The much-heralded secondary market for private equity limited partner interests has just come through a riotous, three-year period of large deals and record volumes.
After the market froze for much of 2009, private equity LP secondary market volume rocketed to $20 billion in 2010 and then to $25 billion in each of 2011 and 2012. Large, splashy deals dominated the landscape; it seemed that from 2010 to 2012, a large private equity portfolio deal was announced every month.
As is often the case in periods of high volume, pricing continued to strengthen throughout, reinforcing the notion that private equity LP interest transaction volume is driven more by pricing improvements than by levels of distress. In the second half of 2008 and throughout 2009, investors were pricing defensively (e.g., “If you want me to buy this, you are going to make it worth my while!”). Headline discounts gapped to levels as low as 50 percent of NAV from par or near-par, according to Cogent Partners’ half-year pricing report.
And even at these levels, sell orders were difficult to fill as buyer interest was limited and overall market depth was shallow. Fear trumped greed in this period.
Is fundraising success planting the seeds of a future overhang?
In the three years that followed, the market established a vibrant equilibrium and provided a lift to the fundraising efforts of secondary franchises. As a result, the 2013 version of the private equity LP secondary market is crowded with well-capitalised franchises that control more than $40 billion of dry powder to be deployed, according to Houlihan Lokey’s data.
At the same time, transaction volume of private equity LP interests in 2013 is significantly lower than in prior years. While secondary transaction volumes are typically down in the first quarter of the year, the lull in large portfolio offerings in 2013 continued through the second quarter. Why all of a sudden does holding now compare favorably to selling? What are the implications for the supply-demand balance in the secondary market?
The nature of the changes
The $40 billion question is whether the precipitous drop in private equity LP transaction volume is seasonal, cyclical or secular. The answer is while seasonality can explain part of the decline, market cyclicality and a secular shift in dynamics are playing important roles.
First, the cycles of the larger private equity market have finally caught up with the private equity secondary market. In its infancy, the secondary market did not show year-to-year cyclicality because volume was small relative to the installed base of LP interests. The secondary market grew because dedicated investors were able to tap into latent demand for the sale of LP interests, causing rising transaction volumes regardless of the cycles of primary fundraising activity. At this point, the secondary market has grown large enough that it has begun to track the inherent cyclicality of the primary market.
Second, the secondary market is undergoing a secular shift to fewer super-sized portfolios sales at least for the foreseeable future. The case for this view rests upon the assumption that sellers today are better informed than they were in the market’s early stages and are less likely to sell large portfolios as a result of non-economic considerations. If this assumption holds true, the market will see fewer large portfolio transactions, putting downward pressure on overall transaction volume.
The fittest will prosper through adaptation to “convergence”
Whatever the root cause of the downdraft in volumes in 2013 – seasonality, cyclicality or secular shift – the result is changed market dynamics with unexpected winners and losers. One trend the market is clearly experiencing is upward pressure on pricing, leading to declining returns on traditional secondary investments. Recent transactions are evidence of this trend, particularly in competitive processes.
As for the fates of the dedicated secondary funds with all that capital to put to work, those with the greatest flexibility to embrace the opportunities in the larger secondary market likely will deliver better returns. Their efforts to diversify target investments beyond plain-vanilla deals, already underway for some franchises, will be richly rewarded by the greater opportunity set in the larger secondary market. The key will be to adapt to the new environment, staffing up or partnering as appropriate to execute transactions away from their historic areas of expertise, and, importantly, to convince their investors that better returns are available in adjacent secondary market asset classes.
The path to salvation runs through adjacent opportunities
One such adjacency that sits close to home for dedicated secondary specialists lies in the portfolio investments sitting in so-called “zombie” funds. There is a significant subset of private equity sponsors that are managing older assets and are unable to raise additional capital due to fund term, performance, team or strategy issues. Some estimates suggest $100 billion is trapped in these funds.
Another adjacency involves hedge fund liquidations, which can play out over a multi-year period. While there was a rash of hedge fund liquidations that occurred as a result of the financial crisis, the fact is that hedge funds go into liquidation all the time. Flexible secondary capital can be part of the solution to ease a hedge fund into a soft landing.
Slightly less adjacent but equally as interesting are a variety of different types of credit positions and structured assets that sit in financial institutions across the globe. These include leveraged loans, high-yield bonds, project finance loans, structured credit, operating leases, life settlements, patent portfolios and royalty streams, to name a few. The 2008 financial crisis has forced many institutions to become net sellers of these assets, creating a large investment opportunity for independent financial buyers. The Financial Times earlier this year estimated that $4 trillion must be disposed on European bank balance sheets alone.
Open minds and flexible mandates will win the day
In summary, secondary franchises have a choice: they can continue to focus exclusively on the maturing private equity secondary market or they can find a way to adapt their franchises to the investment opportunities of the larger secondary market.
This is especially timely given the 2013 swoon in secondaries volume – no matter whether the ultimate conclusion is that the downturn is temporary (e.g., seasonal or cyclical) or permanent (e.g. a secular shift). Such change may not come easily to franchises that have been constructed to focus solely on LP interests, but attractive returns await those that are flexible and nimble and can expand their mission.
Jeff Hammer and Paul Sanabria are the co-heads of secondary advisory at Houlihan Lokey.