Secondaries come to the fore
The secondaries market has developed into an integral part of private equity portfolios
- Limited partners now embrace secondaries to a far greater degree
- This encompasses several different types of transactions
- Finding the correct pricing is the biggest challenge in the market
- Success in the marketplace means being an informed buyer
Secondary transactions look like they were at record high last year, according to some estimates. The private equity secondaries market was once seen as the market of last resort. Today that is far from the case. Secondaries portfolios are often even being used to backfill exposures to vintages they do not have by large new limited partners. The marketplace has evolved to become an integral part of developing and managing private-equity portfolios for investors and a key management tool for general partners.
The market has evolved to encompass three or four different types of transactions, with private equity firms adopting varying mixes of these in their own businesses. Hamilton Lane, an alternative investment management firm, for example, undertakes single-fund transactions, portfolio purchases and complex secondary/restructurings.
Perhaps the most straightforward secondary transaction is exemplified by the almost $1bn (€800,000) sale of a portfolio of 13 fund interests by the UK’s €68bn Universities Superannuation Scheme to Ardian in 2015. Ardian was early in the market to use leverage to buy highly diversified portfolios. With these, the buyer is betting on the market, betting on the index and using leverage to get a higher return. The transaction also exemplified another trend in the marketplace driving secondaries. Many large investors are actively reducing the number of general partner relationships they have to manage by focusing their portfolios with larger commitments made to a smaller group of players.
From the perspective of a secondary investor, says Francesco di Valmarana, a partner at Pantheon, no single company or fund is likely to change the outcome. The success of the deal is determined by the cashflow modelling, the vintages, the exposures and the financial engineering associated with the transaction.
Pure secondary firms such as Coller Capital and Lexington Partners have undertaken some of the most innovative forms of transactions. Such structured secondary transactions can take many forms including spin-outs from banks and corporations, buying assets and finding teams to run them, and dealing with zombie funds – those close to the end of their lives with little incentive for existing management to manage them.
Such transactions can often be undertaken at attractive discounts to net asset value (NAV) but di Valmarana warns that in times of crisis they can be volatile. “Our view is that over the long term – given the wide dispersion of what can qualify as being a structured transaction and the relative nascence of these transactions – there is a degree of uncertainty whether they will turn out well,” he says. The sheer size of the secondary funds raised by several market participants, though, enables them to undertake innovative transactions that are less competitive than dealing in auctions of well-established funds.
The restructuring of funds that are at or close to the end of their contractual life has proved particularly interesting. There have been several general restructurings where secondary buyers have stepped in and reset the carry for the general partner, says Tristram Perkins, co-head of secondaries at Neuberger Berman. There is a commitment of new capital for specific legacy assets and the duration of the vehicle is typically extended. Through that transaction, the secondary purchaser is realigning the interests of the general partner directly with the secondary capital. “The GP is often required to invest some of their own capital into the restructuring at the secondary buyer’s price with the GP investing alongside the secondary buyer. The LPs are given the option of a sale or roll-over into the new structure and in many cases there is a status quo option as well,” he says.
One development of this, he adds, is that while the focus in the past has been on end-of-life scenarios for funds, there have been more general partner-led transactions earlier in the life of the funds to accelerate the return of capital in younger funds.
That has created a large new opportunity for secondary capital. In the past, general partners would only be raising new funds after their existing fund had been at least 75% invested. But as the fund-raising cycle has become compressed, many general partners are coming into the market earlier, so their portfolios have not had enough time to add value, or create liquidity.
One way of creating liquidity before going out to raise a new fund would have been to sell one of their better performing assets. “We would argue they may be selling the asset prematurely. An alternative that we are talking to GPs about is a secondary buyer coming in and buying a strip of the entire portfolio, generating the same amount of liquidity for LPs, but enabling the GP to maximise the probability of extracting value from the timing of any sales of underlying companies,” says Perkins.
While large portfolio deals and structured transactions account for perhaps the largest volume of secondary deals, the greatest number are smaller individual fund or small portfolio transactions. These are favoured particularly by firms that undertake both primary and secondary activities as the firms would argue that they are able to find attractive deals through their close relationships with general partners through their investments in primary funds. From the perspective of general partners a primary concern is an investor is disappearing, will a new investor be likely to re-invest in the next primary fund launch?
Buying individual funds in the secondary market requires a view on whether the pricing is attractive and that is not just a function of a reported discount to an NAV figure that may be months out of date. “The biggest challenge for secondary market investors is how to price a transaction because oftentimes they don’t have all of the information,” says Richard Hope, a managing director at Hamilton Lane.
“Irrespective of accounting guidelines, GPs do not mark to market, strictly speaking,” says di Valmarana. “They can’t. They are private companies, and are different from comparable listed companies.”
Success in the secondary marketplace for individual fund purchases is to be an informed buyer. Firms that are both primary and secondary players have the advantage of being able to leverage their primary relationships and information when undertaking secondary market transactions. “We only buy what we know and we have more than 3,400 funds in our system,” says Hope.
As he explains, pricing requires the reporting information on the fund, capital statements and having an understanding of what the general partner hopes to do. Part of the secondary market returns arises not from what you are buying today, but what the general partner, the ultimate manager of the portfolio intends to do with the company in the future. “The price we are willing to pay is a reflection of how excited we are about that opportunity and how confident we feel in them achieving the end point,” Hope says.
Pantheon’s view is that the ability of private equity to add value through the cycle is determined by the ability of the private equity practitioner, the general partner, to identify a good company and apply value-adding strategies to it so that they can sell a better company. Investors need to be aware that applies to secondary transactions as much as primary.