Secondary volume dips as regulatory-driven sales dry up

Private equity secondary professionals say deal activity may slow this year as financial institutions pull out of the market amid deregulation.

In December, the Federal Reserve Board extended by five years the deadline by which financial institutions must comply with rules governing bank-owned PE. Dodd-Frank’s Volcker Rule limits how much capital banks can tie up in illiquid investments.

The deadline for compliance with this rule, part of the Dodd-Frank Financial Reform act, was July 2017. Banks had become significant sellers on the secondary market as the deadline loomed.

The Fed addressed the extension in a policy statement regarding illiquid fund investments.

“Banking entities argue that it is difficult to sell or terminate contractual commitments to third-party illiquid funds for a variety of reasons, including that the terms on which a banking entity is able to terminate a contractual obligation and sell these interests are often commercially unreasonable,” the Fed wrote.

“Banking entities have indicated that buyers often demand deep discounts ranging from 20 percent to 90 percent relative to current net asset value, and may have little interest in the purchase of the fund if they do not want additional exposure to the general partner of the fund or the remaining assets of the fund.”

With the extension, some banks have pulled processes they had brought to market to sell off PE holdings. This occurred with at least one bank that was selling a portfolio, and after the extension was granted, pulled it off the market, according to a buyer on the secondary market.

“I would bet many secondary funds will be drawing lines through deals where the seller was a Volcker-motivated seller,” said Mike Bego, managing partner at secondary shop Kline Hill Partners. “It’s a positive thing for the banking sector that the government is not regulating banks to spend a lot of time and effort to drive sales resulting in realized losses.”

But financial institutions have been major sellers because of regulation, and overall that cycle is slowing down, a second buyer on the market says. “As a proportion of historical potential trading volume driven by regulatory change, most of it has been taken care of,” the second buyer said.

PE secondary market volume in 2016 was expected to fall below the around $40 billion posted for 2015. Part of the slowdown stems from a lack of large portfolio sales, many of which were sold by large financial institutions.

“The regulatory-driven sales cycle is nearing its end,” the second buyer said. “Most large banks who felt like they needed to do something as a result of the regulatory picture have accomplished what they wanted to do.”

Banks represented about 16 percent of the seller universe in the secondary market in the first half of 2016, according to intermediary Setter Capital’s first-half volume report. The expectation was that would fall to around 14 percent in the second half of the year.

Banks are thus likely to become an even less significant slice of the seller universe with the Volcker extension, as well as the Donald Trump administration, which has made deregulation a priority.

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Fed Chairman Janet Yellen prepares to deliver the semiannual testimony on the “Federal Reserve’s Supervision and Regulation of the Financial System” before the House Financial Services Committee in Washington, on Sept. 28, 2016. Photo courtesy Reuters/Joshua Roberts