Having second thoughts

Anecdotal evidence suggests the secondary market is heating up. Around the world, crisis-stricken investors are hurting in many parts of their investment portfolios. Commitments made to boom-time funds, including those still undrawn, are weighing heavily on some investors' finances.

There are even rumblings about a few so-called “walk-away” deals – largely unfunded stakes in limited partnerships essentially given away by investors at risk of default – akin to what was seen with some venture funds pos t -dotcom mel tdown. Insiders say discounts on LP interests are averaging between 40 percent and 60 percent of net asset value. And, unlike a decade ago when secondary sales were largely initiated by financial services firms, the crowd of sellers is an ever-expanding group including big pension funds, endowments, foundations, individuals and family offices.

“In fact, three of our last four deals have been with family offices,” says John Wolak, head of the secondaries fund of funds group at Pennsylvaniabased Morgan Stanley Alternative Investment Partners.

But don't be fooled: despite an uptick of interested buyers and sellers, few transactions are closing at the moment. Vendors may feel that asset prices currently on offer under-value their holdings; potential buyers on the other hand will look at the same assets and describe the pricing as still expensive.

Is it worthwhile to buy a 2007 vintage that's 70 percent invested? Even if you give it to me at an 80 percent discount, the portfolio still might be worthless

Lorenzo Lorenzotti

“If you're pricing off the June or September 2008 numbers, you have to take into account that there's going to be mark-downs at year end,” says Wolak. “The question is what the real discount is once you have a true mark.”

Clarity on the “real” discount will enable buyers to adapt their pricing – and ultimately pay less for funds. “We believe that absolute pricing, not discounts, will get even cheaper over the next 12 months,” says Hanspeter Bader, managing director of Geneva-based asset management firm Unigestion's private equity funds.

Somewhat paradoxically, vendors are also expected to feel better about doing deals once the 2008 NAV adjustments are fully priced in. Marleen Groen, chief executive of London-headquartered secondaries firm Greenpark Capital: “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. The absolute pricing might be the same, but the discount will look smaller and hence more acceptable.” Market participants estimate this year's amount of closable deal flow will range from $30 billion to $50 billion, an increase from the $12 billion to $30 billion believed to have closed in 2008. “There's an avalanche of holdings in funds waiting to be sold,” agrees Groen.

“Deal flow has been building up since 2007,” concurs Elly Livingstone, London-based head of Pantheon Ventures' global secondaries team. “This is a broader-based sell-off [than what was seen following the dotcom bust], and it's got some way to run. It's still early. This is not a six-month phenomenon.”

Funds of funds are one segment of the asset class well placed to pounce on the glut of interests expected to come to market. Groen points out that most established funds of funds have long had secondary al locat ions , which would typically be used to target interests in funds they're already invested in on the primary side.

Market participants estimate this year's amount of closable deal flow will range from $30 billion to $50 billion, an increase from the $12 billion to $30 billion believed to have closed in 2008

But some of those funds of funds have inverted their typical secondary versus primary allocation matrix to capitalise on opportunities arising from distressed or highly motivated sellers, says Craig Marmer, head of San Franciscobased placement agent Probitas Partners' liquidity management business.

And, unlike most pure secondary houses, some funds of funds may be more willing to purchase newer vintages that are less drawn down. “Historically, it usually took at least four to five years” into the life of a fund before LP interests would go up for sale, “because otherwise you're just selling at the bottom of the Jcurve,” Marmer says. But in this environment, he adds, purchasing funds with large amounts of capital left to invest presents an interesting “primary-oriented” opportunity for funds of funds to realise more potential upside.

Groen agrees: “That is very much a consequence of the current market conditions on the one side and of diverging secondary strategies having been developed over time, the latter being very comparable to developments in the primary market in its earlier years,” she says.

If a buyer picks up one of these fund interests – dubbed “late primaries” or “early secondaries” – at a significant discount, they will essentially be buying exposure to investments made over the next three years, which many people believe could be among the best vintages ever given historical returns data for funds invested during downturns.

“For a fund of funds these holdings could be quite attractive,” says Groen.

Unigestion has just hit the fundraising trail with its second, secondariesfocused fund of funds, having raised the first to capitalise on the dotcomboom fallout. “The opportunities over the next two to three years are huge,” Bader says.

The firm is raising €150 million for investments mostly in mature portfolios more than 50 percent drawn. However, Bader notes: “For other mandates that we are managing we are also looking at little-drawn funds from GPs that are on our “preferred GP list”.”

Lorenzo Lorenzotti, managing director at boutique European funds of funds manager Altium Capital Gestion, also invests in secondaries on an opportunistic basis – though he is less interested in recent vintages heavily invested in deals done at high multiples. “Is it worthwhile to buy a 2007 vintage that's 70 percent invested?” he asks.“Even if you give it tome at an 80 percent discount, the portfolio still might be worthless.”

Late primaries with little capital drawn, however, should be more attractive, Lorenzotti concedes.

Morgan Stanley'sWolak also avoids buying interests in funds invested in frothy deals, though his group targets funds that are on average about 70 percent drawn.“We're really focused in on 2002 to 2005 vintage funds,” he explains. “They are more mature. The money was put to work in a more reasonable environment and maybe there's some investor fatigue as well if they haven't gotten distributions or are worried about their exposure right now.”

Whatever the particular strategy, funds of funds are poised to play an increasingly integral role as a growing number private equity fund assets change hands.