Bullish, or foolish?

Stocks are down. Why aren’t private equity fund interests “down” as well?

When the expected future profitability of a business declines, its stock price tends to immediately fall.

As is painfully obvious today, shares in public corporations around the world are down (then up, then down. . .), indicating that, at the very best, public investors are highly uncertain about the future and, at worst, that they believe corporate profits are set to decline.

Stocks are shares in companies that trade on a secondary market. Private equity, too, has its own secondary market, albeit one that is not nearly as liquid or developed. Those points aside, I was curious to learn recently that the prices at which shares in private equity partnerships are changing hands have seemingly been nearly unaffected by the recent market turmoil. Why is this? Do private equity investors have a more hopeful view of the future than do their public-market cousins?

Several sources in the secondaries market have said that, prior to the summer market swoon, secondary fund interests were frequently trading at par and even winning a slight premium – meaning that buyers expect even more from these funds than is reflected in the GP-assigned net asset values. These prices were up sharply from early 2009, during which secondary deals were being agreed at 60 percent and even 70 percent discounts. In those grim days, you couldn’t find buyers who thought valuations were going to go up.

One secondaries market participant recently told me that he had been nervously anticipating deal activity in September, a “back-to-school” pickup in activity that nevertheless came directly after an August collapse in global markets. However, once September was under way, the source said, deals were being agreed in which, at most, there was a 10 percent discount to NAV. He cautioned that these prices reflected the “winning” bids, not the range of competing offers from a range of market participants. But of course, in markets, the winning bid is the price.  The most bullish buyer determines the official value of the security.

It is hard to say exactly what factors are behind this hold-steady phenomenon, but here are some potential explanations:

Long-term bullishness: It could be that a statistically significant faction of secondaries buyers – both dedicated buyers and “active-management” LPs – do indeed forecast a return to growth, or at least they don’t see the ongoing economic turbulence posing a major threat to the ability of defined groups of GPs extracting value from their portfolio companies. While the markets continue their rollercoaster rides, GPs will hopefully be able to manoeuvre operations, work the capital markets, and position crucial assets for corporate buyers. If you believe the advantages of control and optionality can beat the public markets, then you perhaps do not see a need to discount current private equity fund NAVs.

LP demand: Through the market swoon, many LPs around the world have continued to desire more access to the private equity asset class, and the ability to buy “pre-owned” portfolios diversified both by strategy and vintage year is highly appealing. As these kinds of portfolios become available on the secondaries market, they are getting bid up in price.

Mega-fund demand: A slightly more cynical explanation for strong pricing, offered by one market participant, is that, frankly, there are many well capitalised secondaries player in the market and they need to put billions of dollars in capital to work. This demand to buy will be met by an uptick in reluctance to sell, as many sellers naturally wonder whether it might be wise to wait and re-enter a less turbulent market. Worryingly, the willingness to spend more in order to put money to work has a long history of producing weak returns.

While not enough third quarter data has been collected to meaningfully connect dots, anecdotally a source said that in most recent deals, winning bids have tended to be “outliers” and rather far from the next best bid. One explanation for this trend could be that different buyers see different reasons to love portfolios – perhaps an energy-poor LP is desperate to buy access to a portfolio with many energy-focused LPs; perhaps a certain secondaries buyer is convinced that a certain fund is going to outperform.

In order for secondary prices to hold up, only some participants need to remain confident in the future. If prices begin to crumble in secondaries, it’s time to become very concerned.