurring. People are over indexed in private equity, or they have too big a positions in certain managers, so they're using the secondary market to drive value.

• 16:42Speaker 03

  If we establish a market that feels fair, then people will sell into this fair market when they need liquidity. If we establish a market that feels unfair, then they'll hold on and they'll just suffer through this lack of liquidity environment that they might be suffering through.

• 16:58Ted Seides?

  How else do LPs think about using the secondary market?

• 17:02Speaker 03

  The construct that the secondary market is only for forced liquidity or distressed sellers is probably an antiquated idea, probably idea that was really rooted in the global financial crisis. In today's world, the majority of the volume that we see is probably executed around portfolio construction. And there's a lot of reasons to sell. Sometimes managers are over allocated to private equity. Limited partners are over allocated to private equity. Limited partners are over allocated to specific managers. LPs have change of leadership and as a result, they want to sort of have their imprint on the portfolio.

• 17:47Speaker 03

  So most of the volume we see is almost strategic and not distressed. We are giving them liquidity and what they're going to do with that liquidity, the limited partners, is a strategic decision. Is it to continue to invest in private equity, to get diversification of vintage years? Or is it to just drive liquidity for other uses is something that we don't have the transparency in. But the distressed selling market, I think, is not something we see very often. I would call it a strategic selling market.

• 18:18Ted Seides?

  As an active participant in the secondary market, how do you think about the different ways you want to play in the space?

• 18:26Speaker 03

  Maybe I could create a framework of how I think of the secondary players sitting today. In my mind, it's a three dimensional rubric. On one axis would be deal sizes. For example, RCP, we focus on very small deals, $10 million to $50 million in size. On the very biggest end would be Lexington and Coller. Their transactions are very big. Another axis would be style. We focus solely on North American lower middle market buyout. You have some managers focusing only on venture, some managers focusing only on credit, some managers that have a global footprint. Those are all differentiators in the market today.

• 19:06Speaker 03

  And then the last dimension of this would be how the managers believe they're creating value. So for our RCP, we feel like because we have a very big primary business, our relationships and information give us an advantage in sourcing deal flow and diligencing that deal flow. Some people feel like their values that they could do very big transactions that most people can't do. Some people feel like their values may be buying more complex transactions that some people do not want to do. Understanding that framework really is the foundation for identifying our market is maturing. Once we land into that idea, then we can approach, how do LPs want to use this market? If I go back in 2010, people thought it was an IRR investment.

• 19:51Speaker 03

  Get capital back very quickly, establish a beachhead in private equity, and then supplement that with a primary portfolio going forward. In today's world, secondaries is a complete asset class in itself, and people use it as a position in their portfolio. People use it, yes, for the quicker return of capital. People use it on the GP-led side for return profile and good assets, stable returns. Lastly, just a differentiated piece amongst the entire category of alternative assets. We went from a piece of private equity to maybe being an entirely different sub-asset class.

• 20:31Ted Seides?

  If you look at the value creation piece, in the old days, if it was all distressed sales, assuming you'd think the purchase is an important part of the value creation, you could think about what you own, the underlying asset or the GP. With all those different styles, what do you think works best for creating value?

• 20:54Speaker 03

  Our strategic algorithm, which has been refined both through successes and failures, today is pretty tightly defined. If I could think of this as filters. The first would be a focus on North American lower-middle-market buyout. This is the market that we play in exclusively. As a result of playing in that market exclusively, we know the thousand-plus general partners intimately. We're collecting data on those partners in a very regular cadence. So that gives us a lot of advantages, both in terms of sourcing and diligence. We also have the benefit that lower-middle-market, using prequem data, it's historically outperformed all the other sub-asset classes. We have a little bit of wind at our back. Once it gets through that North American small-market buyout focus,

• 21:38Speaker 03

  which is for us managers under $1 billion in size. The next is manager quality. For us, this is really important. We see managers that are either winding down their businesses or have underperformed significantly over a long period of time. Those are managers we'll back away from. The third element in our algorithm would be good assets. Everybody would say, "We want good assets," but maybe not in today's world. Some people would say, "We don't mind if the asset quality is softer. We'll just price that in." For us, we want a good-quality asset. The fourth part is buying at the right point of the inflection of the value. Let's say T0 is when a fund began. T10, or 12, or 15 is when a fund ends.

• 22:22Speaker 03

  And you plot out the ROICs. Typically, the slope of the return is going to be pretty moderated up until year five or six. Let's call it 1.2, 1.3, 1.4. Then it hits a pretty significant inflection point when you start seeing realizations and you start seeing portfolios appreciate through years, let's call it nine. And then it flattens out that total value, or even degradates down. Some folks will buy tail-end positions. We're not a good tail-end position buyer. We want to be able to identify the value before it hits that inflection point to get our returns. So much so that when you deconstruct our returns, about 80% to 85% of our total returns has been through appreciation, not through discount.

• 23:06Speaker 03

  And then the last piece is price, obviously. So to wrap all of that up in a tighter bow would be good market, good managers, at the right point in time with a good price.

• 23:17Ted Seides?

  How have those lenses changed over the years?

• 23:21Speaker 03

  The two biggest learnings that we had would be first manager quality. When we did our first secondary fund, we did really well. One thing we didn't have a clear grasp on, though, was this construct of manager quality, specifically pressure on returns if manager quality was low. So when we invested our second fund, we were thinking we liked the asset quality, and we were a little bit less tuned in on the manager quality. The way I would define manager quality could be, did they have a subsequent fund being raised? When our second fund, which at this point is a 2013 vintage fund, we had a number of managers that weren't able to raise subsequent funds,

• 24:04Speaker 03

  and the performance of the underlying secondaries that we held suffered as well. That would be something that we tuned into very clearly, beginning in 2017, 18. The other piece of it is this idea of when to be a purchaser. A lot of our contemporaries have done very well being tail end buyers, managers that buy secondary positions at the end of their life. Typically, you're going to see a lot of the value that those folks are getting just through the discounts that they're obtaining. We felt like, because we were trying to target a higher quality manager, and the market was fairly efficient, we're Chicago people, so we believe in an efficient market. We didn't want to necessarily play in the tail end position, so therefore, we reset our filter

• 24:48Speaker 03

  so that we would only be buying positions that are a little bit earlier in their lifecycle.

• 24:52Ted Seides?

  What goes into your assessment of manager quality?

• 24:57Speaker 03

  Our roots are...

• 25:00Speaker 03

  A primary investment manager. If you think about RCP, many would say they're a primary investment shop with a secondary and co-investment funds. And that's what we like. We want to appear like that in the market. It provides a lot of advantages. But having the roots of being a primary manager allows us to assess the construct of team strategy and track record, which we're thinking about in any primary investment. And it also gives us the luxury of knowing these GPs for a very long time. So instead of trying to educate ourselves for the first time on a GP that we're seeing because it's a small market manager, these are folks that we have tracked and followed since their own inception.

• 25:44Speaker 03

  The manager quality element is relative and absolute, but we have that relative capability because we track the entire landscape of managers. And then absolute is around this team strategy and track record framework. Effectively, if we can start seeing a cadence in their transactions, a cadence in their deals, a rhythm, if you will, then we feel like it's repeatable.

• 26:05Ted Seides?

  What level of underwriting do you do on the underlying businesses?

• 26:11Speaker 03

  A critical piece of our strategy is that we're not buying entire portfolios. We're not buying portfolios of 40 funds or 50 funds. Typically, we're buying on an LP interest, a single fund, so it might have five or six companies, or maybe two funds, maybe three. As a result, the quantum of number of companies that we have to underwrite or review is much more narrow than if we're buying 1,000 different companies. So we have the luxury slash benefit of being able to do effectively like a knockdown LBO model for every single company. To do that, you need two things. You need data and you need the qualitative information.

• 26:51Speaker 03

  So on the data side, because we're a primary fund, we're constantly collecting and meeting managers when they're raising capital, when they're issuing data rooms, when they're coming to our offices just to say hello at annual meetings and everything in between. We're collecting all of that data so we can start collecting metrics like EBITDA, revenue, net debt, purchase price multiples on every single company.

• 27:17Speaker 03

  And we can use that to build a bottoms up model. I hope everybody's listened to my colleague and partner Alex Abell's podcast because he talked a lot about the data. But that data gives us the advantage to be able to underwrite everything from the bottoms up. The other lever that we pull is relationships with the general partner. We're going to be talking to both the GPs that own these specific portfolio companies as well as GPs that own comparable portfolio companies to be able to understand the headwinds and the tailwinds of the individual industries, of the individual companies, exit multiples, market appetite. So at the end, when you're thinking about this entire valuation element of when we

• 27:57Speaker 03

  land, it's literally a valuation of every single company rolled up into the cash flow of the fund to figure out what our net returns will be.

• 28:09Ted Seides?

  Having done that collection for the better part of the last two decades plus, how's it changed in the last couple of years with the surge in AI?

• 28:19Speaker 03

  If I'm looking in the future, AI has got a really powerful place in our market. I think historically it has been less so, and we haven't seen it fully manifest yet. Right now, even the data ingestion is a cumbersome task using AI because each of the individual metrics, each of the individual company-specific reporting ideas is in a different spot. Right now, we're still working through like the data ingestion piece of it, and we also use it for maybe like qualitative tear sheets. But in three years, certainly AI will be able to create a first or second run at our models. It might not be able to fine tune or drive a lot of the assumptions that we need the

• 28:59Speaker 03

  qualitative, rich data that we're collecting, but to actually create and populate the Excel model is something that I can absolutely imagine AI using. And I know some people say they're using it pretty robustly today. The delta between the heaviest user of AI and the most of the market is narrowing on a day-to-day basis because AI is getting a lot easier to use.

• 29:24Ted Seides?

  I'd love to dive into the GPU-led slash CV market. What's your broad sense of resolving the various alignment challenges that it poses?

• 29:38Speaker 03

  As a primary investor and as a secondary investor, we wear a two-horned hat, if you will. My partners that are more focused on the primary side feel like the alignment in terms of the valuation is something that they think a lot about. And for us on the secondary side, alignment in terms of the next phase of this investment is something we think a lot about. In 2021, that was a much more poignant topic. GPs could go into the market and possibly sell these transactions. Were GPs getting top dollar? It always felt like as a buyer they were, but always felt like as a seller they weren't. It's sort of like the old thing, both sides are unhappy, then maybe that's the middle point.

• 30:23Speaker 03

  But beginning in 2022, where liquidity really dried up in the market, limited partners recognized the value of the secondary market to drive liquidity in their portfolios. So rather than saying, we don't feel like we're getting top dollar, I think a lot of limited partners moved into the construct of saying, we're happy for the liquidity.

• 30:45Ted Seides?

  As you've looked at the various different CVs that come onto your plate as potential transactions, what filters have you used to decide what you want to engage with?

• 30:55Speaker 03

  The secondary market has evolved in the same way that styles and strategies have. We want to make sure that this is a high-quality asset and that it's de-risked. More specifically, we want to make sure that there's a good reason for the GP-led transaction to occur. It's not just to get liquidity, which we feel would be misaligned. Have they held on to it for a long enough period that it's time to sell? Has it appreciated enough? Do they need more capital to do further add-on acquisitions? Or do they need more time on a hold period because maybe the management team is new? We want to make sure that the GP-led transaction we're buying, the go-forward strategy is

• 31:37Speaker 03

  a continuation of the historical strategy, so it's been largely de-risked.

• 31:42Ted Seides?

  When you've looked at the universe of those transactions over the last couple of years, how's the performance of the universe looked compared to the rest of the private equity universe?

• 31:54Speaker 03

  In terms of the fan of outcomes, it's still a little bit young to think through where the ultimate outcomes are going to be. We've been hit broadly with a less liquid market on the exit horizon as well. So combining younger or less mature assets from a GP-led perspective, as well as a tighter liquidity market, I think the ultimate outcome of a lot of the CVs is still unknown.

• 32:19Ted Seides?

  In the last stage of history, there's this new insurgence of capital coming. Private wealth started to come. How has that played into the secondary market?

• 32:29Speaker 03

  40 act funds or the retail market has influx into the secondary space. 24 was the year of the retail capital. And it's amazing how much capital has been raised from that avenue. Institutional capital has historically been pretty stable and maybe the addressable market is fully satiated. So as managers are looking to raise more capital, this is a greenfield TAM, if you will. The structure of a 40 act fund or an evergreen fund is they call the capital at once right off the bat. And as a result, the managers have to invest that capital very quickly, which is why we pushed into the secondary space.

• 33:13Speaker 03

  When we've seen a lot of the larger portfolios and even a lot of the limited partnership positions trade in 2024, the retail funds have been the main connoisseur of this product. An interesting question is, what happens in the next 10 years? Going back to my history major roots, let's point to the public equities, which was your specialty. I can imagine a space where private equity looks a little bit like the public equity manager market does today, where you have some people that are focused on almost like an index, that would be a pure retail product. Then you will have some folks that are charging a little bit more that will be specialized

• 33:58Speaker 03

  in what's called that in the public equities world, an active managed portfolio. And then you'll have some boutique managers that will be focused on the more historical institutional investor base, and let's call that the hedge funds of today. There's a good argument for private equity pushing into that as we see the democratization of private equity in the retail space.

• 34:21Ted Seides?

  What do you think that would look like? That corollary of the hedge fund into the private equity space?

• 34:26Speaker 03

  Hedge funds are specialized managers that are tapping into a more institutionalized limited partnership, charge a little bit more, and probably have an expectation of a greater return profile. What they lack is the ability to scale like a index fund. That's the trade. And within this private equity world, if I can draw that same corollary, managers that stay in this highly specialized space will be smaller, will have a deep level of specialization, charge a little bit more, but force them to also have better returns. I can go on the same continuum of the full retail product, which would be like an indexed fund, which would be lower return profile, but lower fees as well.

• 35:11Ted Seides?

  What are you seeing today happening to price? Pricing of secondaries as you have this surge of interest coming from the 40 act channel?

• 35:21Speaker 03

  Investment bankers would claim that the 40 act funds are paying anywhere between 200 and 500 basis points more than a typical fund. So it's putting pressure on the pricing. What we're really looking for is there's some folks that are 40 act fund exclusively. There are some folks that have a 40 act fund that runs in parallel with their core fund. And then there's some folks that don't have a 40 act fund at all. My expectation is the people that have a 40 act fund and a core fund are probably not putting as much pressure in the pricing as just the pure 40 act funds are because their model is a little bit different. They have to have the same return profile on both of their products.

• 36:03Ted Seides?

  I'm curious, this juxtaposition of the 40 act channel clearly growing, at the same time you have now potentially real bellwether announcements of secondary sales at Yale and Harvard. Where do you see that shake out? It's the institutional market maybe is saturated or oversaturated, at the same time that there's this new channel of money coming in?

• 36:28Speaker 03

  I think fundamentally, your question is around growth of our space. And let's say in 2025, expected secondary volume is $190 billion, plus or minus. That represents a percentage of the total amount of NAV that is in alternatives in general. Historically, that ratio, which has been the total volume over the total amount of NAV, has been about 1 to 1.5%. Let's imagine a scenario where the total volume goes to 2.5% or 3% or 4%. You could very quickly see our market doubling or tripling or quadrupling. I think that's

• 37:10Speaker 03

  going to drive a lot of the volume that we're seeing in the secondary market, along with the idea that liquidity in our market over the past couple of years has changed in terms of duration. When we first started, the average assumption on a company being held in a portfolio was four and a half to five and a half years. I think today, that same assumption is probably six years plus. And you've seen it with some institutional reporting coming out, where the amount of liquidity that limited partners are getting on a yearly basis has come from a number of 15 to 20% of their total commitments every year returning back to 10% or maybe

• 37:50Speaker 03

  even lower. So as liquidity continues to pressure the market, that will continue to drive volume. Do we have space for all of these new entrants in secondaries? Do we have space for people raising more and more capital within secondaries? Yeah, we could very easily see all of the secondary volume get to

• 38:11Speaker 03

  400, 600 billion dollars. I have a good friend in our space and we call him the trillion dollar man because he thinks it's going to be a trillion dollars. Maybe, but I don't know when.

• 38:21Ted Seides?

  So if you look at the industry as a whole, it's clear that there's an increase in the supply of partnership interests that will drive that one and a half percent to four or five percent. I'm curious where you see the demand for that secondary activity coming from?

• 38:37Speaker 03

  I'm smiling because very often we get the exact opposite question, which is, is there too much capital in the market chasing secondary transactions? And here we are talking about the idea of, is there enough capital in the secondary market to satiate the supply? It's a very valid question. We've seen the market grow from active buyers, which is buy side on it, both in terms of people raising more and more capital, so bigger fund sizes. In 2010, of the top 10 biggest private equity firms globally, one or two of them were secondary players. If you look at it today, it's a handful or more, meaning secondary players are raising much bigger funds.

• 39:21Speaker 03

  And as a result, that is one of the components that's going to be able to satisfy the supply. Secondly, we're seeing new entrants into the market with the 40 act funds. And then finally is we're starting to see typical private equity general partners enter into our space. If I were them, I would be thinking, I'm losing transactions to continuation vehicles, so let me get into the GP led space. A couple of them have already announced that they're raising funds, whether that's Leonard Green, ADV, New Mountain, and then a couple are quietly poking into the background. What's interesting is all of those folks are mostly focused on the GP led volume versus the LP led volume.

• 40:05Speaker 03

  What we're seeing is a further specialization in the market where maybe the LP led volume will be consumed by LP led focused people, where the GP led transactions will be more focused on some of the GP led specialists as well.

• 40:20Ted Seides?

  Have you thought of your competitive positioning in that change in the landscape?

• 40:25Speaker 03

  Our focus of lower middle market has a lot of moats around it. We have these relationships with the GPs. If it's a GP-led transaction will either lead a transaction or be a syndicate player. And for us, there is no economic difference in being a syndicate player nor a lead player. That has evolved, though, where being a syndicate player used to get a full allocation regardless of your position in your relationship with the GPs. Today, it's probably a little bit more difficult. But we still feel really confident in that idea. Another moat is just the quantum of GPs that we're targeting.

• 41:06Speaker 03

  There's no such thing as off-the-shelf pricing for small-to-middle-market manager in Chicago. But we have that relationship with them, so we can price them very quickly. If you're a larger GP, it's difficult to buy those positions because there's not a historical model, there's not a historical knowledge. But for us, we know that. So the moats that we have in place, which is our specific strategy, I think is defensible, both with the 40 Act funds, specialists with large players coming in. But our market's evolving, and I don't think that we can stick our head in the sand and say we should not or we cannot evolve with the market.

• 41:45Ted Seides?

  As you look at the types of companies that are coming through, how have you shifted your preferences to the types of underlying companies in your space that you like?

• 41:56Speaker 03

  When leverage was less expensive, the capital-intensive businesses were a little bit more easily digested, buy-in builds. Where today, the construct of a buy-in build is a little bit more difficult because leverage is so expensive. When we think about our portfolio and how it's evolved, it hasn't course-corrected, it hasn't changed wholesale, but it feels like many of the deals that we're doing today are less capital-intensive businesses that have been able to grow organically and also have a high level of free cash flow yielding off of them. With the market, are we in a recession? Are we going into a recession? Are we in a trade war? Are we going into a trade war?

• 42:42Speaker 03

  I don't know, and I don't think anybody knows. But the market prices that with that in mind. When we're looking at a transaction today, we have to take the worst case scenario position versus the best case scenario position because if we take the worst case scenario position and we're wrong, we're right. And if we take the best case scenario position and we're wrong, we're very wrong. As a result, I think a lot of the construction that you would think to have around volatile market, which we're in today, is being inserted into all of our assumptions.

• 43:18Ted Seides?

  You go through this whole exercise of data collection and looking at all the sourcing and trying to figure out what you want to own. How do you then think about the portfolio construction and management of your portfolios?

• 43:30Speaker 03

  Our portfolio is bifurcated in the LP positions and the GP-led positions. There's even two types of GP-led transactions that occur today. One is a single asset and one is a multi-asset transaction. Now we have three different types of transactions. We have LP positions, GP-led multi-asset positions or diversified portfolios, and GP-led single asset positions. And each behaves very differently from a cash flow perspective, and each behaves very differently from a ROIC or MOIC perspective. When we're building our portfolio, we want a blend of all three of these because when you think about the combination of all of them, they're highly complementary to each other.

• 44:13Speaker 03

  Let's start off on the most liquid part of it, which is the limited partnership or LP secondaries tend to return capital quicker. Additionally, there's a discount involved in many of the limited partnership positions. As a result, the J-curve is even more muted because we can write it up to the NAV at acquisition. The multi-asset GP-led transactions will have a fan of distributions. Now, what's interesting about the multi-asset transactions is

• 44:43Speaker 03

  Historically, in private equity, just on the principal investing side, managers had sold their best companies very early and got stuck with their worst companies. They cut their flowers and watered their weeds. But in a multi-asset GP-led transaction, we afford the availability and we push GPs to get rid of those weaker performing assets. Because all of the assets are getting reset at a price and all of the economics are getting reset, if the GP sells their underperforming asset in year one or year two, only returning 1.5 or 1.8x in one year, that's a very successful transaction. It also allows them to hold their very best transactions to continue to drive ROIC.

• 45:28Speaker 03

  So when you look at the behavior of those multi-asset GP-led transactions, there's both quicker return of capital or liquidity and there's also uplift in value, ROIC and IRR. Then finally, you have a single-asset transaction, which is typically an investment at a point in time and hopefully an exit at a point in time, three to five years later. Having that blending is something that our LPs really appreciate.

• 45:55Ted Seides?

  How do you think about being a preferential LP compared to other secondary buyers?

• 46:04Speaker 03

  That is something that we advertise on our foreheads. Look, the secondary market is efficient. There's an intermediary involved and our job is to try and disintermediate some of the intermediation. And if we can be a preferential buyer, it allows us to do just that. So we get to drive deal flow because the GPs are going to be viewing us as a potential limited partner. When we're sourcing, the secondary world is a small universe and we're all frenemies. I have a deep level of love for them, but also being a frenemy, when we're competing and we're trying to drive deal flow,

• 46:46Speaker 03

  we will try and execute anything that we have in our quiver to be able to get that. So we're selling against secondary players that don't have...

• 46:57Speaker 03

  A primary pool of capital so we can try and advantage ourselves in every way. Going back to that matrix of how we should be thinking about the market and how people are driving value, that is one of the main differentiators we have is a focus on lower middle market and a relationship with these GPs in a really acute way.

• 47:18Ted Seides?

  So, once you have your portfolio, you're monitoring what's happening, you have this big secondary market. I'm curious to ask you about how you think about exiting your positions.

• 47:28Speaker 03

  When we first started our secondary practice, we were thinking a little bit on how long do private equity positions stay alive for? And we did some research, there was some public information from larger pensions and endowments, and it was shocking. It's not 10 years, the life of a fund. It's not 12 years, the life of the fund plus the two-year extensions. It's 15 to 18 years. We want to complete our investment over a specific time horizon. Let's call it 10 to 12 years. Beginning in year nine of our fund life, we begin actively evaluating our portfolio and deciding which to go back into the secondary market to resell.

• 48:09Speaker 03

  And we will curate portfolios that are going to be large enough that they'll attract a lot of buyers and consistently, almost on a yearly cadence, liquidate positions so that our funds do have a terminal life of 12 years.

• 48:24Ted Seides?

  What are some of the big questions you have about how the secondary industry needs to optimally grow and improve itself so that what looks like it will be a continued period of growth does play out?

• 48:41Speaker 03

  I think the secondary buyers always need to have the secondary sellers feel like they're not getting taken advantage of. For us, it's transparency. Even when we're buying a position and we're negotiating with or against a limited partner that's selling, we try to articulate that there is value in the portfolio. And the hope is that the seller recognizes that we have to have a return profile. They can't feel like they're getting their faces ripped off. It just isn't a sustainable business model. And the same is true on GP LEDs. For us to be transparent with the sellers about why we're landing on values, what the expectations are, what the return profiles are,

• 49:24Speaker 03

  will allow people to continue to want to sell into this market. I hate using this term, but a win-win. And that's where we really have to land in order to have that sustainability. We can't just be like predators trying to feed off distressed animals.

• 49:41Ted Seides?

  What are some of the behaviors you've seen that concern you? Of others, of course.

• 49:47Speaker 03

  Right. From a negotiating perspective, putting pressure on people is an uncomfortable feeling. Buyer saying, we're only going to buy all of this even though you might not want to sell all of this, or you have two days to make a decision. Those are all levers that I get. And you can certainly push that tactic through. But my assumption is that a LP that is selling into a high pressured environment is probably not feeling very good after the transaction. That would probably be the biggest thing that we see. On the CV side, sometimes when there's not necessarily a transparent process is a little bit discerning for limited partners.

• 50:31Speaker 03

  Was an investment bank hired? I think an investment bank should be hired. Should multiple people be bidding on this position? Or should the market price be set in a certain way? Having that transparency of understanding that we're getting something fair is the way that we have sustainability in our strategy and our market.

• 50:50Ted Seides?

  So you look out over the next couple of years. What most excites you about your business?

• 50:55Speaker 03

  Being involved in a maturing industry is chaotic. It's like a startup. We're changing and the rules are evolving. And the pace of evolution that we've seen over the past 15 years is incredible. Are we going to continue to see that pace of evolution over the next 15 years? Maybe, but at the same time, I think the pacing will slow down a little bit. So something that excites me is really the ability to refine and not just react as quickly. What does that mean? I think in terms of the ability to source deal flow, thinking about sourcing deal flow on a more proactive basis, the adoption of people opportunistically selling is probably going to be really interesting.

• 51:37Speaker 03

  Now, there's not a general acceptance of this being a high-volume liquid market like the public markets are. If we could get a little bit more liquidity, have that turnover rate go to 4% or 5%, our ability to proactively target assets that we're really trying to go after will only grow and allow our business to grow. If we go back to this idea of index actively managed and hedge fund corollary, to some extent, maybe returns will come down on the latter side of it. What does a retail investor expect? I have a Schwab account. I can open up my Schwab account and I can see how much my portfolio has held that today and how much volatility I had over the past three days.

• 52:22Speaker 03

  I think some of those reporting mechanisms are probably going to be expected by a lot of our limited partners, especially the retail community, will push that idea in a pretty acute way. So it's going to move to a business of customer service as much as investing. And that customer service, going back to Schwab, the technology stack they have is really interesting and getting that reporting, not on a quarterly basis like all of us do today, but on a daily basis, might manifest in a pretty quick way.

• 52:58Ted Seides?

  All right, John, I want to make sure I get a chance to ask you a couple of closing questions. What is your favorite hobby or activity outside of work and family?

• 53:04Speaker 03

  I am either cursed or lucky with a deep love of cars. It started with my dad. My dad is a car guy and some of my earliest memories are with him, sitting next to him in a car, but all the cars have changed. I have that same bug. I like vintage cars. I like to fix vintage cars. I like to understand them. I like to repair them. And then usually when they're perfect, I often sell them. Just the whole process is really rewarding to me. The other piece is when you work on a car or when you drive a car, you're so present. There's no space for noise of work or no space for noise of family.

• 53:45Speaker 03

  You just have to be there. And recently I started racing cars as well. And when you're on a track, you can only look at one thing, which is one or two turns ahead of you. And just to have that cathartic experience of a quiet brain is a really special thing.

• 54:02Ted Seides?

  Which two people have had the biggest impact on your professional life?

• 54:05Speaker 03

  I've been at RCP for 21 years. It's incredible for me to think that I've been there that long and I'm that old. But when I think about two people, it's not two, it's five. It's my partners. We have two really interesting foundational elements of my partners that have allowed me to grow so much. One is we're all very different. If we were to take a Myers-Briggs test, we would be across the entire continuum. Through each one, I've learned, one would be how to better open myself up for relationships. One would be how to not necessarily believe that there's an absolute truth. From one would be diplomacy, which is a really tough one. And then one is critical thinking.

• 54:48Speaker 03

  All my partners have allowed me to evolve because we're so different. The other piece of it is we've been together a really long time and we've been stable. And I think rooted in that stability is a level of transparency and vulnerability that we all have with each other. So life happens, death, divorce, marriage, whatever it happens to be. Within my partnership base, we always alert each other of these issues so that it gives us space to live a life as well. And as a result, we've been able to be immensely stable. My partners aren't my best friends, but they're my partners and they've allowed me to evolve into the person I am today, which I'm really grateful to them for.

• 55:32Ted Seides?

  All right, John, last one. If the next five years are a chapter in your life, what's that chapter about?

• 55:36Speaker 03

  My hope is it's mentorship. I'm 52, so when you get to that point, you start thinking a little bit more about the next mountain or the next chapter. For me, it's curating this idea of mentorship of all of the people that are in my life. That have less experience than I do so that I can help them understand my victories and my failures, my strengths and my weaknesses, so that they can be better people. And ultimately, a lot of that mentoring is organizationally at my firm, as people are progressing and we're giving them opportunity for generational transfer, giving them opportunity to grow. If I can help them grow, that'll be really rewarding.

• 56:15Ted Seides?

  John, thanks so much for taking this deep dive into the secondary.

• 56:19Speaker 03

  Thank you very much. It's been a lot of fun.

• 56:21Ted Seides?

  Thanks for listening to this sponsored insight. Sponsored episodes are paid opportunities for another 12 managers a year to appear on the podcast. If you're interested in telling your story in front of the largest audience of investors in the industry, please email us at [email protected] to apply for one of the slots.