The fog starts to lift

Remind buyers of private equity secondary interests of the saying “timing is everything” and many will view it as a cruel taunt. After all, with some assets and portfolios up for sale at discounts of as much as 40 percent last year, it was not surprising to hear people talk of “bargain hunting”. Many bought the hype and plenty else – piling into a market that had surely reached bottom. Well, it hadn't – not by a long way. Earlier this year, when some private equity secondary interests literally couldn't be given away, a 40 percent discount was at the expensive end of the price spectrum. Suffice to say, some suffered a nasty case of burnt fingers.

As the initial bargain hunters faded away, the market became highly subdued in the first half of 2009. No longer could anyone easily assume they had a clear idea of the intrinsic value of assets in such a volatile economic environment. Just about the only thing that was becoming clear was that the worst recession for many decades was having a highly damaging impact on firms everywhere – including private equity firms and their portfolio companies.

Says Andrew Kellett, a partner at London- and Zug, Switzerland-based placement agent and secondary adviser AXON Partners: “The paradox is that there was a big expectation going into 2009 that there would be an enormous level of activity. The problem is the lack of visibility – there's a fear discount built into the pricing and such caution does not seem to me to be unreasonable. What the true price should be is difficult to determine.”

What no-one disputes is that there has been a huge level of potential deal flow in 2009 – far higher than the secondaries market has ever seen before. Plenty of would-sellers are to be found among all those groups that have committed to private equity: banks, listed vehicles, pensions, insurance companies, family groups and endowments among them. Many of these are over-committed to the asset class and have pressing liquidity issues. And yet, the amount of actual deal flow has fallen markedly.

Estimates vary in the notoriously opaque secondaries market, but sources canvassed by PEI reckon that between $20 billion to $30 billion worth of secondaries deals were closed worldwide last year. At the current time, according to the same sources, around $70 billion to $80 billion of interests is currently available for sale at the right price. Marleen Groen, chief executive of London-based secondaries investor Greenpark Capital, predicts that the total value of deals completed during this year will be less than $10 billion. “This market has the most volume we've ever seen,” she says, “but also the least closable volume.”

BUY-SIDE CAUTION
So why are deals not reaching the finish line? Urs Wietlisbach, founding partner of Zug-based alternative assets manager Partners Group, estimates that distressed sellers account for around half of all secondary assets on the market by value. Many of these are leveraged buyout fund interests of the 2005-2007 vintages that over-exposed buyers are desperate to get out of. The lack of willing takers even at high discounts only serves to underline the wariness on the buy-side with respect to the likely performance of some of the large cap funds and the difficulty of placing a value on these.

Says Groen: “Investment committees take a long time to reach decisions in any environment. In a market like today's it's so hard to assess performance, deal with the lack of visibility and take a view on GP quality and strategic viability.”

“There's a lot of fog out there,” adds Kellett. “We saw weakening performance of underlying portfolio companies in the first half of the year and management teams tearing up their budgets. Some missed their targets by a long way. Until that stabilises, you can't see value clearly. Another issue is that many companies have debt levels well in excess of the current market norm. Triggering a covenant is therefore no longer a trivial issue. Bear in mind also that the exit environment is still desperate – at the big end, in particular, it's been choked off. When will companies exit? You've got to be conservative about that.” Kellett also points out that the picture is further confused by the application of various different valuation techniques to private equity portfolios.

But just because the picture is confusing should not put buyers off if genuine bargains are available. That, at least, is the view held by Ivan Vercoutere, managing partner at Swiss alternative investment funds of funds manager LGT Capital Partners, which in early August posted a first closing on its latest mid-market secondaries fund at $268 million. He says: “We have been very consistent buyers in the secondaries market over the last few years and in February to April [2009] we were very active. We did more in the first three months of this year than in the first nine months of the previous year. There is a misconception that all private equity assets are bad and none will return capital. Our view is that, while some will not return capital, you can get very attractive returns at the level of pricing we've seen this year if you select your assets carefully.”

As an aside, it's interesting to note the view expressed in some conversations that pure secondary investors may have missed a trick by not putting more capital to work in the earlier part of the year. Only time will tell whether it was right to have entered the market at that point or stayed on the sidelines, but it's interesting simply to put on record that views did diverge – as this may have reputational repercussions over the coming months and years.

BAILOUTS PUT BRAKE ON
The other side of the equation when it comes to evaluating the reasons for a stalling market is the sell-side. In the equivalent PEI cover story last year, we reported the view of many market participants that a flood of deals were in the pipeline as a result of the pressure to sell on financial institutions. This, however, was before the government bailouts which helped to prop up balance sheets and make portfolio divestments less urgent. This is not to say that banks do not need to act in order to address balance sheet deficiencies and capital adequacy requirements. What it does mean is that there are a plethora of organisations that would be keen to sell private equity interests at less-than rock-bottom prices rather than compelled to sell at any price.

Furthermore, anticipated sales by listed private equity entities have been slow to come to fruition and not as widespread as many anticipated. Some of these, such as 3i for example, have undertaken successful capital raising exercises. “Some people may have underestimated the creativity of financial institutions in finding more attractive routes to liquidity than distressed sales,” says Groen.

And then there are those GPs that may cling onto ownership of portfolios because – with reputations damaged and prospects for future fundraising bleak – there may appear to be little option other than, in the words of one source, to “milk portfolios for management fees rather than wind them up. Some will decline perfectly good bids for assets because they don't want to sacrifice the fees.”

For all this, the bottleneck of potentially sellable assets should not be overlooked – and nor should the possibility that the trickle of these through the pipeline might gather momentum. Wietlisbach noted a greater number of deals clearing in the second quarter compared with the first as bidders came more into line on their value calculations and the bid/ask spread narrowed. He says there were two contributory factors: “One: the ability to see that the world had not fallen apart. Two: GPs had really written down the net asset values of their portfolios – maybe even too much in some cases.”

A BRIGHTER PICTURE
Brenlen Jinkens, a managing director in the London office of Dallas-based secondary adviser Cogent Partners, says “it feels as if there's a slight pricing uptick. The situation was dark in February but it's a bit brighter now because there is a little more information about performance and certainty about prospects”. This view is given added weight by Vercoutere's observation that 20 to 30 percent discounts are more typical these days than the 70 percent discounts he was seeing earlier in the year.

Another crucial factor in relation to the pace of secondary sales is how quickly the primary deal market picks up. With new deal activity having slumped in most parts of the world “there have not been many liquidity problems forced by capital calls,” says Vercoutere. However: “If there's another dip in the market where valuations go down further, at the same time as increasing activity on the investment side, there will be more selling pressure.” He also notes that the expectation of growing pressure is inclining some buyers to sit on their hands: “People are thinking if they wait for capital calls to become more of a problem for LPs, they may get a better price.”

Dominik Meyer, a colleague of Kellett's at AXON Partners, agrees that there are “some signs of green shoots” in the market, but argues that it's still probably “too early to say things are stabilising”. He adds: “It's been such a rollercoaster of valuations. In 2007, for good funds, you could get a premium – maybe even in the first half of 2008. In the space of two years you've gone from premiums to enormous discounts. This shift and dynamism in the market has been extraordinary.”

The sense of shock at how swiftly and decisively the world turned on its head is felt everywhere. Among participants in the private equity secondaries space, that shock has been felt all the more keenly since this was a part of the market on a rapid upward trajectory. The consensus is that the market will see a steady climb in the number of closed deals for the rest of this year and into 2010. If that indicates a return to some kind of normality, it would be a cause for celebration.

MEZZANINE'S EUREKA MOMENT
It was while in attendance at a private equity conference in Zurich in 2006 that Pierre-Antoine de Selancy had what he describes as a “eureka moment”. It came as he surveyed a panel purportedly representing a cross-section of firms operating in the secondaries market. Three of the four panellists, he noted, represented equity providers; the fourth was from a bank. He took a mental note that there appeared to be a gap in the market – and subsequently set about raising the first mezzanine fund dedicated to secondaries.

Fast forward to July 2009 and London-based 17 Capital, launched by de Selancy with former PAI Partners colleague Augustin Duhamel, completed its first deal – a €30 million investment in a portfolio of four investments owned by Altamir Amboise, a listed private equity fund that co-invests alongside Apax Partners France.

The deal saw Altamir's most resilient and liquid co-investments transferred to a separate dedicated vehicle in which 17 Capital acquired €30 million of preference shares. Significantly, it delivered liquidity to Altamir, which according to a statement, was facing “a lack of visibility with respect to the timing of potential disposals and the current low cash position”.

The generally liquidity-constrained environment provides an opportunity for 17 Capital. As de Selancy says: “If we can go to a GP and say ‘we can help you keep your LPs and find a solution for their cash constraints’, the chances are you will be made very welcome.”

de Selancy says there are three main types of opportunity that 17 Capital targets: “standard” secondaries where it provides finance for the deal by offering mezzanine to the equity sponsor; finance to a fund LP that wants to extract cash without selling; and “top-ups”, where fully called funds need follow-on capital for portfolio companies.

17 Capital has declined to comment on its debut fundraising, which is understood by market sources to be targeting €200 million. The fund has a six-year life rather than the private equity standard of 10 years.