Asian appetite to aid secondaries surge

Family offices are expected to help boost secondaries dealflow in the last months of 2010, as many seek to replace existing LP stakes with emerging market exposure.

Many US and European family office groups are divesting parts of their private equity portfolios in order to ramp up holdings in emerging markets, especially Asia, according to several US-based market sources.

“We’re seeing a lot of [wealthy families] putting money into Asia, and pulling money out of the US and Europe,” according to Justin Pollack, a director at secondaries firm Newbury Partners. “There’s definitely some pervasive view that equities in the US and Europe might not be able to move up for quite a long time, and might bounce around in the current range for a while, and it’s not a bad idea to sell out at some discount in private equity and put it into Asia.”

Family offices, unlike larger institutional investors, have the flexibility to switch investment focus quickly, Pollack said. It’s not unusual for a family office to decide “over a weekend” to ramp up exposure to Asia from 5 percent of total assets to 25 percent in two years, he said.

There are macro trends that all suggest deal flow through the balance of this year will be robust.

David de Weese

Pollack, who works with many family offices on secondaries sales, said he has never seen wealthy families move so quickly to shift geographic exposure. For example, five years ago, family offices started to build up their exposure to Eastern Europe, but the process was slow moving.

Today is the opposite, he said, noting that five years ago an investor with 10 fund interests might sell one in order to boost exposure to another region.  “Now the goal is, let me clear out five or six of those [US and European private equity funds]. There’s a much more bearish tone about the US and Europe we’re hearing than in the past.”

A seller’s market

Family offices won’t be the only sellers on the market. Financial institutions, which brought large portfolio deals back to life on the market earlier this year, will continue to sell off illiquid assets ahead of stricter regulations [see related PEI feature, Breaking through the barrier].

Also, with the economy still rife with uncertainty, businesses and institutions will continue to de-lever and endowments and foundations will still struggle with the same pressure they felt in 2008, according to David de Weese, a partner with Paul Capital.

“There are a lot of pressures that are motivating people to begin to adjust their portfolios, certainly in the regulatory area,” de Weese said. “There are macro trends that all suggest deal flow through the balance of this year will be robust as I expect it will be in 2010 and 2011.”

Triago, a placement agent and secondaries advisor, has forecasted total deal activity in the secondaries market to reach $20 billion this year, and possibly as much as $25 billion. That’s compared to about $7.5 billion of total deals in 2009, and $15 billion in 2008.

This amount of deal activity will be taking place in an environment when many of the steep discounts to net asset value that existed last year have dried up. The average bid price in the first half of 2009 was 39.6 percent of net asset value, according to secondaries broker Cogent Partners. That rose dramatically to 79.6 percent in the first half of 2010, Cogent has found.

The fading discounts and increasing prices have resulted from “an increase in general partners’ visibility into potential exit timing and portfolio company values, which has been buoyed by numerous announcements of IPO filings and trade sales of sponsor-backed companies during the first half of 2010,” Cogent said in its pricing report, which was published earlier this year.

Increased demand has also driven up pricing, especially from traditional secondaries buyers who waited on the sidelines through most of 2009, Cogent said.

Untouchables
All these sellers will bring a wide inventory to the market for buyers to choose from. This huge inventory, however, will inevitably contain some “dangerous” funds. Most dangerous, sources cautioned, are funds managed by GPs who may not be able to raise additional funds.

In the absence of the ability to raise new funds, “you’ll see people leaving for other opportunities, reducing the ability of the fund to maximize the outcome”, de Weese said. “The stability of the GP is always a concern.”

The downturn left a wash of wounded firms in its wake, creating situations in which managers will hang on to simply manage out investments. It’s these cases, source said, that pose the biggest risk to secondaries buyers.

“There’s more groups that may have two or three funds, all of them underwater, and maybe no carry in any of them and no expectation they’ll raise a new fund. You start to wonder if all the partners will stay on board to maximise the value in that context,” Pollack said. “There are more groups that fit that bill, in our view.”

Funds that invested in 2005, 2006 and 2007, and that were able to recapitalise debt, are still hanging on, but in a few years those funds could enter the “untouchable” category, rife with bad performing assets and a shaky partnership structure, Pollack said.

“Just because you don’t bankrupt the company doesn’t mean you’ll make money on it,” he said.