Secondaries liquidity: a vital sign of a maturing industry

The secondary market is now becoming well established. This represents a critical step in the evolution of the private equity market that will transform the way investors think about funds of funds, explains Benoit Verbrugghe, member of the executive committee and head of Ardian US.

In almost every aspect of everyday life, we take for granted the existence of efficient secondary markets. Homes, cars, furniture, appliances, books, electricity – the products and services that surround us and that we depend on have all evolved in the same direction. Secondary markets widen access to goods and services and bring huge benefits both to buyers and sellers. Their importance is such that they frequently grow far bigger than the primary markets from which they spring.

Ardian believes that as the private equity market matures further, the same process is once again taking hold: a functioning, liquid secondary market is emerging that will transform the character of this asset class. We estimate that during 2014 approximately $35 to $40 billion of secondaries transactions went ahead as a wider range of sellers sought the benefits of secondary liquidity, and the capacity of buyers to make a market in these assets continued to expand.

It is clear, therefore, that activity is accelerating, although the process is still in its early stages. The stock of private equity-backed buyouts stands at nearly $1.5 trillion, while about $300 billion of new buyouts takes place each year. This is the context against which the volume of secondary transactions should be judged – less than 3 percent of the existing stock changed hands during 2014, illustrating the potential for volumes to increase over the next few years, as secondary liquidity becomes an established feature of this asset class.

Forced sellers are no longer dominant

For some years, the main sources of large secondaries deals have been banks and insurance companies that were forced to reduce their private equity holdings in response to incoming regulation, including the Volcker Rule, Dodd-Frank and Basel III. A market that relied for its growth on institutions such as these could easily prove a temporary phenomenon: indeed once institutions are compliant with the new regime, where would subsequent deal flow come from?

In fact, although still a feature of the market, secondary transactions involving “forced sellers” are no longer dominant. Instead, sovereign wealth funds and pension trustees are coming to the fore. Their reasons for seeking secondary liquidity are quite different and indicate clearly that this market is now a permanent part of the private equity industry. The emerging breed of sellers may be seeking to rebalance their asset allocation by reducing exposure to private equity; they may be seeking to exit certain holdings and reinvest; they may wish to reduce the number of relationships they have with general partners; their motive may be price discovery. Whatever their reasons, the market is now offering them similar benefits from secondary liquidity to those they expect from other assets.

The market will only get more efficient

Ardian believes this is a highly significant moment because it signals a fundamental change in the character of private equity as an asset class. The secondary market in private equity holdings is far from fully-formed and at such low levels of turnover will only get more efficient. But the trend is becoming steadily more obvious. As it develops, more investors will naturally want to take advantage of the opportunities that secondary liquidity can offer, and in order to do so they will need to work with market players that have the scale and experience to deliver the benefits that they are seeking. As Ardian’s funds are getting bigger, the funds of funds team has an advantage because it is able to propose global solutions and clinch large deals which would otherwise require two or three buyers.

Over the next few years, growing confidence among investors in their ability to access secondary liquidity will enable more active portfolio management, and will increase the potential for higher allocations to private equity. No one should underestimate the long-term importance of the changes that are now under way.

Ardian is an independent private investment company with US$50 billion managed or advised across a diversified range of asset classes, including fund of funds (primary, early secondary and secondary), direct funds including infrastructure, expansion, mid-cap buyout, Ardian growth, co-investment and private debt.