What will the next recession mean for secondaries?

With many predicting an economic downturn, we examine the lessons from the global financial crisis and how firms are reacting a decade on.

If you had the chance to buy Blackstone or KKR funds at a 50-60 percent discount to net asset value, you would take it. That’s what the opportunistic funds formed just after the financial crisis did, according to one secondaries buyer.

“They [opportunistic secondaries funds] were buying KKR, Blackstone at a 50-60 percent discount. And they did very well. Obviously, if you held the assets for a few more years they’d recover nicely.”

The crisis caused a jarring price dislocation that made it difficult to see the true value of private equity assets. Between June and November 2008 the average top bid on secondaries stakes as a percentage of NAV fell by 28 percent, hitting 61 percent at the end of November. Many buyers and sellers decided that to do nothing was the best option.

“Given that the outlook for the underlying private equity investments has deteriorated along with the overall economy, that change in pricing has had to be reflected in the secondary market because the general partners aren’t reflecting it in the valuations they’re holding the companies at,” then-managing director at Cogent Partners, Colin McGrady, told Private Equity International in January 2009.

But others realised the poor economic conditions presented an opportunity. F&C Private Equity, the fund of funds division of F&C Asset Management, responded by launching the secondaries-focused Aurora Fund. Before it hit first close on €30 million in December 2009, it had bought almost the entire private equity fund portfolio of distressed Icelandic bank Landsbankinn at “a very large discount to asset value”, according to its annual report.

And it wasn’t just classically distressed assets which were going for a song. By the end of the first half of 2010 prices had rebounded by 17.5 percentage points, according to data from Greenhill Cogent, as clarity on exit timings and portfolio values caused many investors who had been sat on the sidelines through 2009 to get back in the game. While a return to something like normality was welcome, some had done much better out of the crisis than others.

A CHILL IN THE AIR

No one is predicting a catastrophe quite as large as 2008, but the headwinds are blowing. Apollo, for example, in its marketing materials for the $23.5 billion-target Fund IX, says the continued weakness of European financial institutions and rising interest rates in the US make it “prudent to underwrite investments assuming the possibility of a near-term recessionary environment”. What are the likely implications of recession for the secondaries market? And are buyers and sellers adjusting their strategies in preparation?

At the moment, the mood seems circumspect. Assets that might be considered underpriced are beginning to re-emerge after a period when decent discounts were hard to come by. But a clear picture of how the market will develop is hard to find.

“Attributing a single driving force to any given market trend is a dangerous game,” says Kate Ashton, partner at law firm Debevoise & Plimpton. “That said, predictions of economic uncertainty are having their effect. In the secondaries context, that has meant some spotting and targeting of bargain fund stakes, and a continued flow of fund restructurings. Nothing dramatic has happened yet, though. Like so much in the market at the moment, we’re in a bit of a wait-and-see phase.”

On the sellside, a significant number of secondaries buyers appear to have become sellers over the past 18 months. Ardian has offloaded some big portfolios, including the sale of $700 million of mainly tail-end buyout stakes to Strategic Partners VII in June.
A spring 2016 report by secondaries advisor Campbell Lutyens found that three-quarters of the top 30 secondaries funds had sold a portfolio of stakes, several more than one.

“That’s one way to look at it – that they are thinking it’s the right time to sell [secondaries buyers who are becoming sellers],” says Thomas Liaudet, a partner with the Secondary Advisory team at Campbell Lutyens. “It doesn’t apply to all of their assets, but they’ll do their work and conclude ‘that’s interesting at the right price, we can lock in our returns’. It doesn’t mean there’s going to be a downturn but it demonstrates how they might be thinking.”

On the buyside, there appears to be little evidence of firms gearing up for a potential drop-off in prices, in line with deteriorating macroeconomic conditions. If anything the investment period of secondaries funds is getting slightly shorter, from three to five years traditionally to an average of three to three-and-a-half. In tandem, firms are coming back to the market more quickly to raise larger funds.

SO MACRO

According to one buy-side source, the fundamental mismatch between funds available and attractive assets still dominates thinking more than any macroeconomic concerns.

“In January there was $90 billion of dry powder and that figure is still going up,” they say. “There just isn’t enough dealflow.”

If the economy does take a turn for the worse, one effect is that it could accelerate the disparity between the largest secondaries funds and the rest. The relative return profile of secondaries compared with other asset classes suggests that it will remain attractive to investors and with so much dry powder around, particularly among the largest players, the need to do deals will remain. For smaller funds, however, things may be trickier.

“As with any downturn, there is always likely to be a liquidity impact on secondaries deals and fundraising,” says Alistair Sword, head of alternatives at broker dealer. “This will be felt most in the smaller, more esoteric or tail-end funds, just as it would be for small-cap names in the public markets. At that point the issues of vintage, size and strategy become more pertinent. What might be prudent housekeeping and better portfolio management now, may take on some aspects of distress and the commensurate effects on price, readiness to transact and ability to raise new funds.”