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

0:04Hello, 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.

0:54Madorski, 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 Secondary's business from its earliest stages. His partner, Alex Abel, 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 investment strategy, levers of value creation, portfolio construction and exit strategy.

1:42John also shares his perspective on secondary market pricing, growth, risks and the future of the industry. 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.

2:35This 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 slash about. Thanks so much for spreading the word about our head of content job opening. Please enjoy my conversation with John Midorsky. John, great to see you. Thank you very much for having me. I would love you to take me back to your growing up, eventually leading into being in this business. Yeah. I grew up in Miami, Florida, which is a very different animal. It's a melting pot of many different cultures.

3:18From a community -wise in the 80s, Miami was a very interesting place to be. And then lastly, as I was an up -and -coming preteen, 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 ten trees. As a seven - or eight -year -old, I would cut mangoes down and then walk them to the natural food store and sell them.

4:00An 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 sell a business card in one of our bathrooms that says, walking 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.

4:38As 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? 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 with a history major, which is a funny degree to have.

5:18But the reality is you can spin it into saying it's the foundation for making all investments. 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 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.

5:59And 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. 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. 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.

6:44It's pretty wild. A lot of your focus has 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. Yeah. It's a good question from somebody that was a history major. You know? You know? 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, Collar and Lex, 90 and 93.

7:25and 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 limited partnership interest, but it was still very much a cottage industry and there was not really intermediation in it. And 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 rule largely continued probably until, let's call it, the early 2000s. So in those early years, if somebody wanted to sell or had to sell, if there was no intermediation, how did you even find a collar or a Lexington at the time?

8:12It 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 on 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.

8:48And I think that's the way a lot of people were finding the transactions. 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. What caused that scarlet letter to change? The point of maturation, almost immaculate conception, was global financial crisis.

9:37In 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 sort of 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 and buy this secondary position from this limited partner? It was a real eye -opening opportunity.

10:21For 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 in 2024. We went from a cottage industry to a professionalized or at least acknowledged industry in 2010.

11:06The 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. So at what point in time did the transactions move from LP -led, 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? Beginning in 2012 and 13, there were some early deals, and the language they would use would be like zombie funds or GP restructurings.

12:00Those 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 connotation. 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.

12:48Juxtapose that versus 2010, it was all LP transactions. And it fundamentally changed the way that the market approached secondaries. 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 leads 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 20.

13:31I think the next major milestone is really 24 with these 40 -act funds or a lot of the retail capital flowing into the market. 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? So 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?

14:14I 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. 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.

14:58On 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. 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? 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.

15:45Effectively, 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 or collect. But that's the fair value. So, GPs 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.

16:24On 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 position in certain managers. So they're using the secondary market to drive value. 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. How else do LPs think about using the secondary market?

17:02The construct that the secondary market is only for forced liquidity or distressed sellers is probably an antiquated idea. Probably an 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.

17:47So 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. As an active participant in the secondary market, how do you think about the different ways you want to play in the space?

18:26Maybe 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 Colorado. 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.

19:05And then the last dimension of this would be how the managers believe they're creating value. So for 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 value is that they can do very big transactions that most people can't do. Some people feel like their value is maybe 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.

19:47If I go back in 2010, people thought it was an IRR investment. 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.

20:31If 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? 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 1 ,000 -plus general partners intimately.

21:17We'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 pre -quen 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, which is for us managers under a billion dollars in size, the next is manager quality. For us, this is really important. And we see managers that are either winding down their businesses or have underperformed significantly over a long period of time.

21:54Those 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. And you plot out the ROICs. Typically, the slope of the return is going to be pretty moderated up until year 5 or 6. Let's call it 1 .2, 1 .3, 1 .4.

22:34Then 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 wanna 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. 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.

23:17How have those lenses changed over the years? 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, and the performance of the underlying secondaries that we held suffered as well.

24:09That 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.

24:46So therefore, we reset our filter so that we would only be buying positions that are a little bit earlier in their life cycle. What goes into your assessment of manager quality? Our roots are 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.

25:26And 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. 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.

26:05What level of underwriting do you do on the underlying businesses? 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 a thousand different companies. So we have the luxury slash benefit of being able to do effectively like a knockdown LBO model for every single company.

26:44To do that, you need two things. You need data and you need the qualitative information. 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. And we can use that to build a bottoms -up model. I hope everybody's listened to my colleague and partner Alex Abella'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.

27:31The 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 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. 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?

28:19If I'm looking in the future, AI's 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 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 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.