European secondaries boom unlikely to end soon

Familiar drivers – portfolio management as well as regulatory pressures affecting banks and insurance companies – will mean Europe will host the bulk of secondary assets to be sold within the next two years. Roughly half of investors expect to sell US private equity assets and 35% intend to sell Asian ones within the next two years, but this proportion stands at a staggering 76% for European assets according to recent research presented by Francois Aguerre of Coller Capital at the AFIC yearly gathering in Paris.

"The prominent UK and French markets continue to be fuelled by banks and insurance companies, whereas public pension funds represent the largest category of sellers in the US," says Nicolas Lanel, managing director and head of European secondary market Advisory at UBS. Marleen Groen, CEO and founder at Greenpark Capital agrees: "Many pension funds are also waiting for further clarity on the implications of the occupational pension funds directive upon their private equity holdings," and fear renewed recessions in some European countries.

But might the regulatory constraints affecting European banks and insurance companies be overstated? "While Basel III is certainly an important factor, banks are taking a more fundamental look at their business strategy in the current economic environment and thinking hard about more efficient ways to deploy capital," argues Bernhard Engelien managing director from secondaries advisory business Cogent Partners. James Burnham, head of external relations at the EVCA, corroborates: "We expect there to be no change to the regulatory treatment of private equity [in CRD IV] as per the original 2006 capital requirements directive aligned with Basel II [enabling] banks to achieve a capital charge as low as 15.2% on private equity".

Regulatory constraints and extensive dry powder should continue to fuel European activity

Also, the effects of Solvency II may not be as stark as feared: even though small companies implementing the standard model are likely to be more affected than the larger ones, most seem to have come to grips with the uncanny package and realise holding illiquid and rather low-risk private equity assets is not so bad. Roger Johanson, head of venture capital and infrastructure investments at Skandia Life, shares this view: "Whether or not Solvency II will have an adverse impact on private equity allocation also depends on the broader financial and macroeconomic environment, rather than on the package itself. LPs that have a wide experience of private equity investments are barely affected."

2011 really was a year of two halves
Nonetheless, in 2011, these trends really did cut European activity into two halves. While in H1, the return of portfolio distributions and rising funds' NAV fuelled pricing and in turn supply, resuming tensions after problems in the Eurozone in H2 froze credit markets as well as IPO opportunities, and sent distributions into reverse gear.

But surprisingly, pricing, which peaked last summer after six quarters of uninterrupted growth, has barely eroded, at least in absolute terms. According to Lanel, "The memories of missed opportunities in 2009 as well as the continued 'arms race' at the top have incited buyers to stay open for business throughout the crisis."

"Pricing is very important and is based on the quality of the underlying assets, their likelihood of achieving an exit and the expected valuation on exit," adds Groen, whose firm Greenpark Capital manages developed markets' secondaries funds and is also working with the World Bank's investment arm IFC to set up a $500m global Emerging Markets secondaries fund. "The quality of dealflow hasn't turned out to be worse than before, it is more complex and varied," adds Lanel. "This incites buyers to both distinguish between good and less performing assets, and cope with the accelerating deal flow," he adds.

A market unlikely to slow down soon
Many trends are still providing impetus to the market, particularly regulatory pressure on financial institutions: while the bulk of the "clean-up" has already taken place in the US, there remains considerable work to be done in Europe, including in the UK. On the continent, many of the large French programmes have already been restructured or sold while Germany still offers the potential for some large transactions.

The expected wall of refinancing will also affect the industry, reducing the opportunities of exits and therefore distributions. Signs of GPs restructuring are likely to surface more frequently as well, according to both Lanel and Groen, as was recently illustrated by the spin-off of Omnes Capital. "But the need for an attractive strategy and the stamina required will limit the number of successful spin-offs," warns Groen.

How are these settings going to impact the type, quality and price of assets? "Investors are retrenching from the riskier scopes of European PE, still favouring the dominance of the large buyout funds from the bubble years (estimated to reach a total of $440bn) where the quality of assets and predictability of exit are best," says Francois Aguerre.

The balance between direct secondaries and traditional secondaries is little debated. "Banks have understandably started their disposal programmes with funds' portfolios but as the inventory of plain-vanilla assets decreases, the proportion of secondary directs will inevitably increase," argues Lanel. Groen agrees but states that "directs must have substantially higher expected returns to be worthwhile to invest in, whereas often the quality of the directs portfolios and the managers is less attractive or unproven".

Against this background and considering the large amount of capital raised by secondary funds, pricing should continue to prove resilient: UBS estimates that around $35bn of dedicated dry powder was available to buyers at the beginning of this year. For the most part, this capital was in the hands of a few large participants with 20 of the top buyers currently accounting for an estimated hold of 85% of that total, and 18 of them each having more than $1bn at their disposal.

Whether this would favour secondaries pure players like Coller or Greenpark, or hybrid players like AlpInvest, Partners Group or Harbour Vest, who are all actively raising, remains to be seen. "GPs generally have a clear preference for buyers that have both primary and secondary capital" says Engelien, from Cogent. This is unsurprising, as GPs increasingly look to do staples, whereby a secondaries investment involves a promise of investing in that GPs next fund. Says Lanel: "Ultimately, managers have come to accept that there need not be a stigma associated with one of their LPs having to sell!"

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• Topics
• Secondaries
• Secondaries
• Coller Capital
• EVCA
• Greenpark Capital
• UBS