Second chance saloon

It's November 2008; the ripple effect of Lehman's collapse has transformed into a vicious tsunami that is ripping its way through the banking sector, the public markets are in free-fall, and the economy is plunging in the face of rapidly declining public sentiment and spending. Private equity's big backers - the banks, pension funds, endowments and foundations - are all struggling with liquidity issues. Predictions abound of a wave of defaults and a corresponding boom of secondaries.

The months wear on and the predictions keep coming, but the tipping point is never reached. In fact, by all accounts it is a comparatively lacklustre year for the secondaries market. For those in a tenable position, unattractive valuations caused by a lack of visibility on future earnings provide little incentive to sell, while those with more pressing liquidity concerns are not pushed over the edge as primary dealflow dries up and draw-downs requests are minimal.

Fast forward to the present, and one year on from the voracious predictions at the end of 2008 the secondaries space is again in vogue. Primary dealflow has recorded two quarters of growth on the back of improved conditions in the wider economy (see page 14), prompting many to speculate that LPs will no longer be able to hide from their problems. Defaults are again being talked up; LP stake sell-offs are expected to turn from trickle to flood.

False dawns

Like before, however, the market could be setting itself up for disappointment. It is true that new deals are once again on the agenda, but this may not have the dramatic effect on LPs that it would have had 12 months ago. In short: liquidity concerns are not what they used to be. The denominator effect has given way to a counter-balancing numerator effect, as public stocks have experienced a prolonged rally and illiquid portfolios have been written down sharply.

The lack of draw-down requests has also given many LPs time to deal with their issues (indeed, many were said to have actively requested an investment hiatus for precisely this purpose). "People have defined away their problems, which were essentially artificial," notes Brenlen Jinkens, managing director of secondaries advisor Cogent Partners. He cites the example of CalPERS, which raised its strategic allocation to alternative asset classes to mitigate against the drop in value in its wider portfolio; an "elegant solution". Some LPs may now even be underweight to private equity.

There are also doubts over the improvement in pricing terms that has been witnessed in recent months. Yes, the gap from average bids to NAV has narrowed considerably - according to many, discounts reached 70% or more in the early part of this year - but this is something of a misnomer. "Offered prices are a little higher now but the percentage drop in discounts is largely due to declines in many funds' NAV," explains Eric Pathe, investment director of secondaries specialist Greenpark Capital.

If fears of a false dawn do prove true, this could cause a problem for those that moved into the space in the gold rush of last year. According to Tom Cartwright, partner at UK-based law firm Taylor Wessing, there was a surge in fundraising for secondaries at the end of 2008 and beginning of 2009 and, like the large-cap buyout space, this capital may struggle to find a home. "Everyone thought you'd be able to buy interests for an absolute song, but there just isn't the volume of desperate sellers. The market is pregnant with cash and it's difficult to see how many of these firms can deploy capital effectively in the short term."

From short term to long term

Like much else in the opaque world of secondaries, even the assertions of a large movement into the space begin to appear flimsy when scrutinised. Pathe argues that many of the "new entrants" to the space are in fact opportunistic LPs that already invest in private equity, many of which were not doing traditional secondaries deals. "Many are looking at largely unfunded positions rather than mature positions, often in funds they are already in," he says.

These deals make sound economic sense. The LP gets exposure to a desirable fund - one perhaps that it was denied access to the first time around - and gets a discount on the money already invested to boot, boosting the good returns it obviously believes are possible. There were even reports that during the first few months of this year, panic had set in to such an extent that some LPs were paying buyers to take their unfunded positions off their hands (and therefore off their balance sheet).

So what of the core secondaries players? Well, things have seemingly improved for them too over the course of the year. There was a time when these firms were prevented from buying into top tier funds, as the LPAs of many major GPs prohibited sales of interests to any buyer that lacks a primary investment programme with which to follow-on into the next vehicle. This, clearly, is no longer a priority. "Ultimately GPs are very commercial animals: they are very happy at the moment if they can get in an investor with enough liquidity to meet the calls," affirms Jinkens.

Moreover, while GPs may be more relaxed about entry into their funds, improving market conditions are also making it increasingly likely that LPs' fears can be assuaged. Even the recent decline in NAV discounts, for all that they are something of a fallacy, are said by some to be providing a bridge for the vendor-buyer pricing mis-match. "We're beginning to find a new pricing level that is acceptable to some vendors, largely due to increasing visibility and confidence in the value of their interests," Pathe suggests.

What is more, while the prospects of a short term surge do appear to be somewhat exaggerated, the legacy of the boom years is encouraging for the long term prospects of secondaries investing. Buyout funds that are unlikely to see positive returns and the ongoing de-leveraging of the banking sector form part of an industry re-alignment that will provide opportunities for some time to come. "The supply of deals will come through. Though it is unlikely that there will be a tsunami, executable opportunities will come as the asset class needs to re-balance," Pathe continues.

Maturing market

This last point is key: though the worst of the crisis would appear to have passed - and it would not be wise to be anything less than cautiously optimistic on that score - the private equity industry has not yet dealt with some of the structural issues left over from years of excess. Hyperbole aside, opportunities for secondaries investors are almost inevitable; in what form and on what scale is less clear. Jinkens warns against expecting too much too soon: "2008 was the biggest year on record, it will likely be some time before that is topped."

The market has been on a long-term growth path for some time, as it has shaken off the stigma that, in an immature market, was attached to such deals, and this growth looks set to continue. Indeed, if the current crisis has taught investors anything, it is that things can change very dramatically very quickly, and 10 years is a long time over which to commit capital. Says Pathe: "In the future we might see more fund interests recycled in secondaries - perhaps only up from around 3% now to more like 5%, but even then we are talking about a lot of money."

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• Topics
• Secondaries
• Southern Europe