Secondaries Overview: Watching the waves

When Coller Capital announced in August that it had agreed to buy a £1.03 billion portfolio of private equity assets from UK-based Lloyds Banking Group, it not only served as an excellent demonstration of the current vigour of the secondaries market; it also emphasised some key trends.

For Coller, this was the first deal from its new fund, the $5.5 billion Coller International Partners VI, which closed $500 million above target in July this year. In fact, if fundraising success is anything to go by – and it usually is – there’s no doubting the current health of the secondaries market. “Exceeding our fund-raising target shows there is real appetite for investing in secondaries funds with a strong track record,” says Coller’s founder and chief investment officer Jeremy Coller

AXA Private Equity certainly seems to have found that: the Paris-based firm, which has been one of the most active secondaries players lately, closed a $7.1 billion vehicle (plus a $900 million sidecar) earlier this year. That’s the largest secondaries fund ever raised, just topping Lexington Partners’ $7 billion 2010-vintage fund. And there are also a number of other multi-billion dollar funds at various stages of the process, including offerings from the likes of Goldman Sachs, Partners Group, Paul Capital and HarbourVest Partners. 

“A large proportion of the big secondary players have been raising capital in the last 12 months, and thankfully some of the big ones have been very successful,” says Andrew Sealey of advisory firm Campbell Lutyens, which advised on the Coller/Lloyds deal. “Some will raise more easily than others; I don’t think everyone who’s out will succeed in hitting their targets. But I think a significant majority will.”

FORCED SELLERS

So there’s clearly plenty of enthusiasm on the buy-side. But what of the sell side? According to Sealey, there have been an increasing number of pension funds selling interests in the US, usually to balance or de-risk their portfolio – while in Europe his firm has been working with insurance companies, a trend he expects to continue as the impact of the Solvency II regulation becomes more keenly felt.

But there’s no doubt which area of regulatory change is having the most substantial impact on the secondaries market, as the Coller/Lloyds deal reminds us: the global crackdown on banks, particularly via the Volcker Rule in the US and Basel III in Europe, which is effectively pushing some of private equity’s biggest players to sell off their interests in the asset class. “Banks are facing increasing pressure on their balance sheets, and they continue to sell non-core assets,” says Sealey. “If anything we’ve seen an acceleration of divestment programmes.”

As well as Lloyds, the likes of Citigroup, Mizuho and HSH Nordbank have all completed big asset sales in the last year, while Credit Agricole has offloaded its private equity arm and Bank of America sold out its interests in the fund managed by its former captive group (now renamed Ridgemont Equity Partners).

This level of activity is explained at least in part by the worsening political climate for banks, Sealey suggests. “The impact of Volcker is likely to be more significant than people originally imagined. Most people thought that if anything, it would be softened during the consultation phase. But with all the banking scandals, appetite to fight the case for a loosening of bank regulations is pretty thin on the ground.” That’s why the latest draft of Volcker actually gives banks much less time to comply – forcing them to start dumping assets in a hurry.

Another consequence of the general political climate is that it’s become much harder to get a good price for European assets, says Dominik Meyer, a partner at advisory firm AXON Partners. “European assets have been downgraded, especially from a US perspective,” he says. “There’s now a continental discount, and within Europe there’s also a Mediterranean discount – which is substantial.” (By way of contrast, he suggests, there’s more interest in and focus on Asian assets, which is partly just a function of the increased volume of capital being deployed in Asia).

What this means is that buyers are having to spend a lot more time drilling down into the underlying funds that they’re buying, says Andrew Kellett, another partner at AXON. “Buyers are looking at the cyclicality of the underlying portfolio assets; so if we’re going to have a low or negative growth environment, how likely is it that these companies will suffer?”

PRICE SENSITIVE

So what of pricing generally? “Pricing has been driven by the macroeconomic outlook, so it has ebbed and flowed slightly,” says Sealey. “It peaked at the end of Q1, when it was approaching NAV; then it came off a bit as public markets have fallen and there were more volatility and sovereign currency concerns.”

Kellett argues that the average discount is probably between 10 and 15 percent – although it’s hard to generalise, he says. “The discount will depend on what the assets are and who you talk to on any given day. It depends what’s going on in the fund; if it’s a pure Mediterranean portfolio, it’s probably at the high end of that spectrum, but for a very strong performer, it might be in low single digits, maybe even par or better.”

Are discount sizes constraining the market at all? “The sell side is very sensitive to pricing,” insists Sealey. “Normally in between NAV and 20 percent discounts, you have a healthy market of buyers and sellers; if pricing falls below that, you see volumes drop off very quickly. But we’ve been in that range for most of the last couple of years now.”

The proof of the pudding will be found in overall transaction volume, of course. This is a notoriously hard number to measure in the secondaries market (since there are still lots of non-intermediated off-market deals) but most estimates suggest this year’s total will come in somewhere between $25 billion and $30 billion – which is roughly the same as in 2011. 

This also serves to mitigate the concern in some quarters that the top secondaries funds are getting too big, in the way that some primary funds raised in the boom years clearly did. The market has plenty of capacity to absorb the level of dry powder currently being accumulated, Sealey insists. “We estimate that there will be about $60 billion to invest in the next couple of years, which roughly matches the expected level of deal flow.” 

“The size of these funds doesn’t seem crazy when there are $1 billion-plus deals floating round the market,” agrees Kellett. “These sellers don’t want to deal with eight guys with small funds; they want to sell the whole portfolio to one buyer, if they can.”

However, funds of this size might not always be the norm, warns his colleague Meyer. “Right now it feels as though we’re in an historic moment, with the banks getting out of the balance sheet business. But it could be that this is not a repeat thing; maybe after this wave has gone through, it will be harder to deploy a $5 billion fund.”

PERFORMANCE ANXIETY

Much will depend on the performance of these post-crisis vintages, of course – and therein lies a thorny question. 
On the face of it, secondaries funds have performed pretty well since 2008. “PE funds raised since the crisis have performed well in general, and that performance is there for investors to see,” Coller tells PEI. “The markets have risen since then so any assets purchased in the first few years have become more valuable.”

This view is backed up by Daniel Green, chief investment officer of Greenpark Capital: although post-crisis funds are generally still in the early stages of their lives, he says, so far the signs are good. “By most benchmarks, post-crisis secondaries are already proving their mettle.”

But there is some variation within that, according to Patrick Knechtli, investment director at SL Capital Partners. “If you got in early on the wave, your interim performance will look quite good. But if you bought in a little bit late hoping for a bit more momentum then maybe the performance doesn’t look so clever,” he argues. In other words, the numbers will look good for anyone who did deals in 2009, because the discounts were so big, and not so good for those who did deals in 2010 and 2011.

That’s partly why it’s so incredibly difficult for LPs to gauge performance accurately, says Paul Ward, a partner at Pantheon. “Any deals done in the depth of the crisis generally had a reasonably big discount attached to them. Investors are seeing amazing numbers off the back of this and in some cases it doesn’t mean very much because of the short time period – but it can be very persuasive.”

Performance metrics are particularly difficult with new entrants to the market (see p. 60). “They can point to this interim performance, which is often about how quickly you have written up the assets and the discounts,” says Ward. “But really performance is about market cycles and how you have managed the investment process so you are not buying at the top of the market.” 

The other big issue around headline performance figures is a lack of transparency. It’s often hard to know, for example, how much leverage a firm has in its portfolio, either at fund level or on a deal-by-deal basis. The Coller/Lloyds deal, for example, had none – but some of the other big deals of this year have. That means trying to compare the headline returns from two secondaries funds might be a case of comparing apples with oranges.

As such, other factors will come into the equation other than IRRs – like the speed of deploying capital, the kind of assets typically targeted, how much of the fund has been invested, and so on. 

One consequence of this is that differentiation is becoming more important. “I think there are few enough firms that you can see how different firms differentiate themselves and operate in a certain part of the market place – whether it is different geographic regions, fund structures, the types of deal they go after and so on,” says David Atterbury, managing director of HarbourVest. Investors are increasingly aware of what different people do and select their managers on that basis, he argues.

As Ward puts it: “Performance is always important. But mostly it is a qualifier so you are one of the firms being considered. Investors are looking for performance beyond the mere metrics.”

In the next few years, there should be no shortage of deal flow for secondaries players, and no shortage of dry powder for them to take advantage. But only time will tell whether they’re getting their strategy and their pricing right – and as such, whether they’ll be able to cash in on this potentially-once-in-a-generation opportunity.