LPs Shun New Funds For New-ish Secondaries

Institutional investors are buying fund positions in the secondary market as a cheap alternative to new investments, putting added pressure on an already tough fundraising climate for buyout firms.

Prospective investors are looking to get in via early secondary investments—buying participations in private equity funds before much of the fund has been deployed from investors wanting to exit—for virtually no outlay. Others have shopping lists of assets they want to buy and are prepared to wait for the right funds to come on the market at the right price, often at discounts of up to 30 percent.

“A good way for a primary investor to commit money now is via an early secondary,” said Elaine Small, partner at secondaries specialist Paul Capital.

Early secondary funds function much in the same way as primary funds, because most of the money has yet to be spent. That brings heavy commitments, explaining why investors offer heavy discounts if they want to get out.

The primary fundraising market has slowed as large numbers of investors became over-committed to private equity amid falling prices in other asset classes, and have resisted overtures from buyout funds to raise new capital. The U.S. fundraising market is shaping up to be the slowest year since 2003. In the first nine months of 2009, buyout and mezzanine firms raised only $48.9 billion from investors, leaving the year-end total likely to end up somewhere between 2003’s $32.5 billion and 2004’s $71.9 billion, according to Buyouts. In 2008, U.S. firms raised $264.0 billion.

That investors have yet another reason to hold off on making new commitments is not good news for buyout firms like BC Partners and Montagu Private Equity, who are already waiting to launch new funds, nor for The Blackstone Group, which is trying to raise $20 billion.

The fundraising market could get tougher still, said Small. Close to $25 billion of assets could trade on the secondary market in 2010, Antoine Drean, chairman of placement agent Triago estimates, against just $7.5 billion in 2009 to date. One private equity fund manager looking to raise his first fund to buy distressed companies said he was surprised by having to compete with the secondary market for investor cash. “There’s only a finite amount of free cash available and right now, more often than not, (investors) think it’s a safer play to go for a secondary rather than a primary,” he said.

Non-traditional secondary buyers—pension funds, endowments and family offices—are active in buying early secondaries, said Billy Gilmore, private equity investment director at Scottish Widows Investment Partnership. SWIP is currently assessing one deal where it did not get a chance to invest during the fundraising process, as the firm raised most of its capital from U.S. investors.

Private equity funds that narrowly missed the grade in due diligence, or where SWIP made a smaller investment than it would have liked because the fund was oversubscribed, also presented possible buying opportunities. “We would be quite happy buying individual investor positions in funds we know well,” Gilmore said, adding manager quality is “the most important thing.”

Compared with about only 40 specialist secondary private equity buyers—firms like Paul Capital, Pantheon Ventures, HarbourVest and Goldman Sachs’s private equity arm—there are up to 400 non-traditional buyers, said Triago’s Drean. Many of those 400 have “wish lists” of funds they want to buy, usually where they missed one fund from a favored manager but would like a second bite at the cherry, Drean said.

Sellers, frequently endowments and pension funds with liquidity problems or a need to rebalance their portfolios, were loath to sell when discounts to asset value dipped to 60 percent or lower, but are now coming back as prices recover. Stanford University is looking to sell up to $1 billion of illiquid assets, including private equity, following peers Harvard University and Duke University which turned to the secondary market last year.

While trading is slow, deals are being done at discounts of between 20 and 30 percent, participants say.

— Simon Meads is a London-based correspondent for Reuters.