Friday Letter Waiting for the thaw

Looming year-end revaluations have put secondary deals on ice – for now. But a $30bn ‘avalanche’ of closable deal flow awaits.  

Everybody’s talking about private equity secondaries. But forget what you’ve heard about the market being on fire. It’s a bit more like a giant snow-cap, just beginning to melt around the edges.

To be sure, anecdotal evidence abounds to suggest the market is heating up. There are wide-eyed rumblings about a few isolated “walk-away” deals – largely unfunded stakes in limited partnerships essentially given away by investors at risk of default – akin to what was seen with certain venture funds post-dotcom meltdown. And yes, most people agree discounts on LP interests average between 40 percent and 60 percent these days. But the discounts are relatively meaningless so long as net asset value remains elusive.

“If you’re pricing off the June or Sept ‘08 numbers, you have to take into account that there’s going to be mark-downs at year end,” said John Wolak, head of the secondaries fund of funds group at Morgan Stanley Alternative Investment Partners. “The question is what the real discount is once you have a true mark.”

That’s one of the reasons why – despite an uptick of interested buyers and sellers across a broad range of investors – transactions simply aren’t closing at the moment.

“Most buyers are reviewing a huge amount of deal flow, but sellers are very much inclined to wait until valuations have been adjusted at least somewhat to then be able to sell at a perceived smaller discount,” said Marleen Groen, chief executive of London-headquartered secondaries firm Greenpark Capital. “The absolute pricing might be the same, but the discount will look smaller and hence more acceptable.”

Some of the biggest deals to come to market in the past six months – Harvard University’s reported $1.5 billion sale of LP interests, for example – have been partially pulled or failed to close because of valuation issues and the bid-ask gap. Of the roughly $20 billion to $25 billion of secondary opportunities to come to market over the course of last year, only $12 billion to $14 billion actually closed, Wolak estimated.

This year, the figures are due to increase exponentially. “There’s an avalanche of holdings in funds waiting to be sold,” said Groen. She noted estimates range from $30 billion in closable deal flow to a whopping $130 billion, “a significant amount of which will not close – firstly because it is not of the right quality and secondly because the deal flow supply amount is a multiple of the amount available for secondary investments”.

Secondary investors are amassing an arsenal of dry powder – funds in or expected to come to market this year are raising roughly $38 billion, according advisory firm and secondaries broker Probitas Partners. Most of them will hold off until at least the third or fourth quarter to start aggressively deploying their funds. For the time being, they are waiting to capitalise on, as Wolak characterised them, assets that have been “overly reserved against” by exceedingly conservative managers marking to market.

It’s then that that the avalanche will be unleashed, and secondaries trading will be big business. It will be yet another fascinating stage of private equity’s evolution, one that will make big changes to who owns what in the asset class.