Investors cursing themselves for missing the private equity secondaries train in 2009 can still get onboard, finds Martin Steward

The Year That Never Was. The Year That Promised So Much and Delivered so Little. The epithets applied to 2009 by private equity secondaries managers should reassure those who missed the train that year - and have seen discounts plummet from 35% or more to 8%.

Fundraising and secondary advisory agent Triago Group notes that those “clever or bold enough” to buy in spring of 2009 will soon generate plenty of press with their recent track records. “There were a few, and they were buying at significant discounts to already rock-bottom NAVs,” says head of the secondary team Mathieu Dréan. He picks out a deal that Triago did with Bain Capital IX at a 32% discount. “We were hailed as heroes for that, because the typical discount was more like 60%,” he says. The NAV has since been marked up more than 50%, and the fund now commands a premium.

But the key words in all of that are “a few”. Plenty of firms prepared to fill their boots - in 2009 a record $23bn (€17.6bn) was raised for 21 secondaries funds, according to Preqin - but Triago records transaction volumes falling from $15bn in 2008 to just $8bn. The train never left the station.

Why? Potential buyers were so uncertain about companies’ ability to refinance and maintain top lines that pricing without several layers of safety became impossible. And few potential sellers, working from NAVs a quarter out of date while volatility went through the roof, were desperate enough to sell at those levels.

“A number of US endowments explored the market in 2009 but withdrew because of the discounts being demanded,” recalls ARCIS managing partner Mark Burch. “On the other side the majority of secondaries managers - including us, despite having done a bit in 2009 - were nervous about the leverage and general uncertainty.”

AXA Private Equity, which completed the biggest transactions of 2010, only managed to find $200m worth of deals through 2007-09, according to managing director Vincent Gombault. Partner Stephen Ziff listed a consortium deal on a 3i portfolio and a stake in listed fund SVG Capital when asked what well-known secondaries specialist Coller Capital had closed in 2009. Ex-Coller principal Pinal Nicum, now at Adams Street Partners, says his new firm invested around $600m in secondaries through 2008-09: “We were one of the few that took a deep breath and made some fairly substantial investments in long-standing relationships,” he says.

Deals were not big job lots, and the biggest discounts were available from fiddly and obscure transactions with distressed sellers of individual interests, away from the agents - Middle Eastern family offices, receivers for crippled Icelandic banks, liquidity-squeezed hedge fund side pockets. “At transaction sizes below $10m, we found 30-40% discounts on highly-funded interests,” claims Gregory Getschow, managing director for the listed fund JPMorgan Private Equity Limited (JPEL). “Credit or debt-related investments have also been a fertile source of discounts.”

But unlike these, most 2009 transactions were in 25-35%-funded interests. That is quite attractive to the traditional fund of funds buyer, who can top-up funds he already owns at a 50% discount with a bunch of fees already paid. But secondaries specialists tend to have mandated minimum funding levels (perhaps as high as 80%) and LPs looking for shorter-term, lower-risk investments. “We think a 30%-funded portfolio is a late primary rather than a secondary,” says Pantheon head of global secondaries Elly Livingstone. “It’s not much use in mitigating the j-curve, which is the way we look at things.”

This is not splitting hairs. If you bought in March 2009 you locked-in some impressive expected exit multiples - a 50%-funded interest bought at a 35% discount whose NAV has risen 50% is already at a 2-times multiple on cost. But that discount was only secured on 50% of the obligation - the buyer will have to put the other half to work at today’s prices and sit out the full investment cycle until exit.

Dréan reckons that some 2009 deals will deliver multiples of 3-4 times. Gombault at AXA describes expectations for 1.4-1.6 times from today’s deals, which seems close to consensus. But 4-times achieved at the end of six years on an interest 50%-funded at purchase delivers a similar IRR to today’s 80%-funded interest, done and dusted in two years with a multiple of 1.5 times.

Moreover, not every NAV is up 50% since 2009. “It makes more sense to pay a little more for quality at the right price than to seek a big discount with low visibility,” Gombault observes.

Rather than investing, AXA PE set about contacting the GPs for every US and European deal done between 2005 and 2008, once a quarter, asking about progress on things like evolution of turnover, EBITDA and the likelihood debt covenant breaches. “Overall we found that GPs have done a good job and companies have renegotiated debt and increased EBITDA,” he says. “We think 95% of the deals done just before and during the crisis will send cash back to investors.” The firm went back to the market in earnest, and completed a series of deals in spring 2010 that culminated in a $1.9bn purchase from Bank of America.

Investors should treat these narratives cautiously. AXA PE had raised a $2.9bn secondaries fund in 2006-07, so it could hardly allow 2010 to pass without putting money to work - and it was not alone. While most practitioners feel GPs have actually been slow to mark NAVs back up and are currently under-valuing the graft they put in over recent months, Burch warns against assuming that declining discounts are due to much more than a restoration of technical equilibrium. “The mountain of bullet repayments due in 2012-13 is being steadily managed down, but I don’t believe what I hear about widespread top-line growth improving, GPs being so good they have solved portfolio problems, and so on.”

Even if you buy the fundamental value story without decent ongoing supply the wave of demand will soon wash that opportunity away. Triago reckons $20bn of business was done last year and expects at least as much again this year; and several big names - including AXA PE, Coller, Pantheon, Lexington Partners and LGT - have raised or are raising big funds. No wonder discounts have narrowed so quickly since March 2009, compared with the 2-3 years they took to recover from previous downturns.

Here the picture is a little clearer, as traditional sellers are being joined by institutions facing pressure from Basel III, the Volcker Rules and Solvency II. Banks alone could pour $100bn of supply into the secondary market.

“The tactical seller is back,” says Nicum. “We’ve transacted with pension funds streamlining their programmes who are attracted by current secondaries pricing. There are certainly assets in the market today which we understand well and would be happy to pay par for. Financial institutions are big sellers once more. In the early 2000s the unwind of banking private equity assets took about four or five years. Recent large banking deals do appear fully priced.”

Ziff at Coller agrees. “The impact of regulation will take years to percolate through, but people shouldn’t get hung up on discounts,” he says. “There were never going to be firesales by financial institutions because private equity, although costly as regulatory capital, remains a small part of balance sheets.”

In short, sellers are value-driven and buyers are no longer solely discount-driven, which will inevitably edge pricing back to par. But as Dréan puts it: “Buying at par in a pro-growth environment is not so bad.” This money is not being blown on a ticket for a train that has left the station or been cancelled. It was genuinely delayed - decent volumes of well-funded secondaries simply were not transacted in 2009 - and while it won’t get you to your destination at 300kph, it is still worth catching.