The wheel turns...

The symptoms that were affecting the financial markets as a result of the sub-prime crisis and subsequent squeeze on credit have rapidly evolved in recent months into a broader decline that is spreading throughout the entire economy. Behind the headlines of bank bail-outs and interest rate cuts lies a global economy that is seemingly heading inexorably into recession, and this is putting increasing strain on private equity. Portfolio companies acquired at inflated prices with large quantities of leverage are beginning to feel the pinch, meaning erstwhile attractive returns are likely to see a substantial correction as exit routes (and valuations) decrease and hold periods extend significantly.

On the other side of the partnership divide LPs are also feeling the squeeze. With many areas of their portfolio in decline, institutions are currently reviewing their allocation breakdown. Pessimistic returns prospects combined with cautious and liquidity starved institutions makes for a challenging fundraising market for GPs, but it also creates the sort of conditions on which secondaries players thrive. Indeed it has become something of a truism in the market that these groups are being presented with a dearth of attractive opportunities at the moment. "There has been an enormous increase in people looking to sell- it's at least doubled if not more in 2008," confirms Tim Jones, Partner at Coller Capital.

The buyout bubble
Given the boom that occurred in the buyout space in the last three to four years, which was characterised by huge rises in the number and size of funds being raised, it is hardly surprising to note that the majority of the partnership interests currently coming to market are related to buyout vehicles. "There is a perception in the market that the potential return on offer from buyout funds raised during the last few years is reducing dramatically in the current climate. Many LPs are therefore looking to get out of such vehicles," explains Arnaud Isnard, Managing partner of ARCIS Group.

In the wake of the recent meltdown in the financial sector, banks are obviously amongst the most prominent of LP groupings seeking to reduce their exposure. "The banking sector is going through de-leveraging at the moment in order to shore up unhealthy balance sheets and buyout allocations will likely be a part of this," Jones suggests. This de-leveraging exercise is particularly likely to present opportunities for firms that specialise in direct, or 'synthetic', secondaries; involving the purchase of a portfolio of direct investments. One of the most common forms of direct secondary transaction is the acquisition of the private equity arm of a bank that invests from its balance sheet by backing the spin-out of the investment team - with the secondaries group effectively becoming the sole LP.

However, for many investors looking to sell their interests, the motivation is not simply to take flight from the buyout space. Though most agree that investments made in the 12-18 months prior to the onset of the credit crunch will struggle to make decent returns, many believe that the current downturn is precisely the time to be getting into the sector, as the market swings in favour of buyers. A case in point is the situation following the burst of the technology bubble, when LPs rushed out of venture funds raised in 1999 and 2000, only to watch as firms that raised funds and invested capital in the subsequent doldrum years made impressive returns. "There is a very real possibility that some LPs will seek to sell out of the boom vintages in order to re-allocate their resources into new vintages or new areas of the market, particularly if they were over-allocated to those vehicles," says Erik Kaas, Partner at Partners Group.

Allocation issues
This notion belies the fact that many LPs are currently dealing with a reduced capital pool, which therefore means that allocations increasingly have to be juggled to make sure they cover areas of the market offering the greatest potential in the medium-term. The issue revolves around the fact that many LPs, especially pension funds and endowments, have seen their fund size shrinking in the last year as a result of large declines in the public markets, increasing the percentage of the fund that is represented by private equity - the 'denominator effect'. "LPs are under pressure because in many cases everything in the portfolio is falling in value except the private equity portion, which squeezes the potential allocation for new commitments," Julian Mash, CEO of Vision Capital, comments.

The currently stagnant exit market also serves to compound these liquidity issues. LPs had become accustomed to regular distributions during the buyout boom, which would be used to finance the ongoing activities of the fund. However, hold periods are now being extended, resulting in less regular distributions and therefore difficulties in honouring incumbent commitments. "We are beginning to see a small but growing number of LPs defaulting on capital calls. There are normally punitive clauses in LP agreements and in many cases it will result in the GP instigating a sale, for which they will obviously target secondaries firms," Jones suggests.

The price is (almost) right
With the number of LPs seeking (or being forced) to sell their interests increasing rapidly and the value of portfolio businesses down substantially, pricing has inevitably seen a significant drop (see chart). "For good assets in the current market discounts can be as high as 20-30%, while 12-18 months ago interests were selling on average at a premium of 10%," states Kaas. However, this is not the case across the industry, as groups in the small- and mid-cap value ranges are taking significantly longer to adapt to the pricing shift. "Every deal is different; there are some pretty substantial discounts available at the moment - particularly in auctions for very large assets - but this is not the case widely and in the mid-market it is very much not the case," explains Joanna Jordan, Investor Relations Director at Greenpark Capital.

Furthermore, with a recession looming and trading conditions across the economy worsening, there is a legitimate case for arguing that even the discounts that are currently on offer do not fully reflect the risk associated with some portfolios. This is particularly true when it is considered that many of these assets, as alluded to above, were acquired at highly inflated prices and with excessive quantities of leverage. It is therefore possible that a secondaries firm could easily find itself putting good money after bad in the current market; buying into a portfolio at a discounted price that is still optimistic in relation to its prospects. Indeed, according to Isnard, the ability to evaluate the 'real' (read: future) value of a portfolio in comparison to the offer price is the fundamental key to being successful in the secondaries market: "The skill is evaluating investments and relating the offer value to the real value. However, this changes constantly and is therefore highly subjective. It's like catching a falling knife and you need a little bit of luck."

However, this could be set to change as the year comes to a close, with the end of year accounting process expected to bring prices down to a levels that reflects the realistic trading of the companies in the coming months. Many therefore argue that the current strong pipeline of potential deals, which has yet to be realised on any large scale, could turn into closed transactions in Q1 2009. "Valuations may come down again in December and it is therefore likely that a lot of deals - which are currently being held up due to fact that pricing is so tough - will close in January. There is an expectation that there will be more of a meeting of the minds," says Jones.

Growth potential
Most in the market anticipate that the conditions in the market are likely to increasingly turn in favour of secondaries players, with dealflow expect to rise dramatically in the coming months. Moreover, there is a feeling that the nature of the space is such that this potential could remain, and even grow, for several years. "The secondaries market lags the primary market by around three to four years, which is the time is takes for a fund to reach sufficient maturity," says Jordan, "it is a natural consequence of the primary market and if you look at the enormous funds raised in the last two years, its easy to see the space continuing to grow without any effort".

In addition, the turmoil in the financial sector is expected to reverberate through balance sheets for some time and this will also continue to provide opportunities. "There are a whole series of earthquakes going through the financial sector and many institutions currently have bigger issues to deal with than their comparatively small private equity allocation. Some deals are going to emerge later when they have had a chance to work through their way down the list," explains Mash.

Indeed, the market has, in fact, been growing for some time, largely due to the fact that secondary sales have become a more accepted method of portfolio management in recent years. "Ten years ago if you sold a single company to another private equity you were considered a failure and people would ask why you hadn't managed to take the business public. There is now recognition that a buyer is a buyer and a seller is a seller; it's just a case of perception," confirms Mash. Though this has resulted in an increasing proportion of primary market capital being recycled through secondary transactions, the percentage this represents remains low at around 2%. This further implies that long term growth prospects remain strong, even when the primary market recovers: "The secondaries market is will likely emerge from this cycle more significant than it was on the way in. There will undoubtedly be something of a tail-off, perhaps even as a result of the difficult fundraising climate, but market is definitely here to stay," notes Kaas.

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