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By Kelly DePonte |
The Current Private Equity Secondary Market Environment
Executive Summary
Private equity secondary deal activity increased significantly during the past ten years as a direct consequence of a rapid increase in assets under management by private equity groups globally. However, as global equity markets corrected sharply downward in September 2008, secondary market activity slowed as bid/ask spreads widened dramatically and discounts to Net Asset Value (“NAV”) returned to the market. A significant increase in transaction volume is expected towards the end of 2009 as the future economic picture becomes clearer and bid/ask spreads stabilize and narrow. It is estimated that approximately $100 billion of private equity interests will become available for sale over the next two to three years, creating a buyers market.
The Private Equity Secondary Market
For the last three to four years the driving factor in the secondary market has been the increasing use of secondaries as a portfolio management tool for institutional investors looking to adjust exposure rather than exit the market. Strength in the primary private equity markets over the same period also resulted in improved pricing for potential sellers, particularly in buyouts where the normal discounts to the fund managers’ reported NAV actually turned into premiums. As activity increased, the market began to attract a few primary institutional buyers, in addition to the secondary fund specialists and funds of funds managers with dedicated secondary teams that dominated the sector.
Current Market Environment
The dramatic fall in both the publicly-traded markets and the decline in capital distributions from alternative investments have resulted in a surge of positions being offered in the secondary market to either rebalance portfolios, to generate cash, or to reduce unfunded commitments. However, this sudden increase in the supply of positions for sale has been accompanied by increasing uncertainty of the accuracy and stability of fund manager’s reported NAV. The result has been a steep drop in secondary prices and a widening of bid/ask spreads, with many potential sellers withdrawing positions from the market, especially when faced by discounts of 60% or more on certain positions. The swing in pricing has been greatest in the buyout market, particularly in larger funds most impacted by debt problems, reversing past trends where venture capital funds have fairly consistently traded at larger discounts to NAV compared to buyout funds.
Probitas Partners forecasts that as 2009 progresses fund managers will increasingly write down the NAV’s of their portfolios to more properly reflect their current market value, as we have seen from the first published results of year end 2008 valuations. Correspondingly, sellers will also begin to adjust their price expectations as these write-downs are recognized. As we move into the 2nd half of the year, the number of executed transactions will increase and that will begin to stress the amount of capital available for secondary transactions.
The best indicator of permanent capital dedicated to secondary acquisitions is easily tracked: it is the capital raised by specialist secondary funds. Chart I tracks the capital raised by those funds over the last twelve years. Secondary fundraising in general trended upwards over the period, with 2007 setting a new record by a significant margin as several large funds closed that year. While 2008 fundraising declined, this is more a technical factor driven by the absence from the market of a number of the largest fund managers who had just closed vehicles in 2007, rather than a pull-back of investor interest. This is clearly demonstrated in the Year-to-Date fundraising total for 2009 through April, which has already reached $8.4 billion, higher than any full year except for 2007.
Chart I:
The Fund Raising Environment For Secondaries Going Forward
As institutional investors look forward to the remainder of 2009 and this developing environment, their interest in investing in specialist secondary funds has increased. Every year, Probitas conducts a survey of institutional investors to determine market trends. As detailed in Chart II in this year’s survey, return expectations for secondary funds broke into the top 5 sectors for the first time, and were second only to distressed debt funds. Investors expect that the steep discounts being paid to acquire positions in the secondary market will lead to strong returns, and are focusing their attention on the sector.
Chart II: “For established markets, I expect the best returns for 2009 vintage funds to be in…”
Chart III lists the ten largest secondary funds raised (or being raised) to date. It is certainly telling that five of the ten largest funds are either currently in market or have just closed. Given the strong investor interest in secondary funds noted in our survey and the significant number of secondary funds currently in the market 2009 fundraising has already exceeded 2008, with some chance that the record fundraising total of 2007 may be exceeded this year.
Chart III: “For established markets, I expect the best returns for 2009 vintage funds to be in…”
In order to take advantage of the newfound opportunities in the secondary market, a number of intermediaries with no prior experience as well as new online exchanges promising to match buyers and sellers are entering the market – the latest being a New York firm called SecondMarket. While public trading platforms at first seem helpful in terms of increased transparency regarding an often opaque market, the confidential nature of private equity limited partnership agreements, as well as the strong desire of many sellers for confidentiality, mean that these platforms have had limited success in the past and have been more effective for individuals as opposed to institutional investors.
Summary
The secondary market for private equity limited partnership interests has increased significantly during the past ten years, shadowing the steady increase in funds being raised by private equity firms around the world. At the same time, the secondary market has become an accepted and fairly well known part of the private equity investment environment. During the first quarter of 2009, however, secondary deal activity experienced a severe slowdown, primarily as a result of a disconnect between sellers’ price expectations and the typical 40% to 60% or higher discount to NAV that buyers were offering. It is widely expected that this slow-down in deal activity will be followed by a significant increase in transaction volume towards the end of 2009, an expectation foreshadowed by the strong fundraising for secondary funds so far this year. We believe that secondary volume will remain high for the next two to three years, driven by the need for investors to rebalance their exposures and allocations in the wake of dramatic market changes in addition to the long term secular trend of increased activity.
About the Author
KELLY DePONTE
Partner, Probitas Partners
Kelly has twenty-eight years of industry experience and is responsible for Probitas Partners' research and due diligence. Prior to joining Probitas Partners, Kelly was Chief Operating Officer and Managing Director at Pacific Corporate Group ("PCG"), a leading provider of alternative investment advisory, management and consulting services. Kelly oversaw the partnership investment program, which comprised more than $20 billion in capital dedicated globally to private equity. As a member of the firm's Investment Committee and Chair of the Investment Team, Kelly reviewed and approved private equity investment recommendations for discretionary and non-discretionary accounts. Before joining PCG, Kelly held various senior positions at First Interstate Bancorp, including management of a $170 million venture capital portfolio, oversight of all financial derivative activity in the corporation and its banks, and analysis and management of capital and liquidity positions of First Interstate subsidiaries. Kelly earned a BA in Communications from Stanford University and an MBA from The Anderson Graduate School of Management at UCLA.
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