A coming sea change

Globally, the secondary market has been slow all year. That may be about to change, writes Philip Borel.

Contrary to many practitioners’ expectations, 2009 has not delivered much in terms of private equity fund interests being traded in the secondary market.  In essence, the predicted flood of fund disposals didn’t happen because even motivated sellers – of whom there were obviously many – ultimately weren’t motivated enough to transact. Why? Because the pricing for assets on offer was just too poor. When, at the beginning of the year, discounts to net asset value on largely unfunded commitments rose to somewhere north of 50 percent, holding often made more sense than selling. 

Even those limited partners with the most pronounced liquidity shortages typically found it preferable to sit tight and do nothing – helped in no small part by a primary deal environment in which next to no activity was taking place either, meaning hardly any capital calls were coming through at all. When no one is asking you for money, not having any isn’t such a problem. 

Philip Borel

As a result of the drought, fund managers sitting on big piles of unspent secondary capital haven’t been finding much to spend it on. Estimates vary but there is a consensus in the market that total secondary deal volume for the year so far is somewhere significantly short of $10 billion. This contrasts with deployable funds of more than $40 billion from specialist secondary funds, according to Nigel Dawn, managing director in the Private Funds Group at UBS in New York. Factor in an estimated minimum of $10 billion of secondary capital currently being raised, plus plenty of appetite from non-traditional secondary buyers such as funds of funds and institutions, and there is no question that demand for assets currently outweighs supply by some margin.

Dawn is among those predicting that this picture is likely to change significantly in 2010. “Pricing is improving, and capital calls are definitely beginning to increase, so investors that have been over-allocated to private equity for some time now will have to carefully evaluate their liquidity position,” he said. “And if you are getting offers at discounts in the 30s or even high 20s, the embarrassment factor of doing a deal is a lot less than what it would have been earlier this year.”

Furthermore, with pressure on financial institutions resulting from the increased risk provisions for investments in private equity, the private equity asset class is becoming more expensive – yet another reason, said Dawn, why the supply of secondary assets is likely to increase.

Watson Wyatt, the UK consultants, also believe that activity will likely pick up next year, even their forecast is couched in somewhat more cautious language. Warning of “hype” going on in the secondary market, Mark Calnan, a senior investment consultant at the firm, said in a report published in October: “Many potential sellers have not yet experienced sufficient liquidity problems to be considered ‘distressed sellers’. As such, they are opting to hold on to their positions rather than sell at a deep discount on the secondary market.”

However, pending certain macro developments, Watson Wyatt agrees there is a likelihood of more action coming through next year. The firm said it will take a return to stability of the economy and greater visibility of the underlying portfolio company performance for more secondary deals to happen. It also echoes Dawn’s point that an increase in primary deal-making will force more limited partners to begin to sell: “[A more active primary market] will likely have a positive knock-on effect on the secondary market as capital calls crystallise liquidity issues at some struggling LPs.”

Dawn at UBS is more emphatic: “There are going to be LPs who will seek liquidity where they can, which will help bring about a sea change. The next two years should be material in the secondary private equity market.”