More to come?

While many say the secondaries market has become saturated, with an increasing diversity among players, the growth of the secondaries market is predicted to continue in 2005. A number of secondaries managers raised funds during 2004 including AXA Private Equity, Greenpark Capital, Pantheon and Partners Group and a larger number are expected to be completing their fund raising or entering the market over the next 12 months. The secondaries landscape is expanding with players demonstrating a wide range of experience and tools required to handle the full spectrum of secondaries transactions, from single limited partnership interests, through to portfolios of multi-jurisdictional fund positions and portfolios of direct investments. Angela Sormani takes a look at the landmark deals of 2004 and examines the opportunities available for the funds operating in this highly competitive market.

James Pitt, managing director of AXA Private Equity’s London office, sees 2004 as the year when secondary fund investing moved from being a niche activity to mainstream. “Transactions of over US$500m became quite commonplace during the year and AXA Private Equity’s deal flow has been very strong in 2004 – in fact, we have never been busier. Our sense is that 2005 is shaping up to be just as active.” A good sign given that the group has just raised US$1.04bn for its AXA Secondary Fund III.

Joanna James of Greenpark Capital also forecasts a continuous growth of the market in the year ahead. “We estimate that by 2006 there will be close to US$25bn of secondaries capital available for investment, compared with approximately US$15bn that is in play currently.”

For Greenpark, the robust investment pace of its first fund allowed the team to be back in fund raising mode by mid-year 2004 and the firm announced the final close of its €350m second fund, Greenpark International Investors II, LP in record time following on from its first fund, which closed in January 2003. The new fund has again attracted interest from major institutions in Europe, the US, the Far East and the Middle East.

In terms of deal flow, most players for 2005 see a continuation of the regular secondaries deal flow, that is 1-2% of the primary capital pool, turning over in the secondaries market each year, representing sellers who are looking for an exit for reasons such as strategy shift, housekeeping or alignment of portfolios.

According to William Sanford of US secondaries specialist Morning Street Capital, the majority of deal flow in the secondaries market last year came from non-distressed investors such as banks and endowments and pension funds as they have sought the selective restructuring of assets and are increasingly practicing active management of their private equity assets.

But the deal flow spike that has been apparent over the last year or so, generated by the banks selling in order to bring their capital adequacy ratios into line coupled with a concern about the volatility of private equity earnings, should be coming to an end during the next 12 months as the underlying issues are resolved and Basel II comes into force. And so secondaries players will be looking to other sources for deal flow.

Sanford says: “In 2004, the secondary LP market has become overly saturated as there is too much capital and too many players chasing too few opportunities. Quality deal flow has decreased with respect to the number of quality LP portfolios available in the secondaries market relative to the number of buyers chasing such opportunities and the resultant pricing.”

As a result, he says, many large buyers have reset their sights and are bidding for or have acquired medium and smaller sized LP portfolios. He adds that in 2004 secondaries LP discounting continued to decrease significantly and has become a serious issue for secondaries LP funds as their investment strategy is significantly based upon discounting to ensure an up-front return. “In 2004, many LP portfolios transacted in the secondaries market were priced at a premium to NAV. I would estimate that the average LP portfolio sold in 2004 was transacted at a 20% discount to a 10% premium of NAV.”

But Jordan predicts deal flow will remain robust. “We are seeing an increasing level of complexity involved in structuring secondary deals as we work with sellers to find solutions to their liquidity needs. Although the large auction transactions are the only types of secondaries hitting the press (Abbey National, Swiss Life, Deutsche Bank, Credit Agricole), a significant proportion of deal flow is proprietary and handled discreetly by experienced practitioners who can provide a seamless service.”

The past year also saw the birth of specialist secondary funds, targeting so-called early secondaries or late primaries, where the uncalled capital in a transaction is significantly higher (up to 70% unfunded) than in traditional secondaries (approximately 30% unfunded). Funds such as Greenpark focus on the more mature funds. Jordan says the fund to date has averaged just 14% of uncalled capital, allowing for greater visibility and less uncertainty of where capital is to be deployed.

Other specialist secondary offerings include those focused on purchasing portfolios of direct investments and those purchasing the smaller sized deals. And as the secondaries market matures, further developments in the level of specialisation are bound to occur.

There is always talk of the synergies between fund-of-funds and secondaries funds. Will there be more of these players converging to offer both products in 2005 such as industry giants HarbourVest and Pantheon have done?

André Jaeggi of fund-of-funds Adveq is not so sure whether there are enough synergies between the two business techniques for it to work for their type of business : “We don’t do secondaries, it is a totally different business – it is related to M&A and arbitrage hopes. Our business is manager selection.”

He adds there is a risk that investors who are new to the asset class will try to access the secondaries market in order to speed up their returns. The main concern for Jaeggi is whether secondaries players know exactly what they are investing in. In order to be successful you need to do due diligence on the underlying investments and in a secondaries fund this can be time-consuming and expensive.

Jaeggi agrees that there are parallels between fund-of-funds and secondaries in that both players are fighting for the same institutional money. “An investor has a choice between putting together a pure private equity portfolio where he has quite a long waiting period or investing in a secondaries fund. In secondaries, obviously the cash flow streams are somewhat limited, but they are faster. That is an advantage that secondaries players do have.”

He adds: “To offer a secondaries fund-of-funds might be a good idea to speed up the realization of a portfolio. We wouldn’t add a secondaries offering. You really need an M&A skill set – we think it is a different business. Buying a secondaries portfolio is not a manager selection play, it’s really trying to get discounts on the underlying investments.”

In addition, he says quality-wise the secondaries market is never going to be as good as the primary market. After all, these are second-hand investments. He says: “You also have to face a situation where the interests in the best funds are tied to the rights of first refusal of the other LPs in the fund. So the top-quality secondaries never really come to the market. Quality-wise, it’s not as good as the primary market from the onset.”

Pantheon is one player that has managed a convergence of the two investment techniques. Earlier this year the group, which is now part of Russell Investment Group, closed its latest global secondaries fund on US$900m. The fund raising for Pantheon Global Secondary Fund II (PGSF II) took less than nine months. Some 60 investors from the US, the UK, continental Europe, Scandinavia, Asia and Australia have committed to the fund. Pantheon has been active in the secondaries market since 1987 when it launched Pantheon International Participations (PIP), a listed secondaries fund. Since then the firm has committed over US$1.3bn to secondary investments worldwide completing over 500 fund purchases and 50 portfolio transactions.

A natural progression

As the secondaries market matures, so the number players servicing this market is increasing. Such an example is Triago whose main business is helping private equity firms find investors for their funds. Triago has recently launched Triago-X, a dedicated group for secondary transactions of private equity fund interests. As a natural extension of its fund raising activities, Triago has advised a number of institutions and private groups on secondary transactions covering the entire spectrum from single fund positions to large diversified portfolios. Triago views secondary transactions not only as a transfer of ownership, but as an opportunity to introduce general partners to new relationships and to strengthen their investor base.

Triago-X represents potential sellers and provides them a discreet access to a global network of qualified buyers. The group also intends to develop its online tool,, for the benefit of its members to help bring potential buyers and sellers together. The group is aiming to sell between US$500m and US$1bn of private equity assets second-hand each year.

Nova Capital Management is another natural development of the market. Established around two years ago and with backing from minority shareholder Caledonia Investments, Nova is a portfolio management company targeting under-performing and under-managed portfolios run by private equity and venture capital firms. The firm has just announced the opening of an office in the US and expanded with a number of hires last year.

Managing partner Michael Kelly, says: “The story of what has happened to us and how we are developing is a reflection of what is happening in the market. A more proactive LP community is fuelling this market – underperformance is no longer being tolerated. We’re having more and more discussions with LPs who are concerned about underperformance of funds and want us to have a look at them. Many GPs thought this would never happen and that the LP agreement would be too restrictive. Now it has happened it has caused quite a stir and opened the door for more opportunities for players such as Nova.”

The Albemarle portfolio last year was the first hostile replacement of a GP in the UK. Ninety per cent of the LPs in the fund voted to replace the incumbent manager with Nova. And Nova also sees more of such opportunities presenting themselves on both sides of the Atlantic. At the recent Super Investor Conference in Paris, the largest private equity and venture capital player, CalPERS, stated that it needs to reassess its portfolio of partnership relationships. Indeed CalPERS recently announced it had reviewed its asset allocation strategy and will do so every three years from now on.

“The interests in the best funds are tied to the rights of first refusal of the other LPs in the fund. So the top-quality secondaries never really come to the market.”

Nova has recently taken on a tech portfolio, which was previously managed by West LB, funded by HarbourVest. Kelly says: “One of the trends emerging is the importance of the relationship we have with the LPs in the fund we have acquired or are managing. This is a source of deal flow for Nova – relationship-building and getting requests from these LPs to look at other funds in their portfolio.”

Kelly is also seeing more interest from LPs wanting to back a direct portfolio of investments rather than backing an unidentifiable pool of assets. “In a secondary situation the LP knows exactly where the money is going and they are going to get a return in a shorter space of time. Secondaries definitely have a place in an LP’s mix of allocation in this market. We are seeing more LPs who are saying they are interested in investing in these deals.”

There is a lot of confidentiality surrounding this market because of the mere nature of these deals, adds Kelly. “A lot of the vendors appreciate confidentiality, but they’re realistic about what that means. For example, at the time of the Albemarle deal, which was a fairly hostile removal, the market knew it was happening, but you never saw a press release or a quote from us about it. There’s a risk that if there’s too much transparency too early on, the deal will fall through. Everyone behaves secretively with secondaries. But word gets out very quickly among the community about who’s working on what, where and how.”

Looking towards the future, the market will get more specialized with more niche players. And there will also be an increase in structured transactions bridging the gap between purchaser and vendor.

William Sanford predicts secondary LP funds will continue to aggressively compete for a diminishing pool of assets. And so pricing in the secondary LP market will continue to increase and the average discount will be nil and perhaps even at a premium to NAV. But Sanford does foresee the secondary direct market experiencing a significant increase in volume and deals, as the increase in secondary direct specialists and capital for direct deals will help to source and complete transactions. He predicts secondary direct discounting will still exceed 50%, but will decrease throughout the year. Large and medium sized secondary funds will continue to aggressively source deal flow from medium and smaller sized portfolios and more single/one-off investment positions will be pursued, compared to the traditional strategy of sourcing only investment portfolios.

The attraction of the secondaries market remains for limited partners, particularly those unfamiliar with the asset class because secondaries offer a known quantity and contain existing assets, which a buyer may hope to get at a discount because of the seller’s need to cash out. But for the best-performing funds as always buyers will have to pay a premium.

Reduced risk, however, does mean lower returns than direct investments in nascent private equity funds and buying an LP stake in a fund that has posted for example 30% annual returns and invested 80% of its capital may yield returns of only around 15% to the secondary buyer.