Secondaries Special: Buying from the banks

Banks are finally starting to offload their private equity holdings – but what are the main obstacles secondaries players must overcome to get a deal done? Graham Winfrey reports

Since the financial crisis began in 2008, private equity secondaries investors have been forecasting a flood of bank-driven secondary activity. 

Although some lowered their expectations after secondary deal volume fell from roughly $15 billion to around $10 billion in 2009, according to secondaries broker Cogent Partners, new regulations in 2010 helped fuel further predictions that banks would offload enormous volumes of private equity fund interests and direct investments on the secondary market. 

In Europe, the third installment of the Basel Accords, designed to discourage excessive risk-taking, introduced higher liquidity requirements for banks – which will eventually force them to sell off a substantial portion of their private equity holdings. And in the US, the so-called Volcker Rule (part of the Dodd-Frank Wall Street Reform and Consumer Protection Act) dictates that banks must limit their exposure to alternatives to no more than 3 percent of their Tier 1 capital, and cannot own more than 3 percent of any private equity or hedge fund group. 

But despite this wave of fresh regulation, the expected surge in bank-driven secondary deal flow hasn’t quite materialised yet. Overall secondary volume did grow from around $20 billion to upwards of $25 billion in 2011, according to Cogent; but volume during the first half of 2012 stood at around $13 billion, just shy of the $14 billion during the same period last year.

The main reason why banks haven’t sold their private equity holdings at the rapid pace some expected has to do with the implementation of the regulations. US financial institutions have until July 2014 to fully comply with Dodd Frank, while final rules for Basel III are scheduled to go into effect between 2015 and 2018.

“It was always going to be a multi-year process,” says Todd Miller, managing director at secondary advisor Cogent Partners. “This is probably a two to three-year additional window of selling by the financial institutions.”

The exact timetable according to which banks will have to divest their private equity interests is especially difficult to quantify given the various possible extensions – which, if granted, can give these institutions up to 12 years to liquidate their assets.

“As the regulations got drafted by the actual people that were going to have to execute and enforce them, I think it became pretty clear that banks were going to have a lot of latitude with how and when they disposed of those assets,” says Scott Conners, a partner at secondaries firm Landmark Partners. “It seemed like the regulators were not interested in putting banks into a ‘fire sale’ position.” 

Not surprisingly, the prospect of having more than a decade to sell out of private equity dramatically changes the urgency felt by banks. “I think that a lot of banks came to the conclusion that in that period of time most of the assets would probably be self-liquidating anyway, and I think [that] took a lot of the pressure off,” Conners says.

Still, it remains unclear exactly what regulators will require from banks requesting extensions, and to what extent the banks are likely to succeed in their requests.

“You can’t just say ‘I’m having trouble selling this, therefore I need an extension’,” says David de Weese, partner at Paul Capital. “You’ve got to go with a plan that says you intend to sell it, or expect that in a particular fund, assets will be realised by the general partner and your position will be reduced simply through sales and initial public offerings, et cetera.”

There are practical constraints too. Regardless of how long banks have to comply with new regulations, a flurry of sales all at the same time is unlikely, purely because of the size and complexity of some of these deals.

“If you go to a bank and say I want to do a $50 million transaction, you can probably get it done in three weeks, [but] a $500 million transaction is going to take some time,” de Weese says. “A lot of the transactions that have come to market have been quite large, and the bigger the transaction, the slower it goes.”

One example is Bank of America Merrill Lynch Private Equity Asia, a four-year-old captive group, which in 2011 spun out of its parent with the backing of a heavy-hitting group of secondaries funds including Paul Capital, HarbourVest Partners, LGT Capital Partners and Axiom Asia. The group helped to establish the spin-out’s first fund, a $400 million vehicle seeded with the entire non-real estate private equity portfolio of Bank of America Merrill Lynch in Asia.

“That took almost two years to get done,” de Weese says. “Big organizations move at their own speed.”

PICKING UP SPEED

It’s clear that bank disposals have not produced the “wall of deals” expected by some. In fact, according to Cogent, the proportion of secondary transaction volume from financial institutions (banks and insurance companies) stood at 33 percent during the first half of 2012, well down on the 46 percent figure for the equivalent period last year.

However, there are signs that the pace is starting to pick up. “Over the last 18 months banks have been a very significant part of the secondary market,” de Weese says. “It’s probably on the order of $10 billion per year at the moment. I’m guessing you could expect over the next couple years [that] bank sales could be 50 percent of the total volume in the secondary market.”

Recent deals include AXA Private Equity’s acquisition of a portfolio of fund interests from Nordic lender Swedbank worth between €70 million and €100 million, according to a source close to the situation. In addition, Coller Capital recently purchased a £1 billion portfolio from Lloyds Banking Group (this followed an earlier deal in which it paid Lloyds £332 million for the transfer of 40 investments from the old HBOS integrated finance division into a new joint venture). 

At London-based secondaries firm Vision Capital, founder and chief executive officer Julian Mash says 2012 has been the year bank-driven secondary activity “actually got going”.

“It’s not at all surprising that some people would be disappointed with the pace, but the pace is definitely picking up,” Mash says. “I think this has certainly been the most active year for conventional fund-driven portfolios.”

Vision, which specialises in direct secondaries (i.e. buying the portfolio companies of other private equity firms), has had some success in dealing with the banks: in April, for instance, it acquired Brazilian film packaging company Vitopel from funds advised by DLJ Merchant Banking Partners and JP Morgan Partners.

So what is the key to this often delicate negotiation? What are the main obstacles secondaries players face, and what are the best ways around them?

Pricing is usually the most significant challenge, of course – and often the most intractable, since some banks are wary of the ‘optics’ of selling assets at a big discount.  

However, one tactic banks can use to help complete deals is to offer deferred payments to buyers. “That certainly is a way of closing an apparent bid-ask spread,” de Weese says. “You can do a lot of structuring on transactions to make them more palatable.” 

Equally, it doesn’t always come down to price; sometimes the quality of a particular firm’s relationship with the selling bank can be its trump card.

“Building good strong relationships with banks is pretty critical to getting good deals done, and it may in many instances be worth more to the banks than a modest difference in price,” says de Weese. “Having done multiple transactions with banks is important. If you’ve done three transactions with a bank, the fourth tends to get done with you without competition.”

That said, sustaining long-term relationships with banks in the current climate can be challenging. “The biggest trick there is that these banks have had so much turnover in their people that sometimes knowing the right decision-maker who is actually going to make the decision is very difficult,” says Cogent’s Miller. “Sometimes you think you know the decision maker and then all of a sudden it gets kicked up to a chief financial officer.” For particularly large transactions, final decisions can go to a board of directors or even to regulators.

AN UNCERTAIN FUTURE

But despite the various barriers that make life difficult for secondaries firm when they’re dealing with banks, the good news is that there appears to be no shortage of willing buyers for the private equity holdings coming onto the market, according to Miller.

“There always seems to be somebody willing to step up,” he says. “If you talk to the banks, I think they’re pretty happy with the [sales] they’ve done.”

Historically, banks have played a very significant role as limited partners in private equity funds. In fact, a study by Harvard Business School showed that banks accounted for 26 percent of private equity commitments between 1983 and 2009.

“If you look at the big buyout funds, banks have probably been [more than] 20 percent of their capital,” de Weese says. “So the fact that banks are exiting private equity is a huge problem for the big buyout funds, just because that group of limited partners isn’t going to be there.” 

Might they come back at some point? “I don’t think they’re ever coming back, frankly, because if you get down to 3 percent of your Tier 1 capital, it’s not going to move the needle even if private equity does well. That doesn’t prevent them from operating fund of funds businesses for their high net worth clients – but bank balance sheet money is not going to be there.”

Ultimately, the day may well come when banks transition out of private equity altogether. But it’s anybody’s guess as to when that will happen.

“Secondary investors predict that once the banks are completely motivated to sell, there will be a watershed opportunity – but it never happens like that,” says David Wachter, managing director at secondaries investor W Capital Partners. “My view is that banks are generally pushing this down the road so that they can avoid taking any writedown or discount, and gradually reduce private equity exposure through GP realisations of the underlying assets.”