Popular and under pressure

New private equity secondary funds are flying off the shelf, despite the fact that market conditions are challenging. Philip Borel reports.

At first glance, the current buoyancy of the secondary market for private equity fund interests may seem baffling. According to fundraising professionals, new funds currently being organised by the world's leading secondary specialists are attracting keen interest. Among the vehicles meeting strong demand is Coller Capital's International Partners V, which at $3.7 billion (€2.9 billion) is expected to close later this year as the largest pool of secondary capital ever formed. Coller Capital refuses to discuss its fundraising, but observers say the firm could easily have set out to market an even larger product. Other funds currently in the market are said to be making good progress as well (see table p. 48).

While hard data on secondary market trends remains as scarce as ever, the anecdotal feedback on the new funds' popularity suggests that the strategy is booming. At a time when the whole of private equity is being stalked by institutional investors, this may not seem surprising. However, the new fund offerings appear fashionable despite the fact that making money in secondaries is widely deemed to be getting more difficult.

TRICKY TURF
Practitioners point to a number of reasons why the going has become tougher since the secondary market first took shape in the early 1990s. One is that greater competition for assets has driven up prices. The specialist houses alone, estimates Nigel Dawn at UBS' Private Equity Fund Group in New York, currently have around $20 billion of capital including leverage to invest – twice the $8-10 billion of secondary assets that Dawn believes changed hands in 2005.

In addition, there is a growing army of non-dedicated buyers such as primary funds of funds, pension plans and endowments systematically tracking the market in search of attractive secondary purchases. These players bring access, expertise and tactical savvy, and thus constitute serious competition to secondary specialists.

Further adding to pricing pressure has been the fact that private equity generally is in such rude health at the moment. Those forced sellers that kept the market busy after the market tanked in 2001 are now few and far between, which has only added to pricing pressure. And a growing sophistication among owners of LP interests in understanding the true value of their partially funded holdings has done the same.

To sum up: it is a seller's market. “Today good assets are often sold at substantial premia to NAV, although this depends entirely on quality”, notes Thomas Kubr of Capital Dynamics, the global private equity asset manager based in Zug, Switzerland. “The dedicated players are quite shocked at what some portfolios are trading at. Even mediocre stock fetches decent prices now,” adds Dawn. And Ivan Vercoutère, a partner at alternative asset specialist LGT Capital Partners in Pföffikon, Switzerland, observes: “We're finding the auction market very expensive. Pricing has moved so substantially that you have to be careful and originate more proprietary or complex secondary opportunities.”

Predictably, the trend towards fuller pricing has triggered a debate as to whether dedicated secondaries can continue to deliver the high IRRs that so endeared them to investors in the first place. Some practitioners believe performance has already eroded substantially: “In the late 1990s people expected secondary returns in the 30s. Now expectations have come down to low double digits,” says Jason Gull, who runs the secondary practice of Adams Street Partners in Chicago.

Gull's point relates to the view, shared by many in the industry, that early vintage secondary funds benefited from abnormal market inefficiencies, which in today's environment simply do not exist anymore. Stephen Can, co-head of secondaries at Credit Suisse in New York, makes a similar observation: “Performance levels are getting closer to where they should be for secondaries – a 1.3x money multiple and an IRR in the teens.”

But not everyone accepts that secondary funds will necessarily yield significantly less than they used to. Jeremy Coller, who founded Coller Capital in 1990, says experienced secondary fund managers should be expected to improve their ways of doing business and hence deliver even better results going forward: source deals more creatively, price assets more accurately, employ smarter structuring and achieve greater alignment of interest with vendors.

“If the portfolio companies have been refinanced, the primary investors have already done well. But the secondary buyer is buying stakes in highly leveraged companies. They're buying what's left.”

LPS, COME ON INThe table shows a selection of dedicated secondary funds currently being marketed or coming to market soon.

Fund name Target size Previous Company Offices
fund size inception
AXA Secondary Fund IV €1,500m €1,040m 1999 Paris, Frankfurt, London, New York
Cipio Partners V €150m N/A 2002 Munich, London, Menlo Park
Coller International Partners V €3,700m $2,500m 1990 London, New York
Fondinvest 8 €400m €292m 1994 Paris
Greenpark International Investors III €500m €350m 2000 London
GS Vintage Fund IV $1,500m $1,500m n/a New York
Industry Ventures Fund IV $150m $80m 2000 San Francisco
Lake Street Capital III $150m $35m 2003 San Francisco
Landmark Equity Partners XIII $750m $626m 1989 Simsbury, CT, London
Morning Street Partners $300m N/A 2004 New York
Pantheon Global Secondaries Fund III $1,500m $909m 1982 London, San Francisco, Hong Kong
Partners Group Secondary 2006 $800m €500m 1996 Zug, New York, London, Singapore
Paul Capital Partners IX $1,000m $960m 1991 San Francisco, New York, London,
Paris, Toronto
TIFF Secondary Partners II $150m $150m 1993 Charlottesville, VA
W Capital II $500m $250m 2002 New York

SOMEONE'S PAIN, SECONDARIES' GAIN
Another important source of future secondary deal flow will be distress. Says Kubr at Capital Dynamics: “Private equity has now enjoyed 18 months of deep liquidity, which has meant relatively slim pickings for secondaries. But if the market dives, all bets are off.”

Dawn at UBS, referring to the wave of recently completed primary fundraising, agrees: “The huge primary bets that have been placed will generate deal flow when the market turns.”

If highly motivated selling does stage a comeback following a correction in the market, most of the transaction flow will come from inexperienced investors who, during the recent fundraising flurry, bit off more than they can chew.

An additional, albeit smaller source of purchasable assets could be secondary funds themselves, particularly those which have been using leverage to part-finance their purchases. Depending on market conditions, these leveraged secondaries could become tertiary trades if the current owners run into difficulties.

It also means that for the first time in their relatively short history, some secondary funds could conceivably lose money – especially funds that put extra leverage on positions in the already highly geared buyout funds of today. Says Gull at Adams Street: “Much of what is changing hands right now is buyouts, and you have to ask what it is that people are buying in these situations. If the portfolio companies have been refinanced, the primary investors have already done well. But the secondary buyer is buying stakes in highly leveraged companies. They're buying what's left.”

This is why secondary managers are emphasising the need for discipline and careful stock selection. Raising fresh capital for the next generation of secondary funds does not appear to be a problem. The challenge facing the proprietors of these funds will be to invest the money wisely, and to demonstrate that dedicated secondaries can continue to deliver results in a market place that is becoming more and more efficient.