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Jennifer Bollen asks why buyers of private equity secondaries tend to be owners of primary interests already, and finds the current hot market conditions explain some of the advantages

Private equity secondaries activity is on course for a new record. A report published in July this year by advisory firm Cogent Partners showed secondaries transactions globally reached about $16bn (€12.4bn) for the six months to 30 June, on track to exceed $30bn for the full year for the first time. That figure would represent an increase of more than 10% compared with 2013.

Meanwhile, the average high bid across all types of private equity funds rose to 93% of net asset value in the first half of the year, with the average high bid for buyout funds rising to 100% of NAV – the first time any type of private equity vehicle has priced at or above par since 2007.

“The first half of 2014 was another strong period for the secondary market, with public equity gains, buy-side demand, and readily available financing options pushing secondary prices up across the board and creating a very seller-favourable environment,” Todd Miller, a managing director at Cogent, said in a statement at the time. 

Significant in itself, this strong market is also relevant when it comes to another less-remarked-upon phenomenon – that limited partners (LPs) seem to favour buying secondary interests in funds in which they already have a primary interest. One might assume that pricing should be the main determinant as to whether to buy a secondary, but the advantage existing investors have over newcomers – the huge amount of fund information they already have to hand enables them to bid more competitively – comes into its own when bids are so fierce.

“Investors are more likely to be competitive or to buy where they already have a strong level of familiarity,” says Mathieu Dréan, a managing partner at private equity advisory firm Triago. “In general, pricing is somewhat a function of comfort that the buyer has vis-à-vis the fund or the manager.”

Patrick Knechtli, a partner at SL Capital, a subsidiary of Standard Life Investments, agrees that investors often prefer to buy secondary fund interests in vehicles they have already committed. Dedicated secondaries firms, meanwhile, “look at anything”, he says.

“For somebody like us, and most institutional investors, there is no doubt you are always going to feel more comfortable buying something you know already,” he says. “That has been a core part of our strategy and it makes sense to leverage what you know. We are on the advisory board of many of the funds we target for secondaries. In this way, we get access to more detail in many cases, and the manager’s own insights, into the underlying portfolio.”

This can be particularly advantageous, since a fund report often fails to tell an underlying portfolio’s whole story, whether it be the true underperformance of an asset or a recent uplift in value, he says.

“Even if you do get access to the manager of the fund, it may be on a somewhat limited basis, without much scope to ask detailed questions,” adds Knechtli. “If the GP has given you their exit forecasts, you may discount them to an extent because you may not have the detailed assumptions behind the forecasts, or the confidence in the GP that they can deliver. In other words, the forecasts are seen as a target rather than a realistic outcome. If you are [already] in the fund, you can make a better judgement and maybe have more confidence in the GP’s forecasts.”

For outsiders, the level of detail available to bidders varies from fund to fund but, typically, the larger buyout firms tend to offer more detail because their funds – which have huge numbers of LPs – are generally the subjects of more secondaries deals than smaller funds. 

However, the GP is not obliged to provide bidders with any fund information. This means that existing investors are often able to reach a decision on whether to bid at all much more quickly than newcomers. Secondaries transactions move fast, taking weeks compared with the months it takes for a fund to secure primary commitments. But bidders competing against specialist secondaries houses need to move especially quickly; the dedicated firms have huge resources and can make an investment decision in just two days, says Dréan.

“Being able to move with speed and certainty is extremely important to the vendor’s experience,” says Elly Livingstone, a partner and head of secondaries at private-equity investor Pantheon, which he says can reach an investment decision in just a handful of days.

Meanwhile, outsiders can face difficulties breaking into an existing investor group. First, some funds’ documentation offers existing investors pre-emption rights – essentially first dibs on any secondary interests that come to market. Pre-emption rights are common among venture capital funds but are found in the minority of funds across the overall private equity industry, according to Nils Rode, a managing director and co-head of investment management at fund of funds manager Adveq.

Second, the GP has the right to block a transaction. A secondaries deal requires a GP’s support because the GP must update the documents that assign a fund interest to an investor.

“[GPs] value their LP base and they want to build the LP base they have,” says Livingstone. “If an outsider is coming in, they want to understand whether the outsider can be helpful in building their franchise.”

The long-term relationship between a GP and LP has become more important in recent years as the fundraising market has grown more difficult. 

“For [a GP] to have a pure secondaries buyer come into the fund isn’t necessarily positive for them as, often, it is unlikely there will be an ongoing relationship,” says Nash Waterman, a vice-president in the private equity secondaries group at Morgan Stanley Alternative Investment Partners. “If we buy a secondary interest, they have a direct stake in us taking over the position because they know it can be a long-term relationship.”

A GP’s decision to block a deal is discretionary but a fund’s documentation – the limited partnership agreement – usually specifies to what extent the GP has a role in approving a transaction, says Rode. “It depends on the specific legal agreements,” he says. “There is some rationale that the GP has some control over who the LPs are and that is also in the interests of the LPs. In a fund, you are in a commingled vehicle with other LPs that might need to contribute capital or participate in a voting procedure. It matters who the LPs are.”

However, which new investor comes into a fund is rarely a contentious issue, particularly if the deal could lead to the buyer becoming a long-term investor, according to Stephen McCourt, a managing principal at consultancy Meketa Investment Group. “Even if the documents require a GP’s consent to sell LP interests, most GPs will concede that the LP can sell to any reasonable party, largely because GPs want to maintain a good relationship and reputation with that LP,” he says.

While existing investors may have a head start on outsiders, a secondaries deal comes down to the quality of the manager and underlying portfolio, and the buyer’s confidence in the investment.

“The deal stands or falls on the buyer’s assessment of the manager and, indeed, of individuals at that manager,” says Katherine Ashton, a partner at law firm Debevoise & Plimpton. “That is what they really need to focus on. Sometimes there is a sponsor who may not have had the most perfect track record, but there are certain individuals a buyer has confidence in, or there’s been a recent change for the better in personnel. The crucial thing when purchasing a fund on the secondary market is to know, shake hands with, and look in the eyes of the individuals managing that fund. It’s crucial to be confident they can manage the fund.”

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