Secondaries: Europe adapts to US ideas

There are few corners of the private equity world that have witnessed as rapid growth as the secondaries market. Ten years ago the global value of annual deals was well below $10 billion. In 2014, it reached $42 billion, according to Greenhill Cogent.

Part of this has come from the buy-side, as secondaries specialists raise ever larger funds. Last year, Ardian collected $9 billion to target secondaries investments and, more recently, Lexington Partners closed its latest secondaries fund at $10.1 billion – the largest ever raised and significantly more than its $7.1 billion predecessor.

Yet it’s on the sell-side that the secondaries market has really witnessed a transformation. Historically, LPs sold for liquidity reasons or to exit the asset class.

However, in an era of reduced GP relationships, more direct investing and increased allocations to specific areas, the secondaries market is becoming less a place for fire sales and more a portfolio management tool.

US TREND

This trend has largely been led by US LPs. CalPERS has a track record of selling large portfolios of fund interests in the secondaries market, starting with its $800 million sale to AlpInvest in 2011. This year, the pension fund said it would seek to reduce the number of private equity managers it invests with by two-thirds, to 120.

CalPERS is far from alone. “In the US over the last four years, active private equity portfolio management has become a big topic for LPs,” says Adam Howarth, co-head of private equity secondaries at Partners Group. “Many investors want to clean up old vintages, close down relationships they no longer want to continue and rebalance their portfolios where they are over-allocated to certain geographies. This has been a big driver of secondaries deal flow.”

The recent spate of IPOs has also left many LPs with higher public market exposure than they would like, prompting them to sell in the secondaries market, adds Howarth.

“Portfolio re-positioning is the top reason for selling,” says a report published in July by Greenhill Cogent. “Few investors selling today are over-allocated and almost all investors who are selling have more than ample liquidity, but utilising the secondary market is proving an effective way to acce-lerate portfolio repositioning.”

But what of European LPs? While the size of the European secondaries market is difficult to quantify, the evidence is that the sector is being used in a similar way.

“We have seen sales for portfolio management reasons in Europe, although not as many as the US,” says Howarth. “Family offices are examining their portfolios and looking to trim back where they are over-exposed or where they wish to terminate relationships.”

There have been sales from financial institutions, too. “Many banks and insurance companies have had to cut back some of their private equity portfolios for regulatory reasons,” adds Howarth. “Yet quite often portfolio management rationale is embedded in the choice of sales being made. They are being very strategic in the way they approach this and are using secondary sales as a way of optimising their private equity exposure.”

Funds of funds are also becoming active sellers in the market, particularly as their older vintage funds come to the end of their lives. In an interview with Private Equity International last year, Allianz Capital Partners’ global co-head of fund investing, Michael Lindauer, said: “We’re not really in need of selling, but it would be convenient to reduce our tail-end and lower the administrative burden.”

European pension funds, however, are less prominent. In many countries, pension funds are in the process of building out portfolios, says Bernhard Engelien, managing director of Greenhill Cogent.

“Pension funds started investing in private equity much later than their US counterparts and so the need for portfolio management is not yet as strong,” he says. “Many also have lower allocations to private equity, with 2 percent to 5 percent being the norm, as opposed to 10 percent to 15 percent in the US.

“There is also a reluctance to sell at a time of low interest rates and high distributions as there are few other asset classes that can generate private equity level returns. That said, we have seen some activity over the last two to three years among UK, Scandinavian and Swiss pension funds, whose portfolios are a little more mature.”

Yet while European portfolios may not be as mature as those in the US, there is clearly scope for this type of transaction to grow, particularly if pricing remains attractive. It is currently at an all-time high of 92 percent of NAV on average, according to Greenhill Cogent.

“One of the main drivers for sales in the current market is good headline pricing,” says Mathieu Drean, managing partner at Triago. “The amount of capital raised by secondaries funds, coupled with interest from non-specialist buyers, such as investors looking to build out portfolios, clearly creates demand. This comes at a time when NAVs themselves are rising on the back of buoyant stock markets.

“Distributions are up and typically in such times, LPs don’t sell because they are generating liquidity. However, despite high distributions, we are still seeing a high volume of sales, so it’s clearly not about getting cash – they are taking advantage of a favourable environment to clean up and rebalance their portfolios.”

BROADER ACCEPTANCE

European investors are also now starting to get more comfortable with the secondaries market, particularly as pricing has improved for sellers. “Five years ago, the assumption among LPs was that the secondaries market was punitive,” says Drean. “Now, they see it as a viable option, not only to rationalise portfolios, but also to help them realise strategic goals.”

Skandia Life is among those LPs currently building up private equity portfolios. “While we started investing in private equity in 1989, it’s only since 2007 that we’ve ramped up the programme,” says Jonas Nyquist, head of buyouts at the Scandinavian insurer.

“We now have 10 percent of our capital invested in private equity and as we are still in build-up mode, we’re not looking at selling. We did sell a few interests a few years ago for regulatory reasons and we acquired fund interests in 2009, when pricing was much lower, but our involvement to date has been more opportunistic than strategic.”

That may change in times to come, however. “We are seeing through our secondary fund investments that many LPs are selling for strategic reasons,” adds Nyquist. “And I think that in, say, two years’ time when our portfolio is more mature, we may well look to sell in the secondaries market to help tidy up or rationalise our portfolio.”

Increased secondaries activity is, in turn, changing one of the long-held features of private equity fund investment – its illiquidity.

A report last year by SEI, found that nearly half of GPs and a third of LPs and consultants believed that private equity was becoming an “increasingly liquid asset class”, with the rise of secondaries a major contributor to this.

“The growth in the secondary market over the last five years has been substantial,” says Mark Calnan, global head of private equity at Towers Watson. “That is rapidly increasing liquidity in what has historically been a highly illiquid asset class – and that is a positive development for all investors in the market.”