Awaiting the Storm

The last couple of years have been an extraordinary time for the private equity industry in terms of fund raising, investment rates and distributions to investors. Yet one area of the market has seen something of a slowdown – secondaries. Most players claim to be busy with reasonably brisk deal flow, but admit they are seeing nothing like the activity of two to three years ago. “Two to three years ago, the partnership interest sales activity was very high – they were extraordinary years for the secondaries market,” says Elly Livingstone, partner at Pantheon Ventures. “In comparison with that time, things have quietened down a little.” But, he adds, that won’t last forever.

This is hardly surprising in a counter-cyclical market such as secondaries. Returns to investors have been so good recently, with recapitalisations and high prices being paid for companies on exit, that the bread and butter work of partnership interest sales have been relatively thin on the ground. Some LPs are even having a change of heart part-way through a deal. “With returns so good at the moment, we are seeing sellers changing their minds,” says Sebastian Junoy, partner at Headway Capital Partners. “They are rethinking their strategy to take advantage of the extraordinary times we’re seeing in terms of distributions.”

Instead, much of the activity at the moment in the market is coming from secondary directs (otherwise known as synthetic secondaries) – sales of direct investments by banks, insurance companies and general partners. “Deal flow has remained strong, but it has moved on,” says Livingstone. “It’s a long way from the days when the secondaries market only bought up partnership stakes. We’ve seen the emergence of managers ready to step in and manage out portfolios with the backing of secondaries players.”

Some of these are tail-end investments – those left in a fund at the end of its life, where GPs are looking to sell the assets to return capital to LPs and to enable managers to devote more time to businesses in other, more current funds. “We’re seeing some tail-end transactions,” says Mark Mifsud, partner at SJ Berwin. “They are slowly becoming more acceptable and there is now a recognised market for them.”

Yet deal flow has remained slower in this area than some might have hoped. Some firms, such as Nova Capital, were originally set up to target these types of deals. But they have found some resistance to the idea from GPs themselves, who believe selling is an abrogation of their responsibility, and from some LPs, who believe that GPs should manage out assets to gain maximum value. Besides, these deals are not easy to get right. “We don’t focus on this area, but there aren’t many tail-end portfolios on the market anyway,” says Michael Granoff, president and CEO of Pomona Capital. “It’s a difficult business to be in – you have to be convinced that you know more than a very smart seller. It’s hard to make money from these because there is often a reason why the assets are still in the portfolio.”

Deal flow elsewhere in secondary directs, however, is strong and firms specialising in this area, together with the more traditional secondaries players, are finding this a rich seam to mine. Some of this is coming from GPs with funds that have gone beyond their five or so years of investment period. “There is quite a bit to be done with GPs restructuring,” says Tom Anthofer, founder of Cipio Partners, which specialises in buying up venture capital secondary directs. “With these, the funds have reached the end of their investment period and the management fee drops off at this point. Doing a secondary transaction can realign incentive structures, for example.”

Mifsud agrees: “We’re seeing a lot more synthetic secondaries on the market – deals in which portfolios are being wrapped up in a new partnership and managed by some of the existing management or new management. One of the reasons a manager may do this is to reinvigorate an existing portfolio. They are using secondary money as a support for a platform of deals. It’s just one example of how the secondaries market is now being used as a transactional tool for doing more with assets.”

Some GPs have also seen their strategy evolve as they have raised larger funds. “Portfolios are growing all the time in the primary market and so there are some assets that are getting neglected,” says Mifsud. “Some houses are also evolving and so investments that were made, say, five years ago don’t really fit in with the firm’s current strategy.” Many players say there is a lot of deal flow to come in this category. 3i, for example, is selling off legacy minority interests in around 800 companies and has recently sold a bundle to Saints Capital. Legal & General Ventures has also sold seven of its older investments to Vision Capital for €120m. “There are a lot of larger, institutional houses that have legacy later stage venture investments,” says Anthofer. “They now concentrate on buyouts and so many of these assets are likely to come onto the market at some point soon.”

The other main source of deals is corporates. Some of these are more traditional corporate venturing assets. But even here the market has evolved. “Quite a lot of the deal flow in synthetics is coming from corporates,” says Mifsud. “They are looking to sell trading subsidiaries because of a change in strategy, a merger or some kind of regulatory issue. If they are looking to get out of particular markets, for example, they can sell these subsidiaries to a secondaries player rather than to a trade buyer – that way they can sell them as a package.” Coller Capital’s recent £40m acquisition of a portfolio of “non-core assets” from AEA Technology is a good example. The company suffered from poor results in 2004/2005 and the sale was part of an overall refinancing of the business.

Steady deal flow in secondary directs means that a number of players have entered the market over recent times. Strathdon Investments, for example, has launched a £20m fund targeting venture capital secondary directs and Bioscience Managers Limited has secured €150m in soft commitments, again for venture capital secondary directs. BML has already acquired Nordic Biotech’s stakes in several life sciences companies.

Cipio, Nova Capital, Saints Capital and Vision Capital, on the other hand, have been around for the last three or four years and have established teams. “There are a number of us that have built teams of 10 or more people,” says Anthofer. “As a result, LPs now recognise that there is some longevity in this business.” This is part of the reason Vision Capital has been able to secure €1bn for secondary direct deals. Traditionally, these players have raised capital as and when they have needed it rather than gone out on the fund raising trail. “We have always funded deal by deal,” explains Anthofer. “Raising a fund is very difficult in this market because of the variation of deal sizes. Some you look at may be worth a few million; others up to, say, €150m. So it’s very hard to have a set fund size because a single investment could dwarf the rest of the portfolio.” Another difficulty is that LPs don’t have benchmarks to measure performance against. So, while Vision’s fund raising is interesting, it may be some time before it becomes common practice – if it ever does.

While a lot of focus is on secondary directs, there are still some deals to be done in partnership stakes. The US$1.2bn acquisition of energy company DPL’s private equity portfolio last year was one of the largest deals of this type completed, for example. Yet most of them, say secondaries specialists, are pricey and/or complex. “We’re seeing an abundance of bespoke deal flow – pretty much every deal we see requires serious customisation,” says Marleen Groen, CEO of Greenpark Capital. “There are hardly any plain vanilla deals to be done in Europe at the moment. There are a lot of traditional secondaries in the US, but they are generally auctioned and relatively highly priced – it’s a rather efficient market over there.”

And, with certain secondaries players raising some rather large funds, competition in the market is only set to increase. Lexington is closing its latest fund on US$3.5bn and Coller is said to be in the market for US$3bn. “There are some mega-funds being raised in secondaries right now, but I would ask where they are going to spend that capital,” says Junoy at Headway Capital. “There is a natural ceiling in the market today and the deals at that end of the market are very competitive. Anything over US$100m attracts an incredible amount of interest and is usually intermediated.”

On top of the capital available, the availability of debt is also having an effect on pricing. “There is a lot more leverage going into secondaries transactions,” says Mifsud. “It’s much easier to do with synthetic deals because you have a direct pool of assets to borrow against, but it’s also possible with plain vanilla deals. Banks have become much more comfortable with lending on secondaries deals and are now familiar with the market. It’s more than just a cyclical phenomenon and I think it’s here to stay.”

Yet where, a few years ago, secondaries deals were being done at a discount to a fund’s net asset value, many are now paying a premium. Secondaries players have, for a number of years, used a certain amount of debt to boost returns, but the amounts being put down now are raising alarm bells among some in the market. One secondaries fund manager says: “I’ve heard of a lot of secondaries players using leverage to get deals done. If you add that to the fact that there is a lot of money available at the larger end, then it’s hardly surprising that we are seeing deals being done at a premium. It’s hard to argue that returns won’t be affected by that. If GPs are reporting full valuations for their portfolio companies and secondaries players are paying a premium, they will only make any money if the company outperforms an already high valuation.”

He adds: “We participated in a larger transaction recently and we were stunned by the prices being offered. One of the GPs even told us that they couldn’t see how the firm that completed would make any money.”

It’s a trend noted by Granoff, too. “We want to be careful today,” he says. “Some people are pricing portfolios according to today’s buyout returns. I’m not sure that’s the right extrapolation. One of our challenges at the moment is how to source the deals we want to do and pay a price we want to pay.”

But the current shortage of partnership interests on the market will not last forever and so pricing pressure may ease off a little. The announcement by CalPERS that it is to sell US$3bn of interests could prompt others to do the same. US state pension funds have been slow to use the secondaries market, but many now believe they will start seeing it as a portfolio management tool. Other investors are already there, especially in the US. “Investors in the US have been in the private equity market for a long time and many of them are managing a substantial number of GP relationships,” says Groen. “This has been compounded by the strong fund raising cycle we’re currently seeing. Some investors have committed to 70 to 80 funds in the last few years alone. Many institutions have only a small staff and they simply cannot handle all these relationships any more so some are cutting back on them.”

Livingstone agrees: “We’re seeing an increasing willingness among US pension funds to rebalance their portfolios. A few years ago, it seemed as though they were going to remain LPs until the end of a fund’s life. Now it’s much more acceptable to trade out. A lot of them are having to focus their efforts on a core of GP relationships – it’s simply a way of managing their time, resources and allocations effectively.”

They are also looking for liquidity to enable them to invest meaningful amounts in some of the mega-funds that are being raised. Groen says: “US institutions are selling fund holdings to free up hundreds of millions of dollars for the larger buyout funds when they do not wish to generate further capacity by increasing the allocation to private equity.”

But, more interesting still for secondaries players, will be the market over the medium term. With unprecedented amounts of money going into the primary market, deal flow for secondaries firms will really start hotting up

in three or so years’ time. Some of the promises currently being made by GPs may well prove hard to achieve. And returns are unlikely to remain as stellar as those seen over the last couple of years and so some LPs may well want out. “We’ve seen some extraordinary fund raisings over the last couple of years in the buyout segment,” says Livingstone. “In 10 years’ time, some of these will be judged to have been very successful. But in three years’ time, the picture may be different. We may be in a period in which people want liquidity.”

It’s a time Groen at Greenpark is looking forward to, too. “We are likely to see an interesting wave of secondaries two to three years down the road, when private equity returns in some areas may not be quite what is currently expected. This is of course a cyclical phenomenon, but what’s interesting this time around is that the correlation between public markets and the larger funds has become much stronger.” And if that’s the case, returns may well be lower than historical levels and more volatile – again prompting some LPs to sell out of their interests.

So, if historical trends are anything to go by, the busy times for secondaries players of three years ago may well be back in another three years. Prices may come back down as sellers become more motivated – we may even see the re-emergence of distressed sellers – and distributions become fewer and further between. If that’s the case, the current focus on secondary directs – usually much smaller and more complex deals to execute – may diminish, for a time at least. The extraordinary times for the buyout funds today will soon become another round of extraordinary times for the secondaries funds tomorrow.