Strong public markets hamper secondaries

On Friday, the Dow Jones Industrial Average broke through 15,000 (temporarily) for the first time ever on the heels of a stronger-than-expected jobs report in the US. For investors, this was great news. 

However, for the private equity secondary market, it’s the continuation of a public market rally that, since the latter half of last year, has helped convince potential sellers to hold their LP interests and delay selling. 

The market was in high gear over the past two years, reaching deal volume levels of around $25 billion consecutively in 2011 and 2012 – record-breaking deal activity numbers for the relatively young secondary market. This year, however, is on track to come in well below that number, if the kind of sluggish deal activity seen in the early months of 2013 (and the last months of 2012) continues on through the year.

Cogent reports deal volume of about $3 billion in the first quarter, which the firm calls a “return to normal levels (pre-2011)”, according to Todd Miller, a managing director with Cogent.

“It’s been persistently slow for at least six months,” said Jason Gull, partner with fund of funds and secondary buyer Adams Street Partners. “With the typical secondary market, you have moments of sanity, and moments of frenzy. We’ve not seen frenzy for a while, at least not before last summer.”

Convinced to hold

Professionals cite various reasons for the slow activity, including strong public markets that are convincing potential sellers to hold on to their interests. 

For example, the pressure comes off institutions considering selling down pieces of their private equity portfolio for liquidity when public markets are strong. The performance of marketable securities (usually the biggest piece of an investment portfolio) drives overall fund performance, decreasing the percentage of private equity relative to the overall portfolio and potentially under-allocating the institution to asset class. Selling into this situation would leave an LP even more under-allocated to private equity. A sale also raises the issue of what to do with the proceeds of the sale, sources said. 

But even those LPs not under liquidity pressure, who may simply be working to manage their portfolios, strong returns in marketable securities drives overall performance, potentially creating apathy in potential sellers who don’t need to go through the cost and drawn out process of a secondary sale.

Or, as one secondary market professional said: “It’s the fear and greed pendulum swinging into action. Nobody wants to sell anything because they think NAVs are going to continue to climb. My prediction is the minute the public market starts to become unstable and volatile you’ll start to see lot more selling.”

Along with the strong public markets, distributions have been strong while capital call activity has been steady but not

high, which for many institutions likely has private equity working the way it is supposed to, where distributions are funding capital calls. Cambridge Associates reported in March that fund managers in Europe and other developed markets outside the US distributed more than they called in the third quarter of 2012, the sixth in the past seven quarters that managers in those regions had given back more than they had taken from LPs. 

“There’s been a ton of liquidity out there and I think the interest in selling to create liquidity for those that might be looking for it has been temporarily abated,” said John Toomey, managing director with HarbourVest Partners, who works on the secondary team.

For LPs, it’s also a question of yield. In today’s low interest rate environment, institutions need to find yield from asset classes like alternatives. So they need more exposure to private equity, not less, the secondary market professional said. Ironically, this might be the most attractive market in which to sell, the professional said, because the spread between buyer and seller expectations may be as narrow as it’s going to get, and several large firms are sitting on the sidelines with money to spend.

“It’s an incredible sellers' market, and these don’t come around that often, so if anybody is looking to sell, they should do it now,” the secondary market professional said.

Late year rally

However, some market participants are optimistic that activity will pick up in the latter half of the year.

“The market will be pretty robust, most activity happens in the second half, historically,” said Hugh Perloff, managing director with Portfolio Advisors. “Most people come to the market in the fall.”

Activity on the secondary market has always been seasonal, Toomey said, with the expectation that the year would start out slow but become hyper-active in the final months of the year. That “seasonality” aspect of the market changed after the global financial crisis, he said.

“The last few years we haven’t seen that seasonality, [activity has] been fairly consistent [throughout the year],” Toomey said. “The big question [this year] is whether seasonality has entered the market once again.”

A portion of activity in the secondaries market (though likely not a huge portion) will consist of secondary-backed restructurings of aging private equity funds. Estimates of exactly how much net asset value resides in funds that are 10 years or older vary, but typically range from $75 billion to $100 billion. Within this universe, there are likely “several dozen very interesting fund recapitalisations – and hundreds and hundreds of other funds that will be asked to do the best they can to wrap up those partnerships”, according to David Wachter, founding partner of W Capital Partners, who participated in a secondary-related roundtable with Private Equity International in April. W Capital has been working out liquidity solutions for LPs and GPs in mature funds since 2001.

“Those couple dozen are very interesting to everybody, because they’re the ones with portfolios of multiple interesting

John Toomey

assets – and there’s just a sequence of time or company-by-company variables that have basically put a good GP in a position where they’re just not liquid,” Wachter said. “Those will get re-capped by very large secondary funds, and other funds that have less size, diversification or portfolio attributes that are attractive to the large secondary buyers … they just have to work their way out of those assets.”

Already this year, Landmark Partners has financed the spin-out of the energy team from HM Capital into an independent firm. HM Capital is in the process of winding down, and its assets are being split up with the help of secondary firms and other players. The new energy firm spinning out from HM Capital is called Tailwater Capital, and will hold several energy-related assets from HM’s 2006 fund.

Last year, the Canada Pension Plan Investment Board led the spin-out of HM Capital’s food and consumer products team into a new firm called Kainos Capital. Kainos’ fund has been targeting $400 million, and got an anchor commitment from CPPIB as part of the spin-out.