Institutional investors are becoming active buyers on the secondary market, and that has some traditional players crying foul.
Some see the development as natural, since limited partners like pension funds are already familiar with certain general partners and their underlying portfolio companies. These LPs are using the secondary market as a way to further commit themselves to the funds that have shown them adequate returns.
Many limited partners feel that they have more influence over the direction of the general partnership of funds they are invested in if they can also enter the fray as a secondary buyer. Coming in as a secondary buyer also gives entree to new limited partners. “There’s a different motivation,” says Peter Holden, a managing partner with the research firm Columbia Partners. “Some LPs do it to pool assets. They know who the LPs are in the funds. They are much more proactive. I think it’s a healthy development.”
Others, however, see traditional LPs as a threat to dedicated secondary players, because they have a lower cost of capital. Such a non-traditional buyer might have a goal of a 15% to 20% discount whereas the large secondary fund would need to get a 30% discount. “The ones we’ve seen have been larger pension fund investors whose cost of capital is obviously a lot lower than ours or any of our competitors,” says Anthony Roscigno, a partner with Landmark Partners of Simsbury, Conn. “So it’s easier for them to be a little bit liberal on their pricing and easy for them to buy large portfolios with big un-funded commitments. To them it almost looks like a primary fund investment. If they can buy portfolios of relationships that they’re already in for a lower price, that makes sense.”
Cogent Partners, a secondary research and advisory firm, says that about two-thirds of the deals it handles include or are led by non-traditional players. In the past year Cogent has had a non-traditional player buy two very large portfolios valued at $200 million and $300 million, says Ian Charles, a vice president with the firm. He adds that the larger funds may have a hard time deploying all of their capital due to increased competition from these buyers.
“Institutional investors that are involved in secondary deals have become comfortable enough doing secondary purchases to allocate more money for those deals,” says Peter Martensen, a director with the Pacific Corporate Group (PCG).
For example, the Washington State Investment Board (WSIB) dedicates $100 million to its secondary program, which is dedicated to purchasing secondary limited partnership interests in funds in which it has already invested as a limited partner.
PCG oversees WSIB’s secondary investment program, which invests between $10 million and $35 million per deal. The focus is on domestic and international buyout and domestic venture capital partnerships sold by U.S. limited partners. WSIB buys secondary interests in venture capital funds that are less than 50% funded with a preference for funds that are less than 25% funded. As for buyouts, WSIB likes funds that are more than 50% invested, with a preference for funds that are more than 75% funded.
Founded in 1981, WSIB manages $52 billion in assets for 33 various retirement and other funds for state employees. With a private equity target allocation of 17%, it has committed more than $14 billion into 156 venture capital and private equity funds, including funds managed by Accel Partners, Apax Partners, Battery Ventures, HarbourVest Partners and Oak Investment Partners.
Like WSIB, the California State Teachers Retirement System (CalSTRS) is another major LP that has made direct secondary purchases. Real Desrochers, CalSTRS director of alternative investments, downplays the cost of capital advantage that programs like WSIB and CalSTRS may have over traditional secondary buyers. “I don’t think we have a competitive advantage,” Desrochers says. “The volume hasn’t been what people were expecting.”
But while not competing on the same level as traditional secondaries, the instances of LPs becoming a direct buyer has been happening more and more. “This is a different strategy,” Desrochers says. “You get a foothold with a good name with the idea of being an LP in the future.”
PCG’s Martensen cautions that the secondary market is becoming crowded with inexperienced investors who are threatening to make a mess of things. “There are a lot of new entrants who you’ve seen in secondaries who don’t quite understand private equity and are probably maximizing the prices that they’re paying for opportunities and pushing some of the efficiencies out of the marketplace,” he says.