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It used to be the part of private equity that nobody liked to talk about. The self-professed secondary market was seen to hold a stigma for buyers and sellers alike. It was considered to be predatory, and institutional investors stayed away. All this has changed, of course, and if recent reports are anything to go by, the secondaries market will continue to post stellar growth over the next few years, driven by institutional demand for liquidity.
One of the reasons for the turnaround is the change in attitude towards secondaries. It helps that sellers are no longer primarily distressed players, but people who for a variety of reasons want to drop or restructure their private equity portfolios.
In the past, it was the banks that sold private equity assets in an effort to gain liquidity after the market downturn, and get rid of early stage technology assets. Since the end of 2002, for example, the value of Deutsche Bank’s alternatives assets fell approximately e6bn to e3.5bn. Deutsche lost e100m in private equity the first three months of 2003 alone, and the firm agreed to a management buy-out of DB Capital. Others, like UBS Warburg, and JP Morgan Chase, were also hard hit.
Industry pundits say distressed sellers are now only a minority in the secondaries market. “For institutions now, it is perfectly normal to consider selling fund interests. There was a stigma attached to this, and some GPs felt that if someone was willing to sell an interest in their fund it reflected something wrong. Now many realise that secondaries may happen in almost any fund, and often for reasons unrelated to the fund’s performance,” explains Elly Livingstone, a partner at Pantheon, the private equity firm which last year raised $900m (e705m) for its global secondary fund. Pantheon launched Pantheon International Participations; the world’s first quoted investor in private equity secondaries, as early as 1987. “The market is busy, there is strong deal flow. It is also more competitive,” he says.
Historically, over 2-3% of all private equity commitments turn over to the secondary market. Over $860bn in private equity was raised in the 1997-2002 period, according to Venture Economics. Landmark Partners, the Connecticut-based private equity and real estate player that recently acquired the private equity portfolio of Bank One, estimates that the volume of secondary activity generated from these commitments will approach $22bn, or approximately $2bn annually over the next decade. Meanwhile Columbia Strategy, the New York based consultancy, predicts that between $6-16bn of secondary deals will be completed by 2006.
It means that mainstream managers have had to sit up and take notice. Many, like Goldman Sachs and Credit Suisse First Boston, have opted to create secondary portfolios of their own to ensure a piece of the pie. And the pie is a lucrative one.
“A lot of money has been committed to the secondary market because people have seen the clear rationale. I think it will continue; we raised our most recent fund very successfully in less than six months, with a high level of oversubscription,” says James Pitt, managing director of Axa Private Equity.
He also points out that there are considerable barriers for entry for those wishing to get into the market. “Deals need to be created and structured, it is resource intensive and even getting underlying portfolio information can be difficult.”

For institutional investors, the logic of secondaries is clear. “It is quite an attractive investment sector as far as balance and a diversified portfolio are concerned. It aids diversity,” says the private equity pension fund manager at one of the UK’s biggest county council pension schemes, pointing out that the market offers increasing liquidity to pension schemes who want something more flexible.
Alan Briefel, managing director at StratCom, the London-based consultancy, also points out the benefit in risk mitigation. A secondary fund commitment delivers mitigation of the J curve, because it invests typically three to five years into the life of the capital. “If you’re 60% already invested, you have a much better handle on evaluation.” But he warns investors to be wary of pricing, and pricing has concerned consultants also.
“The larger the market gets, the lower the spreads are because people are competing for that investment. So prices go higher and the potential for rewards is reducing,” says Sanjay Mistry, consultant at Mercer Investment Consulting. He argues that while increased liquidity is helpful, it typically only helps those who are not investing in fund of funds. “The issue is price, and finding the right funds in the secondaries market,”
he insists.
One of the issues investors bring up is whether they need a secondaries portfolio, if they are already diversified through fund of funds. “A lot of schemes have not thought through the attractiveness of secondaries. Many see fund of funds as the starting point,” says Briefel. However, industry observers argue that secondaries are not designed to be balanced, only to provide liquidity. They work complementary to fund of funds, but will always make up only a small percentage of a total portfolio. Some managers, of course, argue that as much as 50% of a portfolio can be invested into the secondaries market, but it is an argument often ignored.
Joseph Mariathasan, a consultant at StratCom, points out that because of a fear of losing market share, many players, including fund of funds, have started to integrate a secondary product into their universe. It means that the market is becoming fragmented with secondary specialists and generalists. “A lot of primary fund of fund players will be doing secondary as a matter of course, but funds that are dependent on auctions with the bid offer spread narrowing will struggle to get returns. The creative deals, the proprietary deals, will go to the specialists like Coller Capital,” he says.
Coller, which one observer claims can “find gold where everyone else finds mud”, has been behind some of the most innovative deals in the last few years, notably the acquisition of Lucent’s portfolio of technology instruments in 2001, and the £300m (e436m) purchase of Abbey National’s portfolio last year. The deal helped Coller hit the mid point with its $2.5bn secondaries market fund only 15 months after raising it. Tim Jones, investment director at Coller, says the firm will only focus on a small percentage of the transactions it sees every year. “To invest in a secondary fund now is far more about manager selection – there’s a risk of losing money in this marketplace because the pricing is tight and the seller knows as much as you.”
He also points out that the rise in M&A activity, and regulatory changes such as the Basel II capital adequacy rules, will continue to drive the secondaries market. And, “a lot of people are still overweight the vintage years,1999-2000.” Most observers agree that there is enough deal flow to ensure that the secondaries market will not retreat into a less mainstream product, but neither will the rate of growth increase significantly in the future.
Others say secondaries are here whether they like it or not. Hugh Lennon, managing partner at Phoenix Equity Partners, explains: “Secondaries makes up 35-40% of the UK middle market. It’s wrong to think of secondaries as marginal, in our part of the market saying no to secondaries is saying no to 40% of the market deal flow.”
And there is an argument for how diversified secondaries will become in the future. Bruno Raschle, veteran fund of funds manager and chief executive of Zurich-based Adveq Capital, says: “I think that the secondaries market may get into a different dynamic. There is a huge inventory of built up companies that do not make it to exit, somehow the capital in these companies have to get financed. We might see a quality segment, a distressed one, maybe something equivalent to a junk bond segment, 10 years down the line.”
Given the increased interest in secondaries, no doubt there will be more than one player waiting to see if Raschle’s predictions turn out to be true.

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