Secondary Rally Could Suffocate Primary Fundraisers

Rising prices for secondary interests, a sizable pool of interests for sale, and a host of new buyers hitting the market are generating more activity in the secondary sector, which in turn is threatening to divert hundreds of millions, if not billions, of dollars away from the primary fund market in the coming year.

Several limited partners plan to raise their exposure to the secondary market next year—either through dedicated funds or by cherry-picking interests on the secondary market—at the expense of commitments they may have made in the primary market. That’s not welcome news in a fundraising market that’s already in the doldrums. In the first 11 months of 2009, U.S. buyout and mezzanine firms raised little more than $60 billion in new commitments, compared with nearly $250 billion during the same period in 2008, according to Buyouts.

Five LPs recently polled by Buyouts said that any investments they make in the secondary market next year will reduce the amount they commit to new funds. Of that group, three investors—Guardian Life Insurance Company of America, the Tennessee Consolidated Retirement System and the Universities Superannuation Scheme—said they have already decided on, or are considering, increasing their allocations to the secondary market next year (see accompanying chart).

A fourth LP in that group, the Chicago Firemen’s Annuity and Benefit Fund, plans to reduce its overall commitment to secondaries in 2010 to $10 million from $15 million in 2009, although any secondary pledges it does make will likely offset commitments to primary funds on a dollar-for-dollar basis, according to Mike Moran, the fund’s CIO.

Meanwhile, according to secondary firm Coller Capital’s most recent survey report, Global Private Equity Barometer, 32 percent of the 108 LPs surveyed said they expect to invest more in secondaries in the next two years, while another 37 percent said they will at least hold their exposure steady at current levels.

Another recent report by San Francisco placement agent Probitas Partners said there is about $21 billion in secondary pools either already in the fundraising market or otherwise expected to be some time in 2010. Several of the vehicles listed in the report, including Coller Capital’s $6 billion-targeted Coller International Partners VI and Lexington Partners’s $5 billion-targeted Lexington Capital Partners VII, are aiming for more dry powder than most new buyout funds in the market.

Lightly-called funds have become a particularly popular flavor among secondary buyers. A number of buyout funds raised in the 2006 – 2007 timeframe have been slow to put their capital to work due to the sluggish deal pace and lack of leverage that followed the financial meltdown. Secondary stakes in these funds offer buyers a discounted entry into vehicles that still have relatively long lives ahead of them.

“It’s basically a primary investment with a kicker,” said Jean-Marc Cuvilly, a partner at placement agent Triago, which also provides sell-side advisory services for secondary trades. “You’re getting a portfolio of active assets, but there’s also quite a bit of unfunded capital to be called. A lot of guys are going that route.”

Goldman Sachs is expected to raise a $300 million vehicle, called the Goldman Sachs Early Secondaries Fund, to buy commitments to private equity funds that are only 10 percent to 20 percent called.

In October, the Maine Public Employees Retirement System tapped investment consultant Cliffwater LLC to help it invest $100 million over the next two years in what it calls “young secondaries,” or funds in which capital commitments are not completely drawn down. The LP, which made its first-ever private equity investment this summer, will likely use the strategy to help it lay a foundation for its portfolio.

Dollar-wise, about two thirds of all secondary deal volume that Triago represented in 2009 year were for lightly-called assets—some of which were still about 90 percent uncalled, Cuvilly said. Discounts on such funds reach up to 30 percent on the high end, he added. “There will be a lot of savvy LPs out there that will look to purchasing secondaries in funds that they know, and they may choose to do that rather than commit to the newest fund out there,” Cuvilly said.

Supply Side

Industry pros believe there should be more than enough supply to meet the growing demand. “Given that trillions of dollars have been committed to PE over the last six to seven years, even if one assumes a very modest churn into the secondary market, this demand clearly outstrips the estimated $30 billion of capital sitting in secondary funds which is to be deployed over the next two to three years,” said Luca Salvato, a principal at Coller Capital.

This build-up in supply is more than a year in the making. The stock market collapse in September 2008 ignited a major sell-off of private equity interests due to the denominator effect. As public market valuations fell, the percentage of illiquid assets in portfolios hit disproportionate highs. LPs like Harvard University and Columbia University grew desperate to rebalance their portfolios and began dumping private equity holdings on the secondary market.

The attempted mass sell-off led to prices hitting distressed levels, with many funds trading at discounts well north of 50 percent and rumors of others being given away by LPs desperate to avoid capital calls. By March 30, 2009, the median bid for buyout funds worldwide was just 39.89 percent of net asset value, according to Laurence Allen, managing member of NYPPEX Private Markets, an intermediary for secondary private equity transactions. With bids that low, sellers had a difficult time getting comfortable enough to let go of their assets.

Now, however, prices are on the rebound, and transaction value has followed suit. As of Dec. 1, the median bid for secondary interests in buyout funds worldwide was approximately 51.38 percent of net asset value, according to Allen. Between this year and next, Allen said he expects a total of $120 billion of private equity assets to be offered for sale on the secondary market. As of early December, more than half (57 percent) of NYPPEX’s secondary offerings consisted of buyout funds. Those funds had a mean vintage year of 2004, with an average of 72 percent of their capital already called by their general partners.