Secondaries: Improving the age

With all the signs pointing to another strong year for the secondaries market, for some the high pricing and record volume of transactions bear witness to the sector’s growing maturity.

In terms of the sale of LP fund stakes, the average pricing as a percentage of net asset value (NAV) is 92 percent for the second year in a row, following four years of hovering around the low to mid-80s, according to a first-half 2015 report from Greenhill Cogent.

Pricing for buyout funds in the first half was also largely unchanged at 95 percent, compared with 96 percent last year. Transaction volume stood at $15 billion, slightly down from $16 billion in the first half of 2014. Greenhill Cogent anticipates that total volume for 2015 will be about $40 billion, compared with $42 billion last year.

Expected returns have dropped materially over the past year or two from multiples of about 1.5-1.6x to closer to 1.3x. This has prompted many buyers in the secondaries market to look for more creative ways to maintain their levels of return. Indeed, as asset pricing has grown the increasing amount of money raised over the past couple of years has needed to be put to work.

Many GPs are using a range of instruments to grab a bigger slice of a slowly dwindling pie. Tools in the secondaries buyers’ kit include wider, and more-accepted, use of leverage, a growing focus on restructurings and a concentration on other asset classes such as real estate, in addition to buyouts.

“Overall, the first half of 2015 [wasn’t] that much different from 2014,” says Nico Taverna, vice-president at Zurich-based fund of funds Adveq. “High pricing is still driven by strong fundamentals and pricing has a lot of impact on overall volume.”

Record high distributions from private equity-owned companies and a bullish stock market with elevated valuations are the major factors pushing pricing higher. Such high pricing is also motivating sellers, even those who may not need to sell, to tap the secondaries market to take advantage of the current positive environment in case a downturn starts having an impact on discounts.

Another sign that the secondaries market has matured is the diverse range of funds being traded. The once dominant buyout funds now take up 37 percent of the market, with real estate growing tremendously.

Sellers are now comfortable with pricing for real estate funds and are turning to the market on a more regular basis. One recent announcement saw CalPERS reveal that it was tapping the market with a $3 billion portfolio of real estate fund interests. For buyers, real estate is an opportunity to diversify their exposure and again maintain returns.

“Several large portfolios have come to the market this year,” says Sarah Schwarzschild, principal and head of the real estate secondaries business for Metropolitan Real Estate. “These transactions have not only increased deal flow dramatically, but also served to increase overall awareness of real estate secondaries.”

IMBALANCE

As dry powder to buy secondaries continues to rise, an imbalance between supply and demand is emerging. A survey this year by UBS found that the secondaries market had $49 billion of dry powder, compared with $45 billion for the same period in 2014. Greenhill Cogent noted in its July report that “with the secondary volume of less than $20 billion in the first half of 2015, ample dry powder and several large secondary funds raising or expected to raise capital in the next 12 months, there is a greater supply and demand imbalance than when the year began”.

There are currently more than $26 billion-worth of secondaries funds being raised on a global basis, according to data from PEI’s Research & Analytics. This is pressuring buyers to push underwriting rates down and ultimately weighing on returns.

RISE IN RESTRUCTURINGS

Another area continuing to gain traction is the number of secondaries firms and LPs taking part in GP-led restructurings and other fund recapitalisations. Some groups, such as ICG, have set up secondaries teams to specifically focus on restructurings.
GP-led transactions comprised about 13 percent of the secondaries market volume in the first half of the year, according to Greenhill Cogent, while about four-fifths of LPs have been actively involved in fund restructurings since the global financial crisis, according to a Coller Capital survey.

Greenhill Cogent noted the “wide range of transaction motivations and dynamics” for the increasing interest in secondaries.

A fund may have run through its 10-year life, and extensions, but still needs new capital to invest in some portfolio companies. It may simply have been raised at a tough time and not been able to invest early due to the global financial crisis, delaying exits as a result.

Another catalyst might be several LPs wanting to cash out at once, prompting a secondaries buyer to want to purchase a large existing stake, transfer the assets to a newly-created vehicle and reset the fund terms. Generally, though, GPs want more time, money, or both, and secondaries firms can help them.

“While the first wave of GP-led transactions were restructurings of existing funds, GP-led tender offer processes and secondary direct portfolio sales are increasing in number, in part due to their relative simplicity compared to a fund restructuring,” according to Greenhill Cogent.

Some market participants frown upon such transactions, however, as they are often linked to funds with a poor track record. One source at a secondaries firm recently said that “restructurings stem more from a problem than an opportunity in most cases”.

In fairness, the quality of the fund manager undergoing a restructuring varies greatly from one situation to another. Some GP-led restructurings turn out well for all parties, while others are mere patch-up jobs.

However, overall, the quality of the GPs/funds undergoing restructurings is growing and an increasing number of GPs are even using the secondaries market to help with fundraising by way of stapled transactions.

It’s also worth noting that GP-led restructurings have been more prevalent in the US than Europe.

“The past three years have seen enormous growth in the number of GP-led restructurings,” says Jeffrey Hammer, managing director and co-head of the illiquid financial assets practice at Houlihan Lokey.

“What started out as a trickle of one-off, highly-negotiated deals has become a regular flow of transactions using increasingly standardised techniques.”

THE FUTURE

The secondaries market seems almost unstoppable at this point, leading some to believe it is too good to last. What could bring an end to the secondaries party?

Most market participants point to the stock market, saying that pricing will be hit and supply shrink if public equities tumble.

However, even in a downturn, the secondaries market will remain relevant if LPs are forced to sell because their investment strategies change or allocations to private equity become too large for their risk model.

It will also continue to be a means for investors to quickly build and diversify private equity exposure, with the purchase of funds past their J-curve. And secondaries may also have an interesting role to play alongside the shift to defined-contribution pension plans, as fund managers start to develop products that would work with DC schemes’ requirements for portability, regular pricing and redemption. Watch this space.