Blurring the lines

For a market that was around $10 billion in size 10 years ago, secondaries has been evolving at a surprising speed. Annual deal volume quadrupled to $42 billion in 2014 and plateaued at around $40 billion last year.

As deal types continue to evolve, so does the buyer and seller landscape, as sister publication Private Equity International‘s Perspectives 2017 survey, due to be published in December, shows. Almost a third of respondents said they plan to increase purchases of fund stakes over the next 12 months, a sign that the already competitive secondaries market may become even more crowded.

“Historically speaking, many folks out there were labelled a buyer or a seller,” says Phil Tsai, global head of secondaries market advisory at UBS. “People always had these labels. That has increasingly become more and more blurred.”

Some LPs such as Canada Pension Plan Investment Board, Government of Singapore Investment Corporation and Abu Dhabi Investment Authority have been building dedicated in-house secondaries teams and are considered serious buyside competitors in certain segments of the market. Others, such as US pension funds, have traditionally participated on the buyside through separately managed accounts with secondaries firms or through co-investments.

LP activity as independent buyers this year has been sporadic. Examples include Michigan Retirement System’s purchase of a $25 million stake in Warburg Pincus Private Equity XII during the second quarter.

While not all LPs have the resources to actively acquire stakes themselves, doing so remains attractive for many, including Australia’s Future Fund. The A$122.8 billion ($93 billion; €85 billion) sovereign wealth fund noted in its 2015-16 annual report it plans to use its Medical Research Future Fund to focus on investments with shorter time lengths until liquidity, and this includes purchasing mature private equity positions on the secondaries market.

On the sellside, just over 16 percent of LPs said they were planning to increase sales of fund stakes over the next year, according to the survey. A major factor has been the high prices sellers can attain, allowing access to liquidity at lower paper discounts.

Stakes across all strategies traded at an average 99 percent of net asset value during the second quarter of the year, the second-highest quarterly price on record, according to a July report by Credit Suisse, and this is tempting more potential sellers to come to market.

Certain LPs are far more focused on perceived paper discounts: “Anything close to par sounds great and nice,” Tsai says. “Some are more bottoms-up focused and are actually doing modelling and assessing what are my go-forward returns. Do I hold? What is the opportunity cost associated with holding versus selling? That dictates a lot of the dynamic.”

Plans to increase sales of stakes were most pronounced in North America, where 20 percent of respondents said they wanted to do so, according to the survey. In the high pricing environment, LPs there see the secondaries market as an even more attractive portfolio management tool, as Florida State Board of Administration’s senior investment officer John Bradley told PEI sister publication Secondaries Investor in July.

“LPs (ourselves included) have increasingly used the secondaries market to rebalance their portfolios or reallocate to across strategies,” he said, adding that he believed the trend will increase.

While no emerging markets LPs signalled they plan to increase sales, around a third said they plan to maintain their levels of selling activity. Market participants say such a response is unsurprising: regions such as Asia-Pacific remain nascent markets and pension funds and insurance companies there have not tapped secondaries as a portfolio management tool as frequently as their North American and Western European counterparts have.

Still, convincing limited partners to part with assets is not easy. “Sellers don’t have a lot of incentive to sell today. What do they do with the cash?” the head of secondaries at a global investment firm says. Not wanting the hassle of having to redeploy cash can lead potential sellers to seek higher prices – premiums in some cases – and can also result in adverse selection where sellers are only willing to sell lower quality assets from their portfolios. “That’s the challenge facing the secondaries market today,” the head says.

Convincing LPs to sell becomes even trickier when it comes to complex deals such as GP-led restructurings, which rose to account for over 30 percent of the market in the first half of the year and are expected to rise, according to a midyear report by Greenhill Cogent. For LPs, whether a GP is being fair and transparent in such processes is crucial, according to Sam Green, private equity investment officer at Oregon State Treasury.

“GP incentives, their economics and their motivations [are] not always clear,” Green said at a New York industry conference in September, adding that there was increasing scepticism among LPs regarding such complex deals.

Despite a few headwinds, LPs remain keen to invest in secondaries funds. Korea Teachers Credit Union, which manages $26 billion, has committed to four secondaries funds since 2012 and considers the strategy as part of its plan to diversify its portfolio through overseas exposure, according to Hyungon Kim, an investment manager at the pension.

Only 6 percent of LPs in the survey said they were planning to curb secondaries fund commitments, and half said they either plan to maintain or increase activity levels – a sign the secondaries market need not pause for breath just yet.

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This article will appear in sister publication Private Equity International‘s LP Perspectives December special.