Private Equity Secondary Funds: Are They Players or Opportunistic Investors?Published: August 05, 2009 in Knowledge@Wharton
Over the last 10 years, the private equity secondaries industry has grown from a few investors looking to acquire existing stakes in private equity funds from other fund investors to becoming a full-fledged asset class. Proven returns and a flood of potential buying opportunities have driven much of this trend. As a result of significant recent fund-raising, secondary funds now have more than $30 billion in "dry powder" available to provide liquidity to an otherwise distressed alternative investment community. But so far, the secondary players have largely held back. So what will it take to unleash this capital? And will heightened secondary investment activity -- and more liquidity -- revitalize the dried-up private equity industry? Three senior members of leading secondaries firms discussed these questions -- and how they view the opportunities today -- with members of the Wharton Private Equity Club (WPEC).
Sebastien Burdel is an investment principal at Coller Capital. Since joining Coller Capital in 2003, Burdel has completed many transactions and contributed to the firm's growing U.S. presence. Prior to joining Coller, he worked in corporate M&A at General Electric and handled direct buyouts at GE Equity. He is part of the team responsible for investing Coller International Partners IV and V.
Wouter Moerel is a partner in the secondaries team at AlpInvest Partners. Moerel joined the firm in 2005 from The Carlyle Group, where he was a principal responsible for telecom and media-sector investments. Previously, he worked as vice president and director at JPMorgan and Lehman Brothers. He heads the European arm of the secondaries team at AlpInvest Partners.
Peter Wilson is a managing director at HarbourVest Partners. He joined HarbourVest's London-based subsidiary in 1996, focusing on secondary investments in Europe and European venture partnerships. Prior to joining HarbourVest, Wilson worked for the European Bank for Reconstruction and Development and the Monitor Group. Wilson now heads the European secondaries effort at HarbourVest.
An edited transcript of the discussion follows:
WPEC: Could you describe the growth and rationale for secondaries as an asset class?
Sebastien Burdel: Secondary transactions are a natural consequence of any large pool of primary investments. The illiquid nature of the private equity (PE) asset class, where limited partners (LPs) are locked in for up to 12 years, makes PE secondaries a valuable exit option. The formation of the secondaries market, which did not exist 20 years ago, created the ability for fund investors to sell their stakes and realize liquidity, increasing the efficiency of capital allocation and boosting the attractiveness of private equity as an asset class.
Beyond simple access to liquidity, the PE secondaries market has become an important portfolio management tool for investors. LPs sell PE interests for many reasons, some of which include re-allocation of capital and human resources, changes in investment strategy, regulatory or accounting changes or M&A activity. In fact, surveyed LPs rank portfolio management ahead of liquidity needs as the key reason why they would sell in the secondary market. Rapid growth in secondary fund-raising and deal flow has been driven by the more than $2 trillion raised by PE funds in the primary market over the past eight years. Despite the recent growth, our market is still a young one: In 2008, the secondaries market reached an estimated $90 billion of cumulative funds raised, still a tiny fraction of the overall PE market.
Peter Wilson: Secondaries typically comprise three transaction types. First, traditional deals involve the transfer of LP interests in a given private equity fund from an existing LP to a new investor who, for an agreed price, assumes ownership of the selling LP's capital account value and assumes the remaining unfunded obligations from the seller LP. Second, synthetic secondaries, or secondary directs, involve creating a new partnership to purchase a portfolio of direct investments, using an incumbent or new general partner (GP, manager) contracted to oversee and ultimately sell the assets in the partnership. Finally, structured transactions involve the formation of special purpose vehicle(s) to establish a unique legal framework/structure that helps accomplish the goal(s) of a particular seller in closing a transaction. In this type of deal, assets may include LP interests or a portfolio of companies, or both.
Wouter Moerel:The developments outlined by Pete and Sebastien are generally in line with our views. We tend to see two trends in the secondaries market: a fundamental market growth driven by a growing primary private equity market and a larger proportion of LPs actively managing /selling their portfolio (the base growth); and periods of extraordinary growth during which LPs are actively selling their private equity investments as a result of financial distress, liquidity needs, reorganizations, refocus of strategy, etc. (the systemic shocks). We believe that we are currently in the middle of a period of extreme systemic shock which has flooded the market, and will continue to do so over the next 12 to 24 months, with secondary transactions. Thereafter, we expect a return to the base growth of the secondaries market.
WPEC: Is now a good time for secondary firms to deploy capital?
Moerel: As a result of an increase in distressed sales in the current market environment, pricing has come down and return expectations on transactions have gone up. This provides for an attractive market to deploy capital over the next 12 to 24 months. On the other hand, it is challenging to price secondaries transactions today, as the economic outlook is uncertain, the real impact on company performance is unknown, and underlying fund valuations keep declining. This has led to a large bid-ask spread between buyers and sellers. AlpInvest Partners estimates that only 20% of transactions which came to market in the second half of 2008 actually closed.
Burdel: Given the lack of visibility in the broader economy and the effects of the economic downturn on PE portfolios, many secondary buyers have taken a cautious approach to deploying capital. We have continued to make selective investments in the current market and expect the pace to pick up as the year progresses.
Wilson: Given current market conditions, we are seeing a further increase in deal flow
volume, but share the view that the level of closed transactions is a fraction of the total opportunity set. Critical to success is structuring transactions that can provide sufficient downside protection while still approaching seller pricing expectations -- not an easy mix.
WPEC: If holding back is the right strategy, what are factors that will need to change for you to start deploying capital again? When do you think this tipping point will happen?
Wilson: It's obviously important not to be pressured to invest, particularly in current market conditions. However, "holding back" is not, we believe, the correct approach, as one cannot remove oneself entirely from the market with the intention of re-entering at a later stage. We are actively pursuing opportunities, evident from the recent Tenaya Capital (the former Lehman Brothers Venture Capital team) transaction, as we feel it is paramount to stay involved in the deal flow. What slows the pace of closed transactions is that there remain divergences between sellers' expectations and buyer pricing. This is the principal reason so few deals are closing at present. Once this valuation gap narrows, we will see a greater number of firms transacting. In terms of timing, no one can actually predict an exact turn of the market. We could, however, infer a busier second half of the year on the back of Q1 and Q2 '09 financials, as people gain visibility on the trading outlook for 2009.
Moerel: AlpInvest Partners believes that the following events need to take place before the standstill in the market can unlock: the uncertainties in the economic environment need to subside somewhat (i.e., no more events such as Lehman, AIG, etc.); it must become clear what the impact of the financial crisis on the real economy can be (i.e., revenues and margins are no longer "falling off a cliff"); net asset values of the underlying funds/portfolio companies need to stabilize (i.e., reflect the true value of companies today based on their current trading and future opportunities/threats); and sellers need to have realistic pricing expectations (i.e., reflecting future value rather than historic valuations). We believe that the market could unlock in 3Q/4Q '09.
Burdel: The volume of secondary transactions being closed at the moment is low because of wide bid-ask spreads. Asset valuation adjustments will certainly be necessary to ease this blockage, and these are already under way. But I believe the real trigger for greater activity in the secondary market will be the resumption of investment by primary market GPs. When this happens, capital calls to LPs will resume, which in its turn will dramatically increase their need for liquidity, as missing a capital call would ultimately lead to complete forfeiture of already invested capital in the partnership.
WPEC: When purchasing LP interests in today's market, how do you gain comfort around uncertainties such as falling valuations, the constantly changing economic outlook, and unstable or collapsing private equity firms? Moreover, how do you assign value to assets when general partners themselves are uncertain about the outlook of their portfolio companies?
Moerel: In light of all the uncertainties listed above, we have become very selective in pursuing transactions. First, we focus even more on quality assets and managers that we know well, i.e. with whom AlpInvest Partners has long-standing relationships through our fund investment program. Second, we concentrate our efforts on acquiring funds/portfolio companies which focus on industries less prone to big economic shocks, such as food, health care, telecoms and the like. Third, we have significantly increased our due diligence requirements, trying to better understand current trading, industry outlook, leverage structures and covenant risks, etc. Finally, we have increased our return requirements. This leads to fewer transactions completed, realistic investment base cases and lower purchase prices.
Wilson: As a firm we have been historically conservative in arriving at performance assumptions and exit valuations. Specifically, we have increased the minimum return threshold that we require from transactions given the current market outlook. That said, our due diligence requirements have remained constant. Only once we have a comprehensive view of a portfolio, its exit prospects, and hence our entry pricing will we deploy capital. The other key factor for us is experience. The 10 most senior investment professionals on our secondaries team have worked together for more than 11 years on average. Institutional memory, as well as experience in designing creative structures, is a critical factor in allowing us to transact in this challenging environment.
Burdel: It is true that the distribution of potential PE investment outcomes has widened. For many buyout investments made in the last three years, it's easy to envisage a scenario where the equity gets wiped out. That's a new reality. On the other hand, venture capital has always had more variable outcomes. As an experienced investor across all stages of investment, we are well used to evaluating a wide range of scenarios. In today's difficult climate, investment judgment will be key, of course, but it always is. Buying poor-quality assets or buying good assets at the wrong valuations was just as risky during the boom years. As we will see, it is not only primary market GPs who will have burned fingers from the PE bull run.
WPEC: What types of secondary transactions are attractive to you right now? Which will be your initial focus?
Burdel: We actively look at a broad spectrum of investment opportunities from single LP positions to large portfolio deals, as well as complex direct or structured deals. Some transaction types have disappeared from the current market. Structured deals that involve third-party debt financing are essentially no longer an option. Stapled secondaries (i.e., acquisition of a secondary position in a fund combined with a primary commitment to a new fund of the same general partner) have vanished from the market.
Moerel: Today, the deal flow is tremendous, leading to significant choice and selection. As mentioned above, we focus on assets we know well, managed by relationship GPs and with attractive return characteristics. In today's market, it is possible to acquire attractive diversified portfolios at realistic prices. However, we tend to pick and choose specific fund interests which meet our requirements rather than bid for entire portfolios, specifically when these include assets that are less attractive to us. We continue to pursue more complex transactions, such as stapled secondaries, secondary direct transactions and more structured transactions, if such transactions meet our requirements and offer attractive returns.
Wilson: As stated above, it is critical to remain opportunistic and creative in getting deals done. This requires a broader range of analytical skills than in previous cycles, and we will look to bring those talents to bear in completing more structured deals in the next 12 to 18 months.
WPEC: How do you think the secondaries industry will change given the large amounts of dry powder available and the expected large fund-raisings in the near future?
Wilson: Notwithstanding the amount of dry powder available and prospective fund-raisings, our experience in 2008 -- and our estimates for 2009-2011 -- is that there will be meaningfully more secondary assets available for sale than capital available to purchase them. This structural imbalance serves as a foundation stone for the potentially lucrative returns that the best secondary firms should be able to deliver to investors in the future.
Burdel: Secondaries will play a key role in helping the private equity market adjust to new economic realities, just as private equity itself will be an essential component in the recovery of the overall business landscape. The current environment is exacerbating investors' need for flexibility and liquidity, since many LPs are heavily committed, distributions have been reduced to a trickle, and holding periods for PE investments are getting longer. These dynamics mean that secondaries opportunity will easily accommodate the capital currently available in the market.
Moerel: Although I agree with Pete and Sebastien that there is a "buyer's market," at least for the next 12 to 24 months, we should all draw lessons from the 2006-2008 buyout fund-raising and buyout excesses. Specifically, being one of the few bright spots in the private equity market today, investment discipline, adherence to target returns and due diligence are more important in secondaries transactions than ever. Inevitably, the secondaries market is and will keep attracting new players. Experience, counterparty trust and relentless focus on quality will improve the position of players like AlpInvest even further.
WPEC: Where do you see returns of the secondaries industry going both in the short and long term?
Burdel: Some secondaries funds of recent vintages will show significantly lower returns than their investors expected because they were invested at the top of the market. In other words, they will have participated too strongly in the buyout bubble. Secondaries' managers who retain investor confidence and are, therefore, able to continue raising money will find attractive opportunities over the next few years.
Moerel: Pricing in the secondaries market is somewhat dynamic over time: It is dependent on supply vs. demand, economic outlook and levels of seller distress. In 2008, we have seen a significant recalibration of these three factors, leading to increased risk and hence a need for higher returns. Today, buyers are seeking returns approximately 25% to 35% higher than 12 months ago for similar transactions. More complex transactions generally command higher returns. We believe that as long as the supply-demand imbalance and macroeconomic uncertainties continue to exist, which we project for at least another 18 to 24 months, these return targets will continue. Thereafter, we expect a gradual decline to the historic returns.
Wilson: Returns for deals completed in the last two years will inevitably see lower IRRs given longer duration and likely reduced exit multiples on asset sales. However, these deals could still generate money multiples at relatively attractive levels. Looking over the next two to three years, we believe that the return profile for secondary players should be excellent, given the confluence of attractive forces that characterize the current market.
WPEC: What do you see as the future role of secondaries in the private equity market?
Moerel: AlpInvest Partners continues to see a long-term potential for the secondaries market, beyond the expected growth in 2009 and 2010, which will be largely driven by distressed sellers (i.e., banks, endowments, family offices, listed private equity vehicles). Fundamentally, the secondaries market grows as a result of more commitments in the primary private equity market and increased acceptance of secondaries as a tool to provide investors in private equity funds with liquidity (i.e., a larger percentage of funds trades every year). We expect both these elements to provide for continued growth post-2010. Large systemic shocks such as the current financial crisis will continue to provide for periods of peak growth and tremendous opportunities for secondaries funds.
Wilson: The principal role of secondaries in the market is to provide short-term liquidity. The creation of a secondary market in which larger positions can change hands and where vendor LPs can adjust their weighting to the asset class will be the main benefits from the evolution of secondaries as an asset class. Moreover, as mentioned above, secondaries firms will play a significant part in the further restructuring of the buyout industry, similar to the role they played with the VC industry.
Burdel: Investors have committed a huge amount of money to PE in the last few years -- some $2 trillion since 2002 -- and they remain strongly committed to PE as an asset class. However, new economic realities mean that changes are required to PE portfolios. It's not only a matter of each portfolio's liquidity profile, but also of its asset allocation by geography, investment stage and even manager quality. The secondary market will allow LPs to manage all these factors far more quickly and proactively than they otherwise could, which will be important for maximizing overall portfolio returns. By offering liquidity solutions for highly illiquid assets, secondaries are improving the attractiveness of PE as an investable asset class.