Decrease font Decrease font
Decrease font Decrease font
Enlarge font Enlarge font
Enlarge font Enlarge font

By Marleen Groen, Principal Founder and CEO
Greenpark Capital Limited

and

By Ferdinand von Eberhardt, Investment Analyst
Greenpark Capital Limited


Improving Liquidity: the Future of Private Equity Secondaries

Following a brief introduction to secondaries in private equity this article will describe how this market has been impacted by economic developments over the last couple of years. It will then set out Greenpark’s expectations for the next phase of secondaries investing from 2010 onwards.

Introduction to private equity secondaries

In brief, secondaries investing in private equity involves the purchase of interests in private equity funds, from investors in those funds, before the expiration date of the funds. Typically, a private equity fund has a 10-year life with two or three one-year extensions at the discretion of the fund’s management so that the fund can continue if there are still some portfolio assets left to be managed to exit. During this relatively long period of at least 10 years many developments may lead to some investors wishing to liquidate their positions and sell their private equity fund holdings during the life of a fund.

The reasons for selling can be manifold and include a changing portfolio strategy over time, the wish to lock in a return, strategic changes at the investor level or simply a housekeeping exercise when too many managers in the private equity portfolio make it very cumbersome to manage the portfolio efficiently. See the chart below for the development of sellers’ motivations between 2007 and 2009. The chart indicates that this seller group’s percentage in the total mix of motivations increased significantly from 5% in 2007 to 52% in 2009.

Given the illiquid nature of private equity it is not surprising that over the last 20 years the secondaries industry has grown exponentially and the total amount available for secondary purchases is now estimated at $50 billion. This has largely been deployed in the US and Europe where primary private equity markets are at a more mature stage and therefore secondaries have developed first. Despite the growth of the secondaries private equity market we highlight that the total amount available for secondary purchases is still a fraction of the amount invested in the primary private equity market.

Recent secondary market developments

Following the collapse of Lehman Brothers in 2008 and the subsequent turmoil in both financial markets and the global economy, the past two years have been a very challenging and difficult period for private equity. The industry was faced with multiple issues: firstly, significant decreases in stock market valuations and the associated decreases in private equity portfolio net asset values; secondly, major difficulties in selling portfolio companies; thirdly, the effective closure of debt financing markets for both recapitalisations and new investments; and finally, investors facing their own global financial crisis related problems leading to a significantly lower level of capital available for private equity funds.

All of the above factors caused an increased interest in the secondaries market and the chart below illustrates the secondaries opportunities flowing from the effective “up-sharing” of risk in financial markets as the global financial crisis unfolded:

The private equity secondaries market entered a transformational period around 2004/05. Selling private equity fund holdings ceased to carry a stigma and secondaries became a useful private equity portfolio management tool and an effective instrument for managing liquidity needs. The secondaries market continued to grow and develop exponentially, validating the maturation of private equity as a more liquid and transparent asset class for all participants. As the crisis unfolded at the end of 2008, many private equity participants were predicting that the secondaries market would see an even steeper growth path given the expected unprecedented need for liquidity.

The expectation of forced sellers across the investor base worldwide, including banks, asset managers, pension funds, endowment plans, and family offices - all in dire need of cash - led to predictions of secondary market activity in excess of $30bn for 2009 alone. Given the volume of primary private equity capital raised between 2003 and 2007 these expectations did not appear unreasonable.

However, the secondaries market did not at all live up to the above expectation for 2009 – for the first time in 20 years of private equity secondaries, the industry actually saw a much reduced volume in secondary sales. Whilst total 2008 secondary sales were in the region of $20bn, 2009 secondary sales were at best around half of this amount. Let us have a look at the main reasons for this unexpected development.

The three main reasons for the low 2009 secondaries activity were: pricing, the maturity and funding levels of the majority of fund positions offered for sale, as well as bank bailouts and interest rates. The chart below shows the resulting gap between market opportunity and transacted secondaries deal volume.

1. Pricing: The lack of visibility on underlying asset performance, falling asset valuations and lack of exit visibility made it difficult for secondary investors to value fund holdings for sale which depressed pricing. This was exacerbated by the valuation methodology of private equity. While the outlook for the economy worsened and stock markets were plummeting in the wake of the financial crisis, risk premiums increased throughout all asset classes. For the secondary market this meant that pricing did not only have to reflect the high amount of economic insecurity but looked even worse as its pricing was relative to outdated fund reporting that reflected underlying asset valuations of previous quarters.

This led to pricing dropping from an average 4% premium to reported net asset value in 2007 (9% for buyout funds)(1) to discounts of as much as 80% to reported net asset value, or in highly unfunded positions up to 100% or more (yes – negative pricing transactions exist!), which many sellers were not prepared to accept unless they had a desperate need for liquidity. This was aggravated by many investee companies being highly overleveraged resulting in buyers’ fear of negligible equity values.

Secondly, a large part of secondaries deal flow in 2009 consisted of highly unfunded and immature positions frequently in larger funds - distressed and cash constrained investors needed to sell these holdings to get rid of the outstanding funding commitments. Many of these fund positions were acquired by either new market entrants that were attracted by the value opportunities represented by the available steep discounts to book value or by non-traditional secondary buyers such as funds-of-funds and established private equity investors that recognised the opportunity to buy additional holdings at high discounts to book value in funds that they had already invested in. During 2009, many of the traditional secondaries buyers remained quite inactive, adhering diligently to their strategy of acquiring more mature private equity positions.

And finally, interest rates and developments in the banking sector play a major role in why a big part of expected dealflow did not materialise. In general, banks were considered a major source of potential secondaries dealflow. However, as banks were bailed out in 2009, the level of interest rates and associated cost of holding assets gave them the opportunity to hold non-strategic assets at a relatively low cost. As a result, they did not transact much in the secondaries market. During the year, banks had to stabilize and strengthen their balance sheets and selling off private equity assets was generally not considered a first priority when pricing was highly unattractive and there was no immediate need to sell.

As pricing fell in 2009 relatively few sellers across the industry were willing to transact. The chart below shows the increase of the seller group motivated by liquidity needs as a percentage of all transactions reviewed by Greenpark.

All of the above aspects had a major impact on the development of the secondaries market in 2009 and explain why the predicted ’tsunami’ of deal flow did not occur. In anticipation of this ‘tsunami’ though, it is estimated that secondary fund capital in excess of $22.5bn(2) was raised. This results in an estimated total volume of secondary capital in excess of $50bn currently available for transactions. Whilst this puts pressure on larger secondaries funds to invest, it will provide a significant increase in liquidity opportunities for private equity investors.

Expectations for the secondaries market from 2010 onwards

In the first months of 2010, the long-awaited increase in private equity secondaries activity has started to come through as buyers and sellers move closer on pricing given that visibility on company performance and potential exits is improving. Stabilizing stock markets, an upsurge in M&A activity, the cautious re-opening of IPO markets and the returning strength of banks and lending activity are giving more confidence and certainty to both buyers and sellers. This has helped boost valuations of underlying investment companies and made fund interests more attractive to secondaries buyers.

Thus, recovery in fund valuations is expected to continue in the months to come as valuations catch up with public markets. This will have a positive effect on secondaries pricing and, as a result, will encourage those sellers who were still reluctant to enter the market last year. Especially for quality funds, the secondaries market has in some cases returned to small premiums being paid, although it should be said that the premium applies to a lower valuation base than it did at the start of the financial crisis.
Secondaries pricing will also be affected by the vast amounts of secondaries capital available. More capital will create more competition in secondaries transactions as pressure to deploy capital for secondaries fund managers increases. This will be accompanied by an increase in intermediation across the industry driven by the sellers’ demand for better price transparency. As in all maturing markets, over the last few years an increasing number of secondaries transactions have been intermediated, a trend which will only continue to develop, more so in homogenous markets such as the US than in Europe or emerging markets.

Furthermore, supply of secondaries opportunities should benefit from the need for special liquidity solutions for fund managers who have run out of cash in their funds, unable to support their portfolio companies and whose investors do not wish to provide additional capital. Such fund managers may, facing dilutions of their holdings, look for secondaries investors to provide annex funds or other side vehicles that allow the managers to further invest in their portfolio companies, preserve existing shareholder rights and potentially provide a capital return to their investors. Such a secondary financing solution would enable them to remain in control of their investments. Of course fund manager quality will be a key factor in this type of secondaries transaction.

An additional factor in relation to expected secondaries deal flow going forward will be the new regulatory environment in the main private equity markets. More stringent regulations such as the “Volcker law,” Basle III and the AIFM directive in Europe will cause a number of investors to leave or reduce their exposure to the asset class which will result in additional secondaries transactions.

In mature primary markets the secondaries market is transforming into a more mature and transparent asset class and we believe that the above factors will all play a major role in the increase of secondaries activity from its current marginal 2 percent of total private equity assets under management to possibly as much as 8-10 percent annually over the next decade.

So what are the consequences for secondaries buyers? Key to success for purchasers of secondaries positions will be to develop and execute a strong strategy and to remain prudent and diligent in the investment process. We would therefore expect that the secondaries market will see a phase of specialization of funds buying into specific asset classes and developing highly distinguishable skillsets. Overall, more attractive returns to investors will continue to be generated in less mature and less transparent markets.

Greenpark Capital Limited is the largest European mid-market private equity secondaries specialist founded in 2000 with $1.8bn of assets under management.

1 - Source: Cogent, average high bid for all funds
2 - Source: Preqin, Private Equity News (Issue 328)

About the Authors

Marleen Groen

MARLEEN GROEN
Principal Founder and CEO, Greenpark Capital Limited

Marleen has over 14 years of global secondaries experience and is responsible for firm strategy, day-to-day management and fundraising. Before moving into private equity, she spent nearly a decade as a senior corporate financier for major European banks, advising on M&A transactions in many European countries. Marleen is Dutch, is fluent in German, French and English and holds an MA (Hons) and a BA both from Leiden University, and an MBA from Rotterdam School of Management. 

FERDINAND VON EBERHARDT
Investment Analyst, Greenpark Capital Limited

Previously, Ferdinand spent almost two years as an Analyst in the Leveraged Finance department of Lehman Brothers in London. He graduated with a degree in Business Administration from the European School of Business, Reutlingen and Universidad Pontificia Comillas (ICADE) in Madrid. Ferdinand is German and speaks fluent English.