Tactical sellers are those using the secondaries market to change the balance of their private equity portfolios by vintage year, investment stage, asset type, geography or manager.
Although the profile of their portfolios would change anyway as existing funds reached the end of their lives and they chose to re-up (that is, commit to that manager’s next fund) or not, the long lives of private equity funds make this a very slow process. By accessing the secondaries market, investors can speed up the transformation of their portfolios dramatically.
Large US pension plans have been particularly enthusiastic tactical sellers in recent times. Examples include: CalPERS; Virginia Retirement System; PSERS; Kodak Retirement Income Plan Trust; and Florida State Board of Administration. Among Canada’s pension plans, Ontario Teachers and CPPIB have been prominent sellers.
Why are they selling? One answer is that LPs are simply becoming less loyal to individual GPs, especially since the GFC, which exposed the divergence in performance between stronger and weaker managers. Coller Capital’s Global Private Equity Barometer for summer 2016 illustrates the point well.
Source: Coller Capital Barometer 2016.
In recent years, many LPs with large numbers of GP relationships, having reviewed their portfolios, have judged a proportion of these relationships ‘non-core’ to their portfolios — for a variety of strategic, financial, and non-financial reasons.
Recognition of the opportunity-cost of holding non-core managers, and a desire to broaden investment exposure (by geography or strategy type, for example), have brought many investors to the secondaries market. With emerging markets likely to account for an increasing share of economic growth over the long term, investors are understandably keen to grow their exposure to these markets — and unwilling to wait until the liquidation of their existing private equity commitments to do so.
Coller’s ‘Barometer’ shows that 55 percent of LPs are currently invested in Chinese private equity, and over 40 percent have exposure to South East Asia and India. Moreover, many LPs already invested in emerging private equity markets want to increase their exposure, particularly to Africa, Central & Eastern Europe, and China.
Tactical sellers tend to be very price sensitive because, by definition, they are not forced to sell. When secondaries pricing fell sharply as a result of the GFC (from 104 percent of NAV in 2007, to 63 percent of NAV in 2009) tactical sellers withdrew from the market, despite the fact that many of them found themselves overcommitted to the asset class. When growing economic confidence resulted in higher secondaries pricing in 2010, tactical sellers returned; and when average secondaries pricing reached around 90 percent of NAV in the first half of 2014 they came to the market in droves.
By 2015, the secondaries market was turning over around $40 billion of transactions annually, and tactical selling by LPs accounted for around two-thirds of its volume. Incidentally, it is worth noting that tactical selling — or active portfolio management — has varied somewhat by geography, comprising a larger part of the market in North America than in Europe, where strategic sellers have tended to be more important.
Investors use the secondaries market to tackle a variety of imbalances in their portfolios, but one imbalance looms particularly large for many — vintage year. Approximately 45 percent of today’s private equity NAV is in funds of the 2005–08 vintages.
GP-led liquidity solutions
Although a significant part of today’s 2005–08 ‘value mountain’ will be realised by GPs in the normal way, a sizable portion will prove challenging for them to exit within a sensible timeframe (especially where the GFC forced GPs to abandon or radically alter their portfolio companies’ initial investment theses). This reality has given rise to another important market issue — a weakening of LP-GP alignment in ageing private equity funds.
Where they have little prospect of carried interest, or are unable to raise another fund, GPs may be unmotivated to exit investments because doing so effectively puts them out of business. Over $95 billion of assets are held in boom-year ‘zombie’ funds (funds with no successor fund since the GFC) according to Preqin.
Because of these issues, GPs and LPs alike have been increasingly willing to see existing private equity vehicles restructured or (in the case of viable GPs) exited en bloc in asset sales (often called tail-end sales). Such transactions tend to be initiated and led by GPs, with the active involvement of secondaries buyers.
A fund restructuring usually has several objectives: to provide a liquidity option for a fund’s original investors; to secure more time, and potentially additional funding, for a fund’s remaining assets; and to realign the interests of investors (and any new investors) with those of the GP, through some re-setting of a fund’s terms and conditions. Restructurings are complex and present many challenges, not least in achieving a satisfactory alignment of interests between multiple parties. As a result, fund restructurings tend to be highly customised, and no two transactions are ever the same.
Given their complexity to structure and execute — and the commitment needed on all sides
— many mooted transactions of this sort never actually get off the ground. Indeed, these transactions typically entail lengthy discussions with a fund’s LP base and the members of its LP Advisory Committee, and often require the approval of 75 percent of a fund’s investors.
On the buy side, a major challenge for bidders is a high level of uncertainty that a transaction will eventually be completed. Nonetheless, between $5 billion and $6 billion of GP-led liquidity solutions were completed in each of 2014 and 2015 — some 15 percent of overall secondaries market volume — and intermediaries believe this level is likely to be maintained or surpassed in the years ahead.