Secondaries get complicated

A combination of financial distress and increased regulation in the West and the maturation of the primary fund market in the East are leading Asia’s secondary market to more complex deal structures. Secondary directs feature, but so too do more Asia-specific transactions, writes Jenny Blinch.

Though the global financial crisis left little institutional stress in Asia’s financial markets, the broad reach of financial institutions in the US and Europe means their distress has been a prime source of deal flow for Asian secondaries.

And with regulations like Basel III and the US’ Dodd-Frank Act (or so-called ‘Volcker rule’) looming, the pressure has increased on these already stressed banks to reduce their exposure to alternative assets.

“Banks are looking at ways to deal with their private equity portfolios and be prepared to do what’s necessary when regulations like the Volcker Rule and Basel III actually come into play. Most people would agree that banks are going to have to reduce their stakes, whether its assets on their balance sheets or interest in funds,” says Lucian Wu, managing director and head of Asia, Paul Capital.

According to Hiro Mizuno, partner and Asia head at secondaries specialist Coller Capital, which has had “hundreds of conversations” with banks over the past 18 months, most banks the firm has spoken to are leaning towards exiting the asset class completely.

“The banks’ preference is to sell their entire private equity portfolio. Basel II is so burdensome from the banks’ perspective – they almost have to put aside 100 percent of equivalent capital for the alternatives exposure, which is just too expensive for them,” he states.

Although Mizuno questions whether some banks might chose to hang onto their Asian private equity portfolio, given this is generally “relatively small”, the impact of Basel III has already been seen in the region.

In September, HSBC agreed to sell an 80.1 percent stake of HSBC Private Equity Asia (HPEA) to the firm’s management team, which is headed by George Raffini. The bank retained the remaining share. In June, the global banking giant had said it was considering selling five of its private equity fund management businesses to their respective management teams as part of a global initiative “to meet the requirements of a changing regulatory environment”.

Few details were disclosed about the HPEA spin-out and it is not known whether the management was backed by third party funding, but Asian secondaries practitioners say spin-outs such as this will become a more staple part of their deal flow in future.

Says Paul Capital’s Wu: “We have had discussions with a number of captive teams, not just in the West but here in Asia because of the uncertainty of their future. We expect captive spin-outs to be more a feature of the market going forward.”

Also expected to play a greater future role in the Asian secondaries market is the other kind of secondary direct transaction, where a portfolio of private equity investments is sold without a manager.

“There are more secondary directs to come on a global basis, not just from the banks, we’ll see other direct portfolios come to market too,” states Alex Sao-Wei Lee, investment director and head of secondary investments at fund of funds manager Axiom Asia.

That’s not to say though that practitioners do not expect to have to go through a learning curve as these deals become a more common feature of the Asian market.

“We have a lot of experience with spin-outs in some of the Western markets and yet they are still challenging deals,” says Tim Flower, a Hong Kong-based vice president at HarbourVest Partners.

“They are even more challenging in the Asian market given the various tax regimes and structures – it's still a new science here. We know what structures work best, but it's how to translate them,” he adds.

Local innovation

Teething problems aside, many in the industry believe it is only a matter of time before Asia’s secondaries market resembles that found in the West in terms of types of transaction seen.

“The market is evolving quickly. We believe that the more innovative, structured types of transactions occurring in the US and Europe will start to happen in Asia in a few years’ time,” predicts Troy Duncan, co-portfolio manager, JP Morgan Private Equity Limited (JPEL).

At the same time, certain secondaries specialists are also finding that there are more esoteric and innovative transaction opportunities arising from the specific characteristics of the Asian market.

“Funds in Asia are evolving at quite a pace in terms of strategy – and there’s a difference between evolving and drifting – but there are a number of GPs finding more opportunities than their funds are able to handle,” says says  Jason Sambanju, a Hong Kong-based director at Paul Capital.

“Rather than just simply buying fund interests or backing spinouts, a few deals we are looking at would be fund restructuring transactions where we would come in and provide additional capital – enough reserves to meet follow-on investment commitments. Or we can step in if GPs were not able to raise sufficiently large funds first time around in the 2008 timeframe – either because they were first-time funds or were not quite able to lock down as many GPs as they would have liked – but are seeing plenty of opportunity for investment 12 to 18 months on if only they had the larger fund,” he adds.

In these deals, Paul Capital would come into the fund as “a very late closing”, and, says Sambanju, despite the fact the firm would actually be providing fresh capital, it would be able to “get a look back into the existing assets”.

“ It’s a win-win for everyone: existing LPs are potentially getting more money for current portfolio companies, GPs get to scale the fund to the size they had originally envisioned, and we get the chance to partake in the returns,” he states.

Paul Capital is also looking more closely at specific Asian markets and anticipating how it might play a role in the future as that market evolves. One such market, says Lucian Wu, is India.

“India has more GPs than it really should have,” he says. “There is going to be a point where some GPs are not going to raise second funds, but their investee companies will continue to need guidance and capital from the private equity industry. We are the specialists at being the grease amongst the cogs.”

Focus on Asia

In view of the rapidly increasing depth of transaction opportunities found in Asia, several secondary specialists have adapted their approach to the region.

Paul Capital’s Wu and Sambanju estimate that they are currently spending over 50 percent of their time on the type of non-traditional secondaries transactions outlined above – as compared to the 30 percent to 40 percent their colleagues in other Paul Capital offices might spend on such deals.
JPEL, a listed secondaries vehicle with $675 million in assets under management, has almost doubled its exposure to Asia over the last 12 months, from 11 percent of private equity assets to 21 percent.

Given JPEL’s focus on smaller, more complex transactions, for example secondary directs or heavily discounted fund interests in lesser-known managers, this doubling of exposure reflects the firm’s belief that Asia will be able to provide it with these more esoteric transactions, says Duncan.

On a larger scale, global fund of funds manager and secondaries investor HarbourVest Partners recently moved Flower to its Hong Kong office from London. He is the fund of fund manager’s first Asia-based secondaries specialist.

“With the evolution of the Asian secondary market and more mature assets available, we decided that a secondary focused team member based in HK would be valuable,” commented a spokesperson for the firm at the time of the move.

To that, Flower adds: “We have looked at a number of [secondary directs] in Asia in the past, and continue to see increased opportunities going forward. It's clearly my ambition to find more if they don't find us. The timing is very prescient for that.”