Secondary coming

With US$13bn transacted in 2007, the secondary market is here to stay. Ostensibly, the movement of portfolio holdings, both individual companies and “package deals”, between limited partners, the current market turmoil has long been expected to trigger some investors to want to revisit their alternative asset strategy.

With last year’s tally a 48% rise on the US$2bn transacted in 2002, however, it is clear that the market has been a long time coming and will not just be a reaction to the credit crunch.

At a round table on the secondary market conducted by Morgan Stanley Alternative Investment Partners, the fund of funds arm of the investment bank, and sandwiched between discussions on hedge funds and real estate, John Wolak, managing director noted that the purchase of secondary portfolio assets had become more mainstream.

In many ways, it has correlations with the development of secondary buyouts, which were initially tarnished with the image of buying “damaged goods” – the selling private equity firm, it was said, had surely extracted maximum value before a sale, so what would be the upside for the buyer?

General partners soon got over such concerns and secondary buyouts now form an established bedrock of financial sponsor-related activity – in the current climate, they have formed the bulk of transactions in the mid-market this year.

At portfolio level, there is still some way to go. According to Morgan Stanley, the secondary market currently only accounts for 2.6% of total private equity funding.

In addition, an estimated US$75bn in secondaries is expected to come to the market in the next five years, over which time about US$40bn is expected to be raised by dedicated secondary funds – already in the market are AXA Private Equity, Henderson, Pantheon Ventures and Lexington Partners – to which leverage may add US$10bn.

So, what is a limited partner’s motivation for engaging in the secondary market? According to Wolak, activity is largely focused on rebalancing portfolio exposure, disposing of non-core GP relationships and reducing the administrative burden. For the buyer, there is also an obvious upside. “Assets are further along, closer to an eventual exit and fewer fees are involved,” says Wolak.

The point about the administrative burden could be an important one. Although JPMorgan Chase launched a new business arm last year offering fund and portfolio administration to European and Middle Eastern private equity firms and their limited partners, some of the larger institutional investors may well need to take more drastic measures.

In the US, the California State Employees’ Retirement System sold a portfolio of legacy private equity fund commitments, reportedly containing about 50 funds, for around US$3bn to a list of usual suspects, comprising Pantheon Ventures, HarbourVest, Lexington Sponsors, Oak Hill Investment Management and its joint venture with Bank of America, Conversus Capital.

While such large-scale deals are unlikely to be seen in Europe for now, there is expected to be plenty of movement as the market shifts away from the US to become more global.

“Supply of opportunities is outstripping the capital available, which will be a good thing for pricing,” says Wolak, who notes that with just 15 to 20 firms involved in secondaries globally and a similarly short list of advisory services available, such as specialist lawyers, manpower will be stretched.

“2004 to 2006 was a sellers’ market,” concludes Wolak. “Hopefully it will swing back in favour of buyers in the future.” Many new investors keen to get a foothold in a crowded fundraising environment, and more mature LPs looking at portfolio management tools, will hope Wolak is right.