Institutional investors are more than one year into their infatuation with secondaries, as pension funds, endowments and foundations keep looking for ways to get a greater piece of the action. Most of these hungry hippos happily sponsor a burgeoning class of dedicated secondaries funds, although groups like the California State Teachers Retirement System (CalSTRS) and the Washington State Investment Board have developed in-house programs.
Why all the fuss? Before getting into the “official” reasons, it’s important to not discount the discounts. Secondaries are bargain buys, and can look awfully appealing to performance-pressured fund managers in need of a few quick hits. Consider this the Sam’s Club school of private investment thought.
The more academic issue, of course, is timing. Just like the private markets lag the public markets by a few months, the private secondaries markets trail the private direct markets by a few years. Example: Venture capital and private fund-raising volume rose consistently throughout the early and mid-1990s, and soon was mirrored by the secondaries market. When fund-raising activity went through the roof in the late 1990s and early 2000s, however, the secondaries market maintained its steady momentum. It wasn’t until last year that the secondaries market began getting to experience its own bubble (or boom, depending on your perspective).
Almost by definition, secondary spikes take on the desperate air of vultures rather than the euphoric yawps of dotcom groupies. Today, this means that the pipelines are filled with financial institutions and technology companies looking to bail on alternative assets. Such groups are willing to take significant haircuts for just a whiff of liquidity, and the burgeoning class has lined up to oblige.
If the lagging indicators stay consistent, secondaries market volume should begin to decline drastically in early 2005 (see chart in next story). Some investors might laud the drop as a return to rationality, but that will be little solace to those left holding dry powder bags. Just like their VC firm counterparts in 2001, few secondaries firms of today seem to be adequately preparing for a severe volume adjustment, and the resulting secondaries fund overhang could be even worse than that created by VCs, as measured on a percentage basis.
Can Portfolio Management Replace Portfolio Abandonment?
Most secondary market sources including those from the eventual over-hangers acknowledge that far too much money is being raised for the projected volume between 2005 and 2009. They also see LP floodgates remaining open to dedicated secondaries funds, particularly as downsized direct funds become more selective.
“Nobody is saying it out loud and I can’t have it attributed to me either but [secondaries] firms are still out raising hundreds of millions of dollars, or even a billion dollars, even though they know the returns are going to be terrible,” says an investor who wishes to remain anonymous. “Once the dealflow slows down, all the funds will either have to give back their commitments like the VCs did, or will be forced to invest with much smaller profit margins because of added competition.”
But all of the secondaries market’s gains will not necessarily be lost. It is true that wholesale divestiture dealflow cannot be totally replaced, but secondaries investors are counting on some measure of sustainability from limited partners who want to manage their portfolios, rather than abandon their portfolios.
Columbia Strategy LLC, a New York-based secondaries advisor details this progression in it secondaries evolution timeline (see chart). The group actually feels that most of the wholesale divestiture business is long past, and that the next few years will continue to see dealflow from limited partners who need to restructure their existing portfolios in order to continue making new investments.
“There has obviously been a boom, but we believe the secondaries market is here to stay,” says Bill Sanford, a principal with Columbia Strategy. “There will be some bumps and spikes along the way, but we do feel that there can be around $2.5 billion in annual activity in future years.”
Reasons that a non-abandoning limited partner would need to restructure include legal issues, allocation issues or an immediate need for short-term liquidity. The secondaries market seems best equipped to handle most situations of this type, although other options can include either total return swaps or asset-backed securitizations. Primary secondaries also have generated some interest as a liquidity strategy, although most of the buyers are large institutional investors looking to establish a relationship with certain general partners, for the purpose of gaining direct access to subsequent fund offerings.
Lawrence Penn, a director with secondaries advisory The Camelot Group, continues to see a substantial amount of wholesale divestiture, but also believes that portfolio management represents the secondaries market’s next evolution: “I think a lot of it is portfolio rebalancing, particularly among pension funds and other municipal investors who are over-allocated,” Penn explains. “Reassessing distribution flows from private equity portfolios needs to be done on an ongoing basis, just like you need to correctly manage any large part of your asset pool.”
Penn also believes that any slowdown of wholesale divestiture activity will, in part, be supplemented by dealflow from outside the U.S. and Western Europe. Camelot regularly sees opportunities from Eastern Europe, Asia and, in particular, Canada. “This is what happens when a market matures,” he says.
One other saving grace could be direct portfolio management on the part of general partners, although few deals of that variety are known to have occurred. The overwhelming majority of direct secondaries still are of the wholesale divestiture variety, and are dominated by corporations and high-net-worth individuals.
Managing Portfolio Management
The question of portfolio management prominence in the future secondaries market will partially be determined by the regularity of success both in terms of financial performance and ease of use. It also needs to continue shedding its stigma as the place to go when things go bad. Both developments are more important for ongoing limited partners than for those market deserters, since the latter typically have fewer options.
For LPs who do look to the secondaries market, the first hurdle is to accept responsibility or at least ownership of an underperforming investment. This may seem self-evident, but fund manager ego/denial has been known to complicate many portfolio restructurings.
It also is important to recognize that once an institutional investor has sold an LP interest in Fund X on the secondaries market, that investor will almost never be re-invited to be an LP on the follow-on Funds Y or Z from the same general partner. “Getting back in has got to be very tough if you’ve sold an earlier partnership,” says Fred Maynard, who oversees secondary partnership investing for Boston-based HarbourVest Partners. “It’s really a relationship management business, and selling a partnership is basically breaking off the relationship.”
Next, retain an advisor, so as to avoid flying solo. Some LPs seem to think that because they made their initial LP commitments without an advisor or with minimal guidance from one that the same rules should apply for the sale of those commitments. Instead, view it like a traditional venture capital exit, where firms bank advisors for an IPO or an M&A transaction.
This is particularly true if the deal will involve a large portfolio of LP interests, because both the buy and sell-side are going to want valuation guidance.
When selecting an advisor, the best advice is to get a second and third opinion. HarbourVest’s Maynard says that auctions are notorious for being poorly run, and that it’s worth trying to learn which advisors are held in high esteem by desirable buyers. Such information isn’t readily available and Maynard declined to share HarbourVest’s preferences but most institutional investors know somebody who knows somebody who can ask somebody… and who also can ask somebody else.
The best advisors are those who have close relationships with a wide range of general partners, because such relationships enable advisors to access confidential valuation information. They also should have demonstrable ties to high-end secondaries buyers, since quality trumps quantity when it comes to auction bids.
The Future Is (Almost) Here
Probitas Partners, a San Francisco-based provider of alternative investment solutions, issued a short report last year, titled Secondary Activity in Private Equity Investing: Liquidity for an Illiquid Asset. In its conclusion, the report argued that the secondaries market had become an inexorable presence in the liquidity management space.
“The same investor actively selling positions to rebalance its portfolio could follow by buying secondary positions to increase exposure to a particular general partner’s group or industry sector,” the report said. It added, however, that the market would increasingly become a seller’s paradise, particularly as large secondary funds encounter increased competition and a decreased ability to invest their billions.