Never have secondaries buyers had to work so hard to find attractive deals. Despite the market being on track to achieve record volumes in 2017, the capital overhang on the buyside continues to grow and dominate.
Average private equity secondaries pricing was 91.8 percent on first quarter net asset values based on pricing of PEFOX Core 100 funds. This appears lower than fourth-quarter 2016 pricing but in absolute terms is significantly higher as NAVs were generally marked up and distributions have been strong. Early indications are that headline prices will fall again in optical terms on June reference dates as GPs continue to mark up NAVs. Overall, market pricing is at historically high levels with the best funds trading at 20 percent premiums and there is still clear desperation among buyers to deploy capital.
Given the strength of pricing, there has been a significant rise in completed deal volumes so far this year compared with the slight lull seen in 2016. The fourth quarter has also started very positively and overall volumes for 2017 are likely to hit approximately $40 billion to $45 billion, marking a record year for the market. However, there continue to be far more buyers than there are sellers. Indeed, the ratio we typically see in our processes is 20 buyers for every one seller. This implies that the market, whilst pushing new heights, is very far from its potential.
So what’s holding the market back? The issue is that LPs today are not selling for liquidity reasons. Approximately two-thirds of PEFOX’s closed transactions this year have been in problematic funds, and discounts, commensurately, have ranged from 10 percent to 40 percent of NAV. The active sellers right now are taking advantage of strong market pricing to dispose of the oldest, most difficult stakes in their portfolio. While sellers may occasionally bundle in higher-quality interests to assist the sale, there is no compelling reason to sell the crown jewels in a portfolio, even at a double-digit premium.
Indeed, the single biggest obstacle to greater secondaries volumes in fact appears to be the lack of attractive buying opportunities. Investors might happily sell CVC Fund VI for a 20 percent premium if they could redeploy that capital at a discount, but that ability to efficiently redeploy does not currently exist for the average LP. Even recycling into primary commitments provides no effective solution, given the length of time before the committed capital is fully drawn down. Thus, while the weight of capital on the buyside has propelled pricing to record levels, it has simultaneously crushed most LPs’ ability to redeploy.
Liquidity can be a burden for many groups and until market conditions change so that cash is once again king, it is unlikely that plain vanilla secondaries will enjoy much higher levels of activity. Rather, it appears that the capital overhang on the buyside will continue to grow as more money is raised. While this may provide some continuing support for the high pricing we see today, it will only add to the log-jam blocking LPs from redeploying capital themselves and therefore acts as its own limiting factor.
Potential solutions are likely to come through innovation in deal structuring and the development of different types of investments. Taking inspiration from the portfolio management tools of other, more mature asset classes such as public equities, we suspect that one missing component in today’s private equity landscape is an effective mechanism for LPs to park capital, for example by using products such as investible indices or (liquid) listed funds. The development of these vehicles would act as a pressure-release valve for buyers and as a mechanism for sellers to efficiently redeploy the proceeds from any secondaries sales.
Without these products, it will be difficult to distinguish genuine market growth from potentially dangerous asset bubbles. Right now, it is widely accepted that many of the buyers paying the highest prices are often no longer underwriting a genuine financial return but rather deploying capital strategically, with their internal economics or fundraising at the forefront. This is likely to be a reaction to the reality that, through re-ups in successor secondaries funds, LPs are effectively rewarding managers for deploying capital rather than maintaining rigid investment discipline.
So far, the risks associated with such practice have been obscured as GPs have consistently marked up their portfolios. Clearly, GPs can only mark up a portfolio for so long and at some stage the music will stop.
Kishore Kansal is managing partner at London-based private equity advisory firm PEFOX. The firm specialising in private equity portfolio management for limited partners and has been active in the secondaries market since 2003.