New perspectives: How secondaries are reshaping PE's risk profile

European GPs holding final closes in 2019 raised more than €100bn across 145 funds, demonstrating the continued confidence among LPs in the asset class. Investors have been attracted by bumper returns compared with public equity, but in the flurry of dry powder and record-high valuations, the risks associated with the industry should not be ignored.

Capital risk, or the risk of making a net loss on an investment, is affected by both company-specific factors and market-related factors. In particular, currently record-high multiples means the likelihood of a significant return is decreasing.

Europe's average entry multiple for buyouts reached 10.3x EBITDA in Q4 2019, according to Clearwater International's Multiples Heatmap. At the IPEM conference in January 2020, Hamilton Lane chair Jim Strang said one of the takeaways from his keynote speech was "being thoughtful around risk, particularly around the valuation levels that are fairly elevated in most parts of the world".

Says Peter Van Dooijeweert, Man Group's head of institutional hedging and portfolio solutions: "We see some aggressive valuation levels, multiples are high and leverage is increasing. With increasing leverage comes greater risk. Consultants and partners of LPs are saying increasing private equity exposure is illiquid and risky, so they are asking if there is a way we can be holistic about hedging their portfolios."

Selection risk
For those LPs wary of the risk profile of private equity shifting, secondaries provide exposure to the asset class, while reducing risk through diversification. Richard Hope, head of EMEA for Hamilton Lane, says: "With a secondary fund commitment, you are getting 45-50 deals [fund stakes]. If each deal has 5-20 companies, you are getting between 500-1,000 underlying businesses."

Beyond using secondaries to diversify a portfolio, the fund-of-funds model of most secondaries investors can add a layer of expertise that can help LPs further mitigate selection risk given the dispersion of returns between primary fund managers – provided they are comfortable with the added fee layer.

Many LPs and asset managers recognise the benefits of specialist advice on secondaries and private equity. In February 2020, Vanguard, which has $5.3tn in assets under management and does not traditionally invest in private equity, announced a strategic partnership with HarbourVest to establish a series of funds encompassing all aspects of private equity investment that HarbourVest currently offers, including secondaries. A statement from Vanguard cited "a wide disparity in manager performance" and the time, scale and expertise it takes to construct a broadly diversified private equity portfolio as reasons for the establishment of the partnership.

Hamilton Lane and Coller Capital also undertake due diligence on individual portfolio companies in the funds in which they invest. Partner Remco Haaxman of Coller Capital says: "We update our models on a quarterly basis at least, and ask ourselves: how does the balance sheet of the company look today? How will those financials evolve during our projected ownership and during an economic downturn? Will there be multiple contractions, and will the company have the ability to repay debt in the future?"

Hamilton Lane has a database of information that spans its entire portfolio, as well as the historic portfolios of the LPs it advises. Hope says: "If you have got the data, you can do the analysis and know what you are buying."

The creativity of the secondaries market continues to impress. A few years ago, deals were not common among larger GPs, but we have seen blue-chip names doing fairly big deals recently" – Richard Hope, Hamilton Lane

Illiquidity woes
One of the main drivers behind the genesis and rapid growth of the secondaries market has historically been the opportunity to address the illiquidity risk inherent to the asset class. Some LPs are comfortable with the illiquid nature of private equity. The asset class's long-term horizon can even help LPs achieve better returns in the long term, says Hamilton Lane's Hope: "Where we have seen underperformance is when LPs have been too tactical. It takes a bit of luck to get that right, so it is better to have a more planned, stable commitment strategy." Hamilton Lane's 2020 market overview concludes that, historically, private markets have delivered a consistent and attractive return ratio.

However, the commitment to lock up significant amounts of capital can strip LPs of their ability to actively manage it and adapt to unforeseen market circumstances. Smaller investors, in particular, which may have a greater need for cash distributions, can struggle with illiquidity.

The secondaries market does offer LPs the chance of cashing out early. Valuations, however, can be a sticking point, given that the underlying assets in a private equity fund portfolio are valued much less regularly than on public markets. For instance, GPs that value their assets most commonly do so quarterly. Most fund managers will base valuations from their own models, though some will use an independent valuer. John Curtin, a partner at Clearwater International Corporate Finance says: "Ultimately, you are never going to know the true value of an asset unless you run a competitive process."

This lack of transparency and, more generally, the inefficiency of the secondaries market in its formative years, meant buyers of private equity fund stakes traditionally demanded, and received, a discount. This, in turn, made it costly for investors to sell their stakes and potentially increased risk for less savvy players rather than mitigate it.

Liquidity is now another selling point [of the private equity industry], given the continued boom and creativity of the secondaries market" – Antoine Dréan, Triago

Cash me out
But developments in the secondaries market since the mid-2010s have made it a much more viable tool on the liquidity front, starting with the sheer amount of capital now awaiting deployment on the buy-side. The value of global secondaries transactions jumped from $52bn in 2017 to almost $100bn in 2019, according to research by Coller Capital. The coming year is expected to see a continued escalation in the size of the market. In January 2020, Hollyport Secondary Opportunities VII closed on $1bn, and Five Arrows Secondary Opportunities V also held a final close on €1bn, in addition to the final close of Lexington Capital Partners IX on $14bn. European secondaries funds currently raising capital amount to 24 vehicles, according to Unquote Data; this notably includes Ardian aiming to raise the largest ever secondaries fund – the firm launched ASF VIII in July 2018 with a target of $12bn, which is reportedly being stretched closer to the $18bn mark.

There are several major trends that bode well for LPs' liquidity options. First, with the greater amount of capital allocated to secondaries, more investors, advisers and data providers have entered the market. Secondaries players – and LPs themselves – can rely on a much broader and granular dataset around transactions and can market-map much more efficiently, too. The market has professionalised, greatly limiting the aforementioned inefficiency drag on valuations.

In Setter Capital's Q4 2019 secondaries pricing research, despite a 2.42% dip in pricing, western European funds remained highly sought after, with the strongest average valuation of the 824-strong sample, at 101.26% of par. This was taking into account a variety of asset classes – western European LBO funds, in particular, were still in high demand at an average of 110% of par.

Furthermore, the influx of liquidity in that corner of the market has inevitably boosted creativity and allowed LPs the option to cash out on attractive terms in a broader variety of situations. As Hamilton Lane's Hope says: "The creativity of the secondaries market continues to impress. A few years ago, deals were not common among larger GPs, but we have seen blue-chip names doing fairly big deals recently."

Last year saw a number of GP-led transactions across Europe – continuing the trend initiated around 2018 – including the single-asset restructuring of Germany-based KD Pharma by Capiton and that of Norway-based Cegal by Norvestor.

Large transactions, such as the GP-led deal for PAI Fund V, often dominate market discussions. The firm transferred the two remaining assets from its fifth fund to a new vehicle that is roughly €2bn in size, realising liquidity for the firm and some of its LPs. However, Haaxman says that almost half of the capital deployed in 2019 was dedicated to transactions valued at more than €1bn. This illustrates that there are secondaries buyers for funds of any size, although the highest prices are paid for funds in the €500m-1bn bracket, according to Setter's research. Small-cap transactions that have occurred in 2020 include the acquisition of six France-based holdings from Sigma Gestion by Altur Investissement. The combined revenue of the companies amounted to €60m.

Paradigm shift?
The rapid development of the secondaries market, and the sheer variety of options it affords both buyers and sellers, has led a number of market observers to note how the traditional model of private equity is changing to the point of influencing primary allocation strategies for LPs. Says Antoine Dréan from placement agent Triago: "Liquidity is now another selling point [of the private equity industry], given the continued boom and creativity of the secondaries market."

For the secondaries market to become active, the primary market needs to have been established for a very long time" – Michael Halford, Goodwin

Other players, however, are concerned about the sustainability of the growth in the secondaries space, and of the risk associated with basing allocation and risk management strategies on it. A number of investors still caution against banking on secondaries as a liquidity management tool, given the fluctuations on pricing, and instead consider them primarily as a portfolio management solution. Nicholas Schellenberg, head of EMEA PE & VC research at Cambridge Associates, says: "We would use [secondary sales] less as a liquidity means and more for portfolio construction. Most of the time, LPs have to accept a discount on the current NAV when they are selling." Coller's Haaxman says: "Average pricing reached 104% of NAV just before the financial crisis, but the market now appears more disciplined."

The latest Setter Capital report shows that pricing remains correlated to a number of factors, including vintage, with the highest prices paid for LBO funds for 2018-2020 vintages at 107.5% of par, compared with 2010 and older vintages at 86.28%. Fund size, liquidity ratings and how funded the funds were, also factored in the cost, according to the report.

Another potential blindspot is the unpredictability of outcomes in the event of a market depression – a report from the BVCA entitled Risk in Private Equity, states: "While the secondary market can be very active in a normal market environment and during boom phases, this level of activity is far from what one would see in even the most illiquid of listed markets. Moreover, the secondary market was shut down during the financial crisis in 2009 with very low trading volumes."

Man Group's van Dooijewert concurs: "Secondaries, historically, have worked in a rising market, but there is not that much evidence of how much liquidity there will be in a down market."

However, the glut of capital dedicated to secondaries could prevent this from occurring again. Even through a market correction, Cambridge Associates managing director Dan Aylott argues that due to the large funds raised by secondaries managers, the secondaries market will still provide a liquidity option. He says: "There is pretty much a price for anything on the secondaries market and it is much more mature than it used to be."

New frontiers
That last argument is a convincing one, and the potential of secondaries in helping build a diversified, well-hedged portfolio is unlikely to be ignored by the majority of LPs when it comes to their buyout-fund strategies.

The efficacy of the secondaries market as a liquidity tool for other pockets of private equity exposure, and other alternative asset classes altogether, is now more limited. Goodwin partner Michael Halford says: "For the secondaries market to become active, the primary market needs to have been established for a very long time. For example, infrastructure secondaries are only just beginning to happen, as are Asian secondaries."

And despite venture capital having been a staple of allocation strategies for much longer, Haaxman says the secondaries market in that space has not yet reached the same size as its private equity counterpart for another reason: "Secondaries are used for diversification and investors are used to a fairly narrow band of outcomes. Buyers find it harder to buy venture assets because they are much more binary and bifurcated in their returns."

But this only serves to highlight future opportunities for LPs, and the venture market has seen interesting developments in recent months. Greenspring Associates notably held a final close for Greenspring Secondaries Fund IV on $800m in January. The venture capital secondaries vehicle, launched by the $10bn investment venture capital platform Greenspring, targets venture capital investments globally, buying stakes in venture funds and direct stakes in venture-backed companies. Hong Kong-based Ion Pacific, meanwhile, also launched a global venture secondaries vehicle, with a target of $150m.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• Secondaries
• UK / Ireland
• France
• Benelux
• DACH
• Nordics
• CEE
• Southern Europe
• LPs
• Secondaries