Friday Letter: Fund transfer oddity

Private equity secondaries is still a growth business, even though this is not a claim that can be proved easily. The market for partially funded limited partnership interests and bundled directs remains opaque. Hardly any data exits to track even basic trends such as fundraising and capital deployment rates.  

This is of course just how those specialising in the strategy like it. Nowhere in private equity is transparency a more formidable enemy to investment performance than in secondaries, where a low entry valuation is the most important ingredient in a successful investment. And with ever more capital pushing into the sector – practitioners estimate that in 2005, $10 billion of secondary capital was put to work – buying low is already difficult. The last thing dedicated buyers want is for visibility on deal flow to increase.

The good news is that investors active in private equity have finally come to embrace the secondary market as a useful portfolio management instrument. Selling no longer has a stigma attached to it, and so sophisticated limited partners are using the market strategically to fine-tune their holdings.

According to market makers, private equity’s current buoyancy means that quality assets now fetch substantial premia to net asset value, and even “mediocre stuff” is being discounted relatively modestly. And while full pricing is bad news for buyers, at least there is plenty of selling going on, which provides homes for sizeable amounts of capital.

This is despite secondary transactions remaining cumbersome. In the case of partnership interests changing hands, this is partly because the general partners need to give permission for the transfer – and often refuse. Many limited partnership agreements, at the behest of the GP, contain language allowing the manager to block transfers without giving a reason for doing so. Among the groups notorious for taking a dim view on transfer requests is industry primus Kohlberg Kravis Roberts.

Unsurprisingly, those keen to buy or sell the funds in question are finding this obstructive. Once they have cleared all other hurdles en route to a successful secondary trade, the last thing they want is to be tripped up by a reticent fund manager. Says one intermediary: “Managers are destroying a lot of goodwill with investors in this area. What do they gain from preventing a transfer? It’s pure stupidity. Will it change over time? You bet – just wait for the next downturn in this business.”

The rant may seem understandable, not least because it is hard to think of other securities where a sale requires the issuer’s consent. However, private equity as an asset class does have a few rules of its own, and whether this particular one will become extinct any time soon remains to be seen.

Most general partners care deeply about who they have in their funds, and some use their right to withhold consent as a weapon in the battle for investor base longevity. Hence an investor looking to buy into a group’s Fund III in the secondary market may find it tough to win the manager’s approval unless they are seen as a likely provider of primary capital to future funds as well. Likewise, an investor trying to acquire a piece of a strongly performing Fund III, having already refused an invitation to participate in the subsequent Fund IV, will find it hard to get the manager onside.

For the time being, the power in private equity remains with the best-performing GPs. Only when the cycle turns should one expect any movement on the transfer issue. As far as secondary buyers are concerned, therefore, this particular headache won’t go away for a while. This they may continue to lament. What it will not do is prevent their business from expanding: probably even more than primary private equity, the secondary market looks set for continued long-term growth.