Secondaries Special: Crest of a wave

Tsunamis hitting. Floodgates opening. Waves crashing. Dams breaking. You could be forgiven for expecting private equity secondaries professionals to be constantly sporting waterproof attire given the headlines the financial press (ourselves included) has used to illustrate the dramatic spike in activity their market has experienced since 2010.
Insiders estimate that around $22 billion- to $23 billion-worth of secondary deals were agreed last year, a sharp increase over the lacklustre figures from 2009, when only $9 billion to $10 billion-worth of transactions closed.

Although there is no single source for official statistics, and the secondary market by nature remains rather opaque, sources suggest a ‘normal’ run-rate is around $18 billion or so.

Still, the increase from 2009 to 2010 was probably steeper and faster than most in the secondaries world expected, says Joseph Marks, a New York-based managing director and co-head of secondaries for fund of funds manager Capital Dynamics. “Sellers who were sidelined in 2009 due to wide bid-ask spreads came back in flocks in 2010,” he says. “On the buyside, if the story of 2009 was the emergence of non-traditional secondary buyers such as pension plans and insurance companies, 2010 marked the return of the traditional dedicated secondary buyers.”

Their return was largely due to fund interests’ discounts to net asset value (NAV) narrowing, as the economy (seemingly) improved and investors had greater clarity on funds’ underlying assets. Pricing has continued to rise over the past two years: aggregate market first round high bid prices averaged 39.6 percent of NAV in the first half of 2009, but hit 84.5 percent of NAV in the first half of 2011, according to data from secondaries broker Cogent Partners.

“Headline mega-transactions that were done at single digit discounts to NAVs sent reverberations through the market and set a new bar,” Capital Dynamics’ Marks says. “I think the silver lining is that the pricing appears for the time being to have plateaued, at least for buyout funds.”

Discounts continued to narrow in the first half of the year for stakes in sought-after buyout funds, with high bids averaging 91.6 percent of NAV, Cogent found. Many high-quality buyout funds have been trading at or even above par.

The narrowing, or indeed disappearance, of discounts hasn’t necessarily put off buyers. “A transaction completed at a small discount can make sense if the assets are appropriately attractive, the management groups are good and the risk levels underlying [the assets] are well understood,” says Elly Livingstone, global head of Pantheon’s secondaries programme.

 
A CAPTIVE AUDIENCE

 The healthy activity levels of 2010 have largely carried over into 2011. Cogent said in its pricing report that the first six months of 2011 were the busiest “of any year in secondary market history”, with $14 billion of activity recorded. Fellow secondaries broker UBS, meanwhile, puts the total closer to $16 billion – and estimates between $25 billion and $30 billion will transact by year’s end.

While bundled fund interests have comprised the bulk of activity in the past year or so, with financial institutions and pension funds putting up large portfolios for auction, they certainly haven’t been the only type of secondaries deals getting done. A number of captive groups have gone independent with the backing of secondaries players, including the former Candover team (now Arle Capital Partners), whose spin-out was backed by Pantheon; the former Bank of America Merrill Lynch Asian private equity unit (now NewQuest Asia), which went independent with the help of Paul Capital, HarbourVest Partners, LGT Capital Partners and Axiom Asia;  and Phase4 Ventures, a venture capital arm of global investment bank Nomura, which was backed by HarbourVest.

Redemptions at hedge funds prompting a need to sell illiquid assets in side pockets has also contributed to activity, with Paul Capital most recently agreeing a €70 million deal to buy 20 debt and equity assets from Cognis Capital.
Another trend has been the growth in secondary direct investments in pre-IPO venture-backed companies, in particular social media companies, says Capital Dynamics’ Marks. “It’s not new,” he says, noting there have long been secondary direct specialists. “What’s unique is the volume and the run-up in pricing. I think the trend in direct secondaries will grow.”

Stephen Ziff, partner at secondaries firm Coller Capital, says one of the reasons for such high activity levels is that a range of major drivers are at play simultaneously. “Regulatory pressures are unprecedented. Portfolio re-shaping has become an urgent issue, because investors’ PE exposure became very unbalanced during the boom years – by vintage year and investment stage, for example. The global economic landscape has also changed enormously since the crash. And investors’ liquidity issues are only likely to get worse as the net cashflows from their portfolios deteriorate.”

Dominik Meyer, partner with European placement and advisory firm Axon Partners, agrees. “If current pricing and market conditions find a new floor, there’s a very good chance to continue to garner interest from opportunistic and strategic sellers. But if the macro picture continues to decrease, you’re going to have further supply from more distressed sellers.”

 
HOW MUCH IS TOO MUCH?
 
“A lot of people keep saying there’s an overhang of capital and a lot of money chasing few deals, but I’m not sure,” says Patrick Knechtli, investment director at fund of funds SL Capital. “I think dry powder’s probably $40 billion or so, [and] if you get $25 billion of transactions done this year … that’s not a lot of dry powder. You’d usually expect dry powder to get used up over a two- to three-year period and at current run-rate that dry powder will get used up quicker.”

Pantheon’s Livingstone concurs. “I don’t see any systematic capital overhang at all. There are from time to time large deals in the marketplace, and when a large deal gets done that very quickly takes up quite a bit of liquidity from the buyside.”

Their views are clearly shared by many peers – secondaries vehicles are currently raising some $30 billion in fresh dry powder (see insets).  “It’s still a market that’s very, very busy from a fundraising perspective,” agrees Nigel Dawn, global co-head of UBS’ private funds division and head of its secondary market advisory practise. “Our sense is that it will remain busy for some time.”

 What remains to be seen, however, is whether activity levels can continue at the same pace as in the first half of 2011. “I don’t think you need to be pessimistic to say the macro environment looks very vulnerable,” says Axon’s Meyer. “The pricing we had by the middle of this year was quite maxed out; I wouldn’t be surprised if in a couple of quarters’ time we look back and say this has been a peak in some sense.”

 Volatility in global markets may prompt bidders “to build in a bit more margin of error and you can see that actually some of the fundamental data – operating data on funds’ underlying assets – is weakening”, he adds.

It’s inevitable that the secondaries market will be impacted by any negative macro events, particularly when rising NAVs aren’t such a certainty. “There’s a sense that a lot of buyers are happy to take the foot off the gas, so to speak,” says UBS’ Dawn. “If something is attractive they’ll still go for it but … they’ll be more risk-averse for the remainder of the year unless there’s some compelling buys.”