Experiments in liquidity: secondaries reaches a new level of maturity

Secondaries has earned a royal seal of approval. Documents leaked towards the end of last year known as the ‘Paradise Papers’ revealed Queen Elizabeth II, monarch of the United Kingdom of Great Britain and Northern Ireland and head of the Commonwealth, is a secondaries investor, having invested in HarbourVest Partners’ 2005-vintage Dover Street VI flagship secondaries fund. The amount was tiny – a mere $7.5 million – but is a vote of confidence if ever there was one.

Speak to any secondaries market participant and they will tell you the strategy has reached a new level of maturity. Gone are the days when a limited partner selling a stake in a fund brought shame on the fund’s general partner; brand-name managers are now embracing the strategy through GP-led processes such as fund restructurings or stapled tender offers on their own funds.

In the last 12 months firms including Warburg Pincus, Nordic Capital and EQT have tapped the secondaries market to help with existing vehicles or fundraising. TPG Capital and Providence Equity Partners are the latest to jump on the bandwagon, with the latter set to close a stapled deal worth as much as $1.4 billion by the end of September that will help it reach the $5 billion target of its latest buyout fund.

Managers are also planning ahead and incorporating secondaries tools into their latest funds, such as Macquarie Infrastructure and Real Assets, which included a facility for secondaries sales in the documentation for its 20-year Super Core Infrastructure Fund.

“The stigma associated with fund restructurings has gone away for the most part,” says Verdun Perry, head of Blackstone’s Strategic Partners secondaries unit. “If you look at what’s happened over the last 12-18 months, there are funds that are doing fund GP-led restructurings and fund recaps that are high-quality blue-chip names.”

Transaction value has grown more than 132 percent over the last five years, according to data from Greenhill Cogent. Last year set another record with $58 billion trading, a 57 percent rise on the previous year. The firm estimates $27 billion traded in the first half of 2018 alone, up almost 23 percent year-on-year.

This growth is expected to continue; last year’s level of deal volume is the new normal, says Perry.

“We’re probably on track to see somewhere between $50 billion and $60 billion again this year,” he says.

The last 12 months have been punctuated by record-breaking figures. Pricing for second-hand stakes hit an average 96 percent of net asset value in 2017, a record high, according to research by Credit Suisse’s private fund group. High-quality buyout funds attracted even higher pricing, with buyers willing to pay 10 percent premiums last year, the group found.

“It is definitely a seller’s market,” says Nigel Dawn, head of Evercore’s private capital advisory group. Keen pricing has been attracting more sellers who are parting with non-core assets at prices they couldn’t have achieved several years ago. “That’s really what’s changing the market right now,” Dawn adds.

Francois Aguerre, co-head of origination at Coller Capital, says high pricing is widening the profile of sellers.

“The market feels competitive, but broadly balanced, with well-capitalised buyers and high prices on the one hand, and record transaction volumes on the other,” Aguerre says. “More and more investors are bringing assets to the market, and not just LPs. Restructuring of private equity fund portfolios led by GPs is gaining traction rapidly.”

Lowering returns

With pricing at an all-time high and huge levels of dry powder, market participants say it’s inevitable returns will come down. Including leverage, there will be up to $200 billion in buying power available over the next 12 months, with $64 billion in dry powder and around $77 billion to be raised in the second half of this year and early 2019, according to Evercore.

A survey by UBS’s private funds group in April found 23 percent of secondaries buyers lowered their returns targets over the last year as growing competition places downward pressure on performance.

Buyers are underwriting to a multiple of 1.2-1.4x and an implied internal rate of return of 10-15 percent on an unlevered basis, according to Bernhard Engelien, a managing director at Greenhill Cogent.

“We are not too concerned about the increasing levels of dry power as the ratio of dry powder to last 12 months transaction value stands at 1.9x,” he says. In January the ratio was 2.2x and a year prior to that it stood at 3x, he adds.

Cracks have already begun to appear. Secondaries funds underperformed the all-alternatives benchmark across most time periods in the fourth quarter of last year, according to the Institutional Limited Partners Association. The ILPA Secondaries benchmark, which tracks pooled net IRRs, delivered lower net IRRs than the ILPA All Funds benchmark across one-quarter, one-year, three-year and five-year timeframes. Just a quarter prior, secondaries had outperformed the All Funds benchmark across all but two time periods.

One institutional investor lowering its return expectations for the strategy is the Florida State Board of Administration.

Fundraising on the rise

Still, LPs continue to show strong appetite for the strategy. A record $37.3 billion was raised for dedicated private equity and real estate secondaries vehicles last year, a slight rise on the $36 billion raised in 2016. In the first half of 2018, just $12.7 billion was raised, almost 50 percent lower than the same period in 2017 and the lowest first half in five years, according to PEI data.

But this drop signals more of a technical blip, as several large funds are likely to hold final closes before the end of the year or early next year, Dawn says.

The largest fund to hold a final close in the first half of this year was Landmark Partners’ eighth real estate secondaries vehicle, which amassed $3.3 billion and was the largest such vehicle to date, according to PEI data. Portfolio Advisors clinched the title for the biggest private equity vehicle to close, collecting $1.5 billion for its third dedicated fund.

As of early August at least six of the top 10 largest secondaries firms were in market with dedicated secondaries vehicles, including Ardian, Coller Capital and Lexington Partners. In total, 43 funds are seeking dedicated secondaries capital and at least 27 of these have known target sizes. These are seeking a combined $57.1 billion, according to PEI data. Many of the funds are racing towards their targets, suggesting a bumper second half. Lexington’s ninth flagship fund, for example, was understood to have raised at least $9 billion of its $12 billion target as of mid-July and was expected to hold its first close after the summer.

Niche segments of the secondaries market are also benefiting from the hot fundraising environment. Whitehorse Liquidity Partners took just three months to raise $836.4 million after launching its sophomore fund in January focusing on preferred equity, a strategy that sits between debt and secondaries in providing financing for portfolios. The firm, founded by former Canada Pension Plan Investment Board secondaries head Yann Robard, hit the $1 billion hard-cap on the vehicle on Tuesday, as Secondaries Investor reported.

With more than two-thirds of LPs in a February survey by preferred equity specialist 17Capital saying they have either used or would consider using an alternative to secondaries, chances are the types of products on offer will only proliferate – a boon to an already burgeoning market.