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Emerging from the shadows

The secondaries market is attracting a lot of interest at the moment. As many limited partners seek to liquidate their private equity interests, others are jostling to buy them. But what does this mean for the industry? And is there anything worth buying anyway?

The past couple of months have been pretty quiet in the private equity world. Investors have been sitting on their cash, reluctant to commit to funds until they are more clear about where the world's economies are heading. Private equity firms have all but stopped investment in new companies because they have been too busy looking after ailing existing investments and because they, too, feel uncertain about what the future holds. In the run-up to 2001's festive season there seems to have been little to get excited about.

Yet, if the delegates at Specialist Pension Services' recent Hamburg conference are anything to go by, there is something eliciting quite a lot of investor interest - the secondaries market.

Given the current economic climate, it is hardly surprising that this sub-section of the market, which allows limited partners to buy and sell interests in private equity partnerships, is getting more attention than previously. The last few years of the 1990s and the year 2000 saw a flood of institutional money into the private equity industry. Many investors were new to the asset class and didn't fully understand the nature of the business. Back then, private equity investing seemed to be a great way of making good returns quickly.

These investors didn't see that this industry operates on long-term horizons and they didn't foresee the stock market slump that started at the tail-end of last year. This left many of them over-allocated to private equity as they saw their investments in public equities as a percentage of their whole portfolio plummet. They have also been left with some pretty poor investments in underlying companies that private equity firms made in haste when the rush was on to invest in anything with a dot.com suffix. Add to this mix the rash of high net worth individuals who invested before they saw their paper fortunes disappear along with the bull market, and you have a long queue of limited partners wanting out of their private equity investments.

So should people be buying? The advantages of secondaries investments via fund of funds or specialist players are clear. Investors in secondaries start seeing returns much more quickly than in primaries, they are able to diversify by vintage year more easily and they are not investing blind in that they can analyse a fund's portfolio company investments. Secondaries players also argue that by investing in this part of the market, investors can build a mature portfolio relatively quickly. Some investors are saying that now is a good time to go into secondaries because of the long holding periods for many investments. ‘After such a fast-paced few years, it's now time to slow down and take stock,' said Maximillian Broenner of LGT Capital Partners. ‘Investors won't start seeing returns for a very long time, so they should be investing in secondaries to improve cash flow.'

And, with so many limited partners opting to sell, there will be some good deals to be done. But investors should look very carefully before they leap. Not everything going cheap is a bargain. ‘You are seeing 20 to 50 per cent discounts at the moment,' said Broenner. ‘Some are at a 90 per cent discount just so that limited partners can be rid of their capital commitments. But this business isn't about discounts. It's about the quality of the portfolio companies.' Axa's Sasha van de Water agreed. ‘We have done very few secondaries this year,' she said. ‘Many may be negative at the moment, but they still wouldn't be worth taking on. Besides, investing in anything that's flavour of the month is dangerous.'

Many of the secondary interests currently for sale may well include some very sick companies indeed. Unless an investor is certain that there will be at least one star company that will make up for all the duff ones, it should steer well clear. Otherwise, it is simply throwing good money after bad. ‘There are plenty of assets for sale right now,' said Tim Jones of Coller Capital. ‘But most of them, we just wouldn't want to buy.' This will be particularly true of venture capital secondary interests on the market - many of these will have invested in high tech companies at a time when valuations had gone through the roof. Producing any return on these will be more than an uphill struggle.

It's also worth bearing in mind that where there are opportunities, there are bound to be opportunists - especially in the world of venture capitalists. The past couple of years have seen many new entrants into the market, including some fund of funds adding secondaries to their list of products. There are bound to be many more in months to come. Many are inexperienced and some will be under the impression that investing in the secondaries market is much like investing in primaries. As any experienced secondary player will tell you, it's very different. With many secondaries investments, limited partners need to value each portfolio company individually and assess which will be the winners and which the losers. They can't just rely on general partner valuations - in many cases these are two or three quarters behind current valuations. And if there are co-investments or direct investments involved, it becomes still more complicated. There is no doubt that some inexperienced secondaries players - and their investors - will have their fingers burned over the coming two or three years.

Still, the fact that the secondaries market is receiving so much attention is a sign that it is becoming increasingly accepted as a means to create liquidity in an illiquid market. It is starting to shake off its shady image of a market plunging the murky depths of distressed funds for deep, deep discounts and is gaining respectability as a tool for creating instantly mature private equity portfolios. This has to be good for the industry as a whole. What won't be so good is the aftermath of a flood - should this happen - of inexperienced players.

For more information on Specialist Pension Services conferences, please visit www.spsconferences.com

AltAssets is publishing an in-depth research report on the secondaries market early in the new year. For more information, or to order a copy, click here

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