Ian Charles, a partner with secondaries fund manager Landmark Partners, likes to compare the cycles of the secondaries market to giant waves with peaks and valleys.
“The bottom of those waves is where people feel at risk,” he says. “They are uncomfortable with current liquidity levels and may feel over-allocated to private equity. They may feel significant regulatory pressures and look to sell because they are concerned with current illiquidity constraints.”
The global financial crisis and its immediate aftermath represented one of those periods. Distressed sellers of LP interests were dominant, unloading stakes in non-performing real estate and buyout funds to bring in much-needed liquidity.
As the economy slowly recovered, the pressure to sell on the secondaries market shifted to financial institutions under regulatory pressure to reduce or eliminate their private equity portfolios. Similar to a distressed seller, financial institutions didn’t necessarily want to sell, but they were forced to.
In anticipation of the implementation of new regulatory frameworks such as the US’s Volcker Rule, many financial institutions have sold their private equity interests in bulk in recent years. But the Volcker Rule’s compliance deadline was extended earlier this year and thus many financial institutions have put their plans to sell on hold. As a result, they have been largely absent from the secondaries market in 2015.
“Over the last 18 months, financial institutions comprise less of the secondaries supply side and they are being replaced by public pension plans, sovereign wealth funds and other investment managers,” says Charles, adding that secondaries firms and funds of funds have also emerged as sellers this year.
These opportunistic sellers don’t have to sell, but they want to. They hope to take advantage of strong headline pricing, which was close to or above par earlier this year. Charles believes the secondaries market may have reached a peak in the cyclical “seller motivation” wave at the beginning of 2015.
“There is a lot of liquidity,” he says. “There are plenty of opportunities and sellers are using secondaries as a way to re-sculpt their portfolio and actively manage it.”
As private equity markets continue to mature in some parts of the world, the use of secondaries is also becoming more common and accepted. Historically, sellers have predominantly come from North America and Europe – those long-time supporters of alternatives that have fueled primary markets for decades.
But a shift has recently taken place and over the last year and a half, deal volume from the Asia- Pacific region, particularly Australia, has begun to represent about 10-15 percent of total volume, according to Charles.
In the region, “the market has seen Australians, several Asian sovereign wealth funds and institutional investors as large volume sellers,” he says. “Those programmes are starting to mature enough to undergo their own portfolio management process.”
The many shapes of portfolio management
To take advantage of the secondaries market as a portfolio management tool, LPs can simply invest in secondaries funds, which can generate excess returns, allow LPs to deploy capital faster and mitigate the J-curve. Investing in secondaries funds allows LPs to instantly create a diversified private equity programme from scratch.
Additionally, secondaries funds tend to return capital within three years on average, compared with six years for a buyout fund, providing investors the ability to reallocate capital much faster, Charles notes.
On the sell side, LPs are able to shape with precision an existing private equity portfolio and exposures to various strategies, sectors and regions. Retooling a private equity portfolio can take years and by the time an investor has actually achieved a desired composition, it may not be the desired portfolio any more. Charles notes that secondaries allow investors to achieve an optimal portfolio for the current environment, regardless of the varied goals an LP is trying to achieve.
“I hear dozens of reasons why people are selling,” he says.
One that is quite common among larger LPs, especially public pensions and endowments, is a desire to reduce the number of manager relationships.
“There is a narrative that works its way through the LP community, ‘I want to do more with fewer managers’,” says Charles. “That will result in a more focused, more rational, efficient and effective programme to execute a particular investor’s strategy.”
It is not uncommon for a pension fund with a mature private equity programme to have accumulated exposure to more than 150 different partnerships over the years. That pension may elect to reduce the number of relationships it has to perhaps a few dozen managers, while maintaining its aggregate dollar exposure to the asset class. The secondaries market can help complete a large portfolio sale within a matter of months if they wish, or simply unload a small fund interest in a few weeks.
The issue of management fees continues to be scrutinised by some LPs and can be another driver in using the secondary market as a portfolio rebalancing tool. This is particularly the case in the US and Australia, says Charles.
Other LPs are looking to generate highly customised exposure to private equity, which secondaries can facilitate, especially through separate accounts or co-investments. Funds of funds, for their part, have increasingly been selling tail-end funds that only have a few remaining investments.
Many LPs are benefitting from the current full pricing and market dislocations, allowing themselves to prune poorly performing GPs from their portfolios. The most recent disruptions have occurred in funds focused on the energy sector, due to dwindling gas prices, and in Asian funds, due to the devaluation of China’s renminbi and a slowdown in growth generally attributed to the region.
Regardless of reasons to sell, the secondaries market has become a widely used tool for portfolio management.
“There are distinctive trend lines between valleys and peaks when the market transitions from liquidity-driven to portfolio management-driven,” he says. “It ebbs and flows. We might be transitioning from peak to valley or we may temporarily hover in the peak.”
For now, investors are still riding the wave.