Money Magnet

Last year was, according to most industry experts, the best ever year for the global secondaries market, with 2007 looking set to be even more exceptional. The volume of deals soared, with over US$10bn worth of deals transacted globally, 65% to70% of which emanated from the US. This is a substantial growth from 2005’s US$6.7bn, 2004’s US$6bn, 2003’s US$5bn and 2002’s US$1.9bn volumes, according to Cogent Partners.

The market is now characterised by a far greater range of deals. As well as traditional LP partnership interests in buyout and venture portfolios (with buyouts still monopolising volumes), plain vanilla and auctioned assets and the more customised, complex and proprietary transactions, direct secondaries are also rising in importance.

In addition to bigger deals, transactions as low as US$5m are now common. This is in stark contrast with early secondaries, which mainly involved large whole portfolios sold by distressed sellers or investors exiting the asset class. “Last year was excellent for the global secondaries market. From what we could see, transacted volumes hit a record highs and the supply and diversity of deals grew significantly,” says Elly Livingstone, head of secondaries investments, Pantheon Ventures.

The market is also growing in complexity and sophistication. While traditionally, secondaries have been all-cash transactions, more and more now involve an element of structuring. This can entail an agreement with the seller about the purchase price, with delayed payments, or with the seller retaining partial exposure to the portfolio. Structuring can also be buyer-driven, involving special purpose vehicles, leverage or vendor asset swaps. The use of leverage, in particular, is rising notably.

Even though buyouts still dominate volume, one of 2006’s most prominent deals was a venture transaction – Pantheon’s landmark acquisition of LP interests in a portfolio of 90 VC funds and eight minority direct investments from Italian fund-of-funds Cdb WebTech in October. With a total transaction value exceeding US$400m, the deal was not only one of the largest public secondary purchases of 2006, but also one of the largest venture transactions ever completed.

Other prominent recent deals include Swiss Re’s sale of a mixed US$500m funds portfolio to Alpinvest in December, Coller Capital and Goldman Sachs’ purchase of the majority share in Temasek’s US$800m Astrea portfolio last June and the April 2006 US$925m purchase of a global equity fund from JPMorgan by a consortium including CPP and Paul. This March, on the venture directs side, Coller purchased 45% of its Shell Technology Ventures Fund 1, comprising a portfolio of 34 technology investments.

Strong supply has been driven by a significant expansion in the universe of sellers. Distressed vendors seeking short-term liquidity are a thing of the past. Although some sales still spring from strategic changes and the desire to reallocate capital, most of today’s vendors are selling for portfolio management reasons, rather than any shift out of the asset class. To the contrary, as the recent primary fund raising extravaganza testifies, LPs have greatly increased their overall allocations to private equity. Yet as their allocations have grown, many are finding their portfolios unwieldy or are unhappy with some GPs’ performance. They are looking to prune and simplify their portfolios and make larger commitments to fewer GPs. As a result, many have been selling some of their interests.

This is a major change in the vendor space in Europe in particular, where until relatively recently sellers usually just comprised exiting institutions or GPs using the market to raise primary capital, offering buyers secondary interests in return for fresh capital for their latest funds. “There has been a fundamental change in the market in the last year, with an extraordinary growth in the pool of vendors. Sellers are no longer distressed or just changing strategy. LPs are selling for many more reasons now, including portfolio management, poor GP performance and relocation to better funds,” says Richard Sachar, MD at placement advisor Almeida Capital.

US pension plans in particular have become increasingly prolific sellers. “A big change in the last 18 months has been the increase in pension plan vendors – especially in the US. They are selling tail-end portfolios to free up capital to invest with their target GPs,” says Pantheon’s Livingstone.

Fund raising frenzy

As part of the overwhelming increase in investor appetite for private equity as a whole, the amount of capital targeting secondary firms’ funds has also soared in the last two years. Investors looking to commit larger and larger sums to private equity are using secondary funds to supplement their primary fund commitments and augment their overall exposure.

As a result, secondaries players have enjoyed a veritable fund raising bonanza of late, with an unprecedented volume of capital raised. Traditional dedicated specialists with solid track records have been able to scale up substantially, raising extremely large funds with notable speed. This culminated in the final closing of Coller Capital’s ground-breaking US$4.5bn Coller International Partners V fund in April – the largest secondaries fund ever. CIP V was originally capped at US$3.75bn, but, with a staggering US$5.6bn of investor interest, the cap was increased. “Appetite for our fund was astonishing – there was so much demand that we had to increase the cap to US$4.5bn,” says Jeremy Coller, CEO of Coller Capital.

According to Private Equity Intelligence, US$10bn was raised by 16 funds in 2006, with funds closing on average 28% over their original targets. Yet although this was an all-time record, it has already been swiftly surpassed this year. Including Coller’s jumbo, by mid-April, a staggering US$10.5bn had already been raised from six funds. Another 10 funds are on the road seeking an aggregate of US$8bn, with predictions that US$15bn to US$18bn will be raised over the course of 2007.

Major shift in buyers

Yet even with these record funds raised, an even more notable development has been taking place in the buy-side in the last two years. There has been a major shift in the behaviour of non-traditional investors – namely, in LPs such as pension funds, endowments, family offices and others normally investing on the primary side – which have markedly increased their secondary buying activities.

LPs have sporadically bought secondaries for well over five years, but institutions such as Alpinvest have really stepped up their activities in the last 18 months. Many LPs are under pressure to manage their portfolios to maximise returns and also to meet their increased allocations to their favoured GPs. They are turning to secondaries to help. Newer LPs are also buying, to help build their programmes more rapidly. Unlike primary funds, which involve investing in a blind pool of assets subject to the J-curve effect in the early years, secondaries allow investors quick and diversified entry into private equity.

“There has been an even greater change in the buy-side than in the sell-side in the last 18 months. Previously, secondaries were deemed rather exotic, bought only by specialists or those looking to build portfolios extremely quickly. Now, secondaries are regarded as a useful portfolio management tool to maximise returns or refocus GP relationships. Everyone wants to buy them now and the market is becoming far more mainstream,” says Almeida’s Sachar. According to Almeida’s March 2007 Secondaries Survey, 83% of LPs have now bought, or intend to buy, a secondary interest in a fund or portfolio of companies.

To date, most LPs have been buying on an opportunistic basis, as they are not equipped to compete head-on with the specialists. “Most LPs are not buying regularly as they lack the resources to analyse secondaries, unless the deal is in a fund they are already invested in. You need a totally different skill-set – transactional expertise and the ability to analyse the future value of holdings in a fund are paramount. Most LPs lack the resources with these skills,” says Marleen Groen, CEO of Greenpark Capital.

However, a few LPs – especially larger funds of funds such as HarbourVest – have built up dedicated secondary teams and are entering auctions and bidding extremely competitively now. These LPs represent a real threat to the specialists, as they are often happier to provide stapled secondary participations (investing in a GP’s primary fund at the same time). “Funds of funds and non-traditional investors now pose formidable challenges to dedicated secondary specialists. They are very appealing to GPs, as they can do secondary investments and make primary commitments,” says Brenlen Jinkens, MD at secondaries adviser Cogent Partners.

LPs that are participating in auctions can also be formidable adversaries because they often have a lower cost of capital. “Dedicated secondary players charge management fees and carry and have a higher cost of capital than non-traditional investors. As a result, the non-traditionals have made life tough for the specialists, and frequently outbid them in our auctions. The specialists have responded by using leverage and other structuring techniques to win deals,” says Cogent’s Jinkens.

Yet despite the increased competition, many specialists remain relatively sanguine. Given the rapid growth of the market, many feel there are enough deals to go around. Also, many specialists operate in the more customised, complex deal space, where LP buyers are still rare. “Competition for plain vanilla, larger and auctioned deals is ferocious now. But there is far less competition for smaller, mid-size, more complex deals,” says Greenpark’s Groen.

There are also still certain barriers to successful investment for newer buyers. To win deals, investors need solid relationships as secondary investors with GPs. They also need to really understand the underlying assets to price and structure bids to attract institutional vendors. “The rise in competition is not great news, but many of the LPs now buying secondaries are not looking at the same sort of deals as us. Also, our in-depth valuation skills and database analysis allows us to pay just as competitively for assets we consider attractive,” says Coller.

Sellers’ market

Even so, with competitive pressures causing secondary prices to leap in the last 18 months, it is very much a sellers’ market at present. While two years ago, nearly all secondaries were sold at discounts, with venture deals at a high discount, today many bids are at par, with premiums paid for higher quality assets.

Some statistics show that larger, plain vanilla transactions – those usually sold at auction – now fetch significant premiums. This is a complete turn-around from just a year ago. “Our research shows investors paid an average premium of 9% in 2006. This represents a significant increase on 2005, where on average we saw discounts of 5% to6%,” says Cogent’s Jinkens.

Although below the parapet of the auctioned deals, many secondaries are still sold at discounts – especially in Europe, where fewer deals are auctioned than in the US – in the auctioned space concerns are rising that some buyers are overpaying. “Prices have reached record levels that are even surprising some sellers. Quality, brand-name assets are attracting huge premiums now. Some buyers are overpaying to break into the market, or secure entry into GPs’ primary funds,” says Almeida’s Sachar.

Not only are investors paying more for assets, but leverage has rocketed. Today’s deals are far riskier. “An asset that was priced at a discount two years ago might go for par or a premium today. Also, we detect that some people are paying premiums for lower quality portfolios. One factor which is key here is that leverage in some underlying assets is higher than a couple of years ago and therefore portfolio risk has gone up,” says Pantheon’s Livingstone.

Many specialists predict trouble ahead for some deals, especially with a downturn looming. “Some deals being done now will make a loss because of the inflated prices that are sometimes being paid. We have seen this phenomenon before in relation to some highly priced transactions that were done in the late 90’s” says Greenpark’s Groen.

The way ahead

With pricing, leverage and risk all rising, it seems certain that, as in the primary market, returns will fall. Yet despite this, many specialists remain extremely positive. Firstly, they point out that in private equity generally, there is a large dispersion of returns. “Average secondary fund returns will definitely fall, in line with primary returns. But as in primary, the top quartile funds may maintain more constant returns. Our returns have not fallen in 15 years, despite several cycle changes during that time,” says Coller.

Returns are expected to fall far less in the more customised part of the market, while also average returns are still predicted to outperform other markets. “Secondary fund returns will fall in the next few years – particularly for the larger, auctioned deals. But even these are still likely to be higher than public market or hedge fund returns, which is why LPs are still heavily investing in private equity,” says Greenpark’s Groen.

Most industry experts also remain upbeat because they perceive huge opportunities. “Bigger, better, stronger, faster – that is the outlook for the secondaries market. Europe especially is hitting its stride and we expect significant deal-flow in the next few years,” says Cogent’s Jinkens.

With such vast primary funds raised and increasing demand among GPs and LPs for liquidity, the secondary market looks set for even greater record volumes ahead. Predictions are that 2007 volumes could soar to US$15bn. “1-2% of the pool of primary capital raised in the last eight to 10 years will come to the secondary market every year – which amounts to about US$15bn per year currently. And that’s without portfolios of directs coming from corporates and without an economic downturn, which will inject far more supply into the market probably in the not too distant future,” says Greenpark’s Groen.

Indeed, the anticipated private equity downturn is only expected to play into the hands of secondaries investors – as in the last dip in 2001 and 2002, when large numbers of unfunded positions flooded the market. “A downturn would actually be good news for the secondary market, as it would drive more assets into the secondary arena. Prices would also fall – although given the increase in competition, they might not necessarily fall as far as they did in the last downturn,” says Pantheon‘s Livingstone.

With the market thriving even more in a downturn, future supply seems assured. Secondaries are becoming a vital part of the asset class, with its increasing liquidity significantly boosting the primary market’s attractiveness. “Secondaries will continue along the current trend-line, irrespective of any downturn. Investors will start to look at secondaries as interchangeable with primary investments. From now on, if you have a private equity strategy, you will always have – or at least consider having – a secondary component. Secondaries are no longer a small part of the private equity landscape and all primary investors are now looking at them,” says Almeida’s Sachar.

There are still a couple of clouds looming on the horizon, however. Any downturn is bound to see some casualties and a fall-out in the number of players and fund raising difficulties are anticipated. “When the downturn arrives, there may be a reduction in the number of players – especially some of the newer entrants. It may also be harder for the market as a whole to raise new funds, as a downturn would negatively impact portfolios and investor appetite. There will be more opportunities for dedicated investors and volumes will increase, though,” says Coller.

Another concern is secondary firms’ ability to successfully invest the vast funds they have now raised. Even with the predicted healthy volumes, it is far from clear whether supply will be sufficient to satisfy the mammoth funds raised, especially given the intensity of competition for the more attractive deals. “There is too much money being raised for secondaries investment now. It is not clear that all the firms who have raised large funds will be able to deploy them to good effect,” says Coller.

Venture and directs rise in profile

Although traditional LP partnership interests in buyout portfolios continue to dominate secondary volumes, venture secondaries are attracting increasing interest from investors. In addition, both the number and volume of directs (where equity stakes in private companies or portfolios of private companies, rather than in private equity funds, are acquired) has risen notably in the last two years.

Indeed, increasing interest in venture is one of the major trends to emerge in secondaries in the past year. Although still a relatively niche part of the overall market, appetite has nevertheless rocketed. “From a standing start in 2004, when almost nothing was done, venture arrived on the secondary scene with a vengeance in 2006. The US market in particular has really accelerated, due to the maturity of the underlying funds and increased investor confidence,” says Cogent’s Jinkens.

One the largest public deals of 2006 was venture – Pantheon’s landmark acquisition of LP interests in a portfolio of 90 VC funds and eight minority direct investments from Italian fund-of-funds Cdb Web Tech in October. With a total transaction value exceeding US$400m, the deal was not only one of the largest secondary purchases of 2006 to be announced publicly, but also one of the largest venture transactions ever to be completed.

Direct venture secondaries are also on the rise generally – as seen with Pantheon’s funding of US VC fund QTV Capital’s US$123.6m purchase of a portfolio of venture and late stage growth equity assets from Alliance Semiconductor Corp in December.

Back in 2002, Pantheon had invested in the spin-out of the QTV team itself from Quantum Corp. “Although venture remains a small part of the global private equity asset class, the volume and number of secondary deals involving venture assets last year was significant. Distressed venture vendors are extremely rare now, but there remain vendors motivated to sell to rebalance their exposure within the asset class,” says Pantheon’s Livingstone.

Activity is mainly centred in the US. Not only is Europe suffering from a comparative paucity of deals, but to a certain extent, some negative perceptions of volatility and risk in European venture persist. Interest in Europe has definitely risen for mature venture funds, but many investors remain shy of early stage venture. “Although interest is definitely rising, venture is still a very small part of the secondaries market in Europe – a lot of our competitors here still don’t do it,” says Coller.

Even so, many European investors are keen to re-enter the asset class, snapping up US venture secondaries instead. “The worst 1999-2001 venture portfolios have long disappeared and the ones that remain now comprise good quality, growth assets. As a result, there has been a very significant increase in interest in venture over the past year,” says Almeida’s Sachar.

Scarcity value has only compounded demand for more mature European venture secondaries, with some experts saying there is even more competition for high quality, performing venture names than for buyouts. Some even say many venture deals are now attracting similar prices to buyout interests. “Historically, venture interests have traded at much less attractive prices than buyout. But in 2006, for the first time, venture pricing equalled buyout pricing. Surviving 1999-2001 vintage VC portfolios now mostly contain mature, high quality, transparent assets. This has fuelled competition, which has pushed prices up,” says Cogent’s Jinkens.

Meanwhile, although the directs markets is also still a relative niche, it has grown perhaps even more significantly than venture in the last 18 months. This growth has been partly driven by increased competition for assets in the secondaries market overall, propelling specialists to cast around for new ways to invest. Directs offer a higher return profile, as they are harder to do.

The rapid evolution in directs is also attributed to the many specialised directs players that have been founded in the last few years and, particularly, to the emergence of specialist managers such as Vision Capital, Nova Capital Management and Cipio Partners, which manage portfolio companies on behalf of buyers.

Many secondary players are passive investors unable to actively manage portfolio companies – something that had been a previous block to the market’s development. Yet the emergence of manager firms, or “rented GPs”, to manage buyers’ direct and co-investment activities post-purchase has caused many more secondary players to enter this space. Many of these manager firms also doing directs themselves – as seen with Vision Capital’s November agreement to purchase a portfolio of businesses from Northern Foods plc for £160m.