This article is excerpted from the second release of Columbia Strategy LLC’s latest secondaries research report, “What Private Equity Firms Need to Know about Secondaries.”
Last year the secondaries market saw a transaction volume of nearly $9.2 billion, representing a 157% increase over 2002 volume, which registered approximately $3.6 billion. The majority of secondaries activity originated from corporations and institutions divesting non-strategic portfolios. However, a large component of this growth stemmed from a few large international banks restructuring their private equity holdings in an effort to reduce exposure to the asset class. In addition, the emergence of tail-end funds being sold off also contributed significantly to secondaries growth.
Overall secondary deal volume is expected to total about $23 billion from 2004 through 2006. There are fewer distressed sellers in the market, and buyers are seeing reduced leverage in transactions, as compared to recent years. The “fire sales,” a market phrase often used to describe sales at all costs, are over and we are nearing the state of market maturation where secondaries activity is primarily based upon various “active management” strategies (investors proactively divesting underperforming investments and/ or redeploying capital into new investments). Asset allocation changes and portfolio rebalancing are becoming more usual, as investors have come to rely on the liquidity offered by the secondary market. Historically, once reliable liquidity is introduced into a market, much like the mortgage market of the 1980s, it often becomes sustainable and will continue to grow.
On the buy-side, $18 billion has been raised by dedicated secondary investment vehicles. Most of that capital is allocated for purchase of limited partnership interests and is managed by only a few buyers. Many of the secondaries funds, which were relatively small until two years or even a year ago, are now quite large, often exceeding $1 billion or more. These funds have been forced to deploy their capital in larger and larger deals in order to put money to work in a reasonable timeframe.
Emergence of “Nontraditional” Secondaries Buyers
The last two years have witnessed the emergence of “non-traditional” secondaries buyers who do not have dedicated secondaries vehicles, but actively buy on a secondary basis – with the vast majority focused on buying LP interests rather than directs. Pension funds, such as General Motors Asset Management and AlpInvest Partners (formerly NIB) have been active buyers, some participating in large syndicates. Foundations, endowments, fund-of-funds, and even sophisticated family offices are increasingly buying in the secondary market, after witnessing the strong returns with minimized volatility often inherent in secondary investing. They typically buy only LP portfolios rather than directs, given the management burden of directs, the uncertain amount of follow-on capital often required with directs, and the difficulty assessing and pricing directs. Interestingly enough, often these buyers are already investors in secondaries funds, competing or participating alongside the funds in which they are already invested. Sellers with fund portfolios have gained experience and now actively look beyond the secondaries buyers to these non-traditionals, as they are typically less price sensitive due in part to their lower cost of capital. Moreover, GPs have increasingly exercised approval rights in LP transfers, in favor of buyers who can invest in their next fund. This trend in approvals represents a tremendous advantage to the pensions, endowments, foundations and fund-of-funds over a traditional secondaries fund. This emergence of new buyers has dramatically changed the supply-demand ratio in the LP secondaries market and substantially added to the increased pricing power of sellers.
Secondary Fund Returns
Among the reasons secondary firms have been so successful in raising capital is their impressive historical returns. From 1987 through 1999, secondary funds have had time-weighted returns averaging 27.19%, significantly higher than either venture or primary buyout funds returning 22.26% and 14.72%, respectively. At the same time, secondary funds have boasted significantly better risk-adjusted returns with an annual standard deviation of 10.82%, while venture capital and buyouts have registered in at 17.78% and 12.63%, respectively. The reduced risk present in secondaries investment occurs because the typical investment sold into the secondary market consists of seasoned assets-“survivor assets” made up of companies further along in the “J-curve.” As portfolio companies become more seasoned, transparency increases, as more data points and information become available to assess company performance. As capital has increased on the buy-side and the secondary market has become more efficient, particularly on the limited partnership side, returns have come under pressure. Secondary funds have been able to achieve superior returns in the past due to little market competition, but as competition increases, prices increase and returns suffer accordingly.
As the secondary market has matured, there has been an increase in specialization and specific market focus among buyers. In part, this change is a natural result of the rapid increase in deal flow and transactions beginning in 2001. Buyers simply could not bid on all deals offered. Firms have been forced to develop areas of expertise in certain industries, stages, geographies, vintage years, and asset types (LP vs. directs). Particular expertise and areas of focus have allowed for more scalability in the pricing of assets and due diligence. Additionally, this change has eased the burden of managing the assets themselves. Specialization has also occurred simply as a means of fund-raising. A great deal of capital has flooded into this market, forcing funds to differentiate themselves and their strategies to LPs.
A Focus on Buyouts
For some time, there has been an increased focus on buyout assets, which have recently been more favored by many investors and, in many cases, have experienced bid premiums in the secondary market. Many funds raised or currently in the market have a near exclusive focus on buyouts, which would not have been seen only a few years ago. The secondary market is, in large part, driven by the growth in primary private equity investment in the preceding years. For example, from 2000 to 2002, there was a rebalancing in the primary market, as more and more capital shifted away from early-stage investments into late-stage and buyout investments. Late-stage and buyouts increased from 38% of private equity allocations in 2000 to 86% in 2003. With that shift, more and more late-stage and buyout assets have and will become available in the secondary market.
A Focus on Directs
Secondary direct deal volume is expected to total approximately $12 billion from 2004 – 2007. The large influx of secondary direct activity in 2004 is generated by the anticipated “in-house cleaning” of private equity portfolios by corporates and private equity and venture capital funds. These portfolio divestitures and tail-end fund sales will drive the secondary direct market. The approximate capital raised by secondary buyers for direct assets hovers between $2 billion and $3 billion, demonstrating that this is truly an underserved sub-asset class in the secondary market.
Particularly in the direct market, deal structures have become more complex and highly structured, compared with simple outright LP sales. When our firm first applied the term “structured partnership” to secondary transactions in our first research report in 2002, such mechanisms were rarely used and such frameworks did not exist for sellers to consider as options. Since then, the structured partnership concept has become widely used for the divestiture of direct portfolios. The use of these mechanisms has helped certain buyers to better complete direct deals and specialize in an underserved market.