By James Williams (pictured) – The private equity secondary market has experienced significant growth in deal volumes and investor interest in recent years. According to Cogent Partners, secondaries volume was USD22.5 billion in 2010. This rose to USD27.5 billion in 2013, and reached USD42 billion in 2014. Last year, deal flow was estimated to have reached USD40-50 billion.
As SEI stated in its paper Private Equity Liquidity: A Work in Progress, (www.seic.com/enUK/im/15106.htm) the growth of the secondary market has probably had more impact on private equity liquidity than any other development to date. This then, is an area of the market that has experienced a significant deepening of liquidity.
But what exactly is this asset class and how does it work?
Defining private equity secondaries
Private equity secondaries involve buying out interests in private equity funds.
To make an analogy, think about the stock market. A primary investor is one who brings a company to the stock market by way of an IPO. Following its listing, the consequent trading of shares in that company is carried out by secondary investors.
Similarly, in the private equity world, primary investing – also known as `blind pool' investing – involves providing a commitment to a manager (GP) to go out and find companies to invest in, drawing capital from investors (LPs) along the way. Investors join on the basis that there are no assets in the fund.
With a private equity secondaries transaction, a lot of investments in the fund will have already been made. The investor effectively steps into the shoes of an existing investor in the Limited Partnership, based on an agreed price. Whereas the secondary trading of stocks and shares is fairly homogenous, with private equity secondaries, every partnership is different.
Although secondary deal volumes are still strong, investors need the necessary expertise to identify the best opportunities and assets in which to take LP interests. They also need to be effective negotiators; after all, investing in secondaries requires the consent of the General Partner.
The evolution of the secondary market
Ten years ago, the PE secondary market was around USD10 billion in deal volume. It has now quadrupled. Similarly, 10 years ago the biggest fund was probably in the region of USD3-4 billion; today, some of the biggest funds are now USD6-8 billion; or in the case of Paris-headquartered USD55 billion manager, Ardian, USD10.8 billion.
Over the last five years, the market has continued to expand, but it's worth putting things into perspective. The primary market for fund raising is around USD500 billion, so even with its impressive growth, private equity secondaries is still only a fraction of the market. Regardless of the asset size, the biggest change in the last 10 years has been one of market perception.
"It used to be regarded as a sign of distress and only people who were in trouble would trade in the secondaries market. GPs did not want to talk about secondary trades or whether they had any secondary investors in their fund. It was almost a dirty secret.
"That's now changed. Now it is seen as an active tool for asset management and it is widely accepted that secondaries exist for the right reasons," says a spokesperson for a prominent multi-billion dollar fund manager.
As the market has matured in Europe over the last 15 years it has allowed LPs to sell their interests in the secondaries market and prune their portfolios strategically. Equally, it is giving investors the opportunity to invest in new secondary funds supported by higher deal volumes.
If investors want to build particular exposure to a manager or backfill a vintage, the secondaries market is a great way to do this. In short, it is supporting more active, sophisticated players.
As for secondary funds themselves, some develop strategies that focus on LP trades, some on direct transactions, some are doing large investments, some are doing small investments. With the increase in options, this is a positive change, but at the same time, it is a hindrance as it is making it harder for investors to know the best secondary funds from which to choose.
At an event sponsored by SEI's Investment Manager Services division at their new London offices, a panel of leading secondaries investors discussed some of the main trends and developments in the market. The following are five main trends developing in the secondaries market in 2016:
1. The use of secondaries as part of active portfolio management
It's worth restating what one of the panellists said, and that one of the most significant changes within the secondary market has been that of market perception. Secondary sales used to be regarded as a sign of distress and only investors who were in trouble would trade in the secondaries market. GPs did not want to talk about secondary trades or if they had any secondary investors in their fund.
That's now changed. Now it is seen as an active tool for asset management and it is widely accepted that secondaries exist for the right reasons.
The change in perception has gone hand in hand with the development of a wider pool of sellers in the secondary market. For banks and insurance companies, for instance, the combination of the financial crisis and resultant market regulation has led such institutions to reduce the volume of illiquid assets on their balance sheets.
Pension funds, particularly in the US, are moving to focus on a smaller number of key relationships within private equity. Once they've decided which managers to stick with, their next step is to sell LP stakes in those managers they no longer deem suitable for their portfolios, even if they are performing well. Endowments and fund of funds have also been more active traders as liquidity has improved.
As such, there is more opportunity for LPs to sell their interests in the secondaries market and prune their portfolios strategically. Equally, it is giving investors the opportunity to invest in new secondary funds – containing interests they never would have had access to previously – supported by higher deal volumes.
There is no sign of the level of demand abating, as investors in private equity funds take the opportunity to cash out early, at the right price, rather than wait for their commitments to reach full maturity. In a survey of over 70 large investors earlier this year by the private capital advisory group, Evercore, it was found that "active portfolio management," as opposed to regulatory pressure or a state of distress, motivated half the sales. This was up substantially from just 27 percent of sales in its 2013 survey.
To capitalise on this fact, Ardian has attracted USD10.8 billion of investor assets to launch the largest secondary fund of its kind (Secondary Fund VII). They note that the secondary market has matured to such an extent that it offers similar levels of liquidity to that of established asset classes. Benoît Verbrugghe, a partner at the USD55 billion firm, said that because pension funds and sovereign wealth funds are selling private equity assets as part of their active portfolio management, "we can clinch complex and large transactions" with the new fund.
According to Preqin's Private Equity Secondary Market special report in March 2015, public and private sector pension plans, insurance companies, asset managers and endowments are the biggest buyers of private equity secondaries. Fund managers that have been most successful in fund raising for dedicated secondaries vehicles include the likes of Ardian, Lexington Partners and Strategic Partners Fund Solutions, who between them raised in excess of USD22 billion in investor commitments in 2014.
In 2015, there was an estimated USD50 billion of dry powder in the market.
2. An expanding variety of asset classes and deal structures
Whilst the majority of secondaries are in core private equity, deals are starting to become more frequent in infrastructure and real estate, as investors make tactical decisions to divest their holdings ahead of maturation. This will only increase as private fund structures continue to be used for a wider variety of assets including private and distressed debt.
The transaction structures of secondary deals are also changing. It is no longer a case of simply going to market directly, through brokers or via an auction. Variations now include transactions such as:
- Tail end transactions – taking out specific assets from a fund that has gone beyond its expected lifespan; and
- GP restructurings – taking an existing pool of assets and restructuring them into a new fund structure with a re-incentivised GP.
Whilst the broad range of assets and deal structures coming to market are providing existing LPs with increased liquidity options, the competition also means that dedicated secondary funds need to be more innovative and efficient in the way they evaluate and execute deals.
3. An evolving relationship between pricing and deal volume
Calculating the true net-asset-value (NAV) on a fund whose assets are not marked to market has always been more art than science. Although private equity as an industry has taken large steps to improve reporting transparency and valuation methodology, the price of a secondary purchase necessitates further evaluating whether a NAV is a fair representation of a fund's future cash flows.
This subjectivity has led to wide swings in price perception for long-term assets. Back in 2007, secondaries traded at a premium of 10 per cent on average. When the financial crisis took hold, some secondary assets traded at as low as a 70 per cent discount to NAV before recovering somewhat in 2010. Last year, a survey by Preqin found that the average price paid for buyout funds purchased on the secondary market was 90 per cent of NAV; or a 10 per cent discount.
Pricing has a direct impact on deal volume. The process of buying and selling secondaries is a bit like dancing the tango; both sides have to come together and reach a harmonious agreement. If discounts to NAV start to climb beyond 10 per cent or more, LPs are likely to become more resistant to sell their stakes unless they are forced to. Put simply, as discounts increase, deal volumes decrease, and the `dance' becomes more challenging.
As one of the secondaries managers at the SEI event stated: "Sellers will look to minimise their losses in most cases. They are going to want to sell as close to the fund's NAV as possible. The moment you get too much of a discount it creates too wide a gap between buyer and seller. There is generally a perception in the market today that sellers of secondaries will get close to NAV."
4. Leveraging technology to improve due diligence and reporting
Linked to pricing is the ability of purchasers (whether LPs or secondary funds) to conduct efficient, accurate due diligence on deals. Many of the larger secondary fund managers have evolved out of primary allocators and therefore leverage the data points, relationships and reporting they receive as an existing market participant. Over the years, such data has been maintained in in-house databases and marketed by secondary fund managers to their investors as the "secret sauce" to secondary investing.
However, many of these private databases are now struggling to keep up with the increased volume and variety of data available in the market. There are also now many more technology firms looking to solve the private capital data challenge i.e. how to get accurate financial data on private funds and underlying portfolio companies. Database firms are maintaining wider and deeper data sets across the private capital markets.
These can not only be leveraged by secondary firms, but also enriched with their own data sets as well as CRM data, accounting data, public market benchmarking data and, in the future, big data. Integrating this further, into accurate management and investor reporting, provides further competitive advantages in terms of new product development and client service.
Secondary firms therefore need to assess whether they keep on spending to build, maintain and improve their own technology, or instead leverage developing market solutions.
5. The rise of the secondary mega-fund
The increase in active portfolio management, secondary deal opportunities and an overall appetite from investors, has led to large growth in the assets under management by the leading secondary fund managers.
At the start of the second quarter this year, 36 secondary vehicles were attempting to raise USD30 billion collectively, the highest volume that data provider Preqin has recorded in five years. Well-known specialist firms in secondary investing have raised recent funds with over USD5 billion apiece, rivalling traditional buyout funds.
Firms that can raise such huge amounts of money will undoubtedly be able to reach farther in market relationships and leverage more sophisticated technology to track GP relationships and secondary opportunities. However, it is also likely to put more pressure on pipeline development with the result that the variety of deal structures and asset classes (as noted above) will evolve even faster.
There is no doubt that the private equity secondaries market has come a long way since the start of the millennium, and the signs would suggest that this growth trend will continue for the foreseeable future. It has matured into an important sub-asset class within private equity, and is helping investors conduct active portfolio management, and give buyers an opportunity to make more strategic investments into existing funds.
But there are nuances. The complexity and scope of deals needs to be considered, as well as the track record of managers bringing secondary funds to market. With deal volumes still strong, this is proving to be a resilient corner of the market.