PRINT THIS PAGE

What's up in secondaries?

The secondaries market has experienced a period of rapid growth over the past two years. Flourishing deal flow combined with a handful of recent high profile mega-fund closings indicate that 2004 is set to be another bumper year for the sector. But is this level of growth sustainable or are we in the midst of another private equity bubble? We ask a panel of specialists for their view on what's happening in the market.

	Tim Jones is a partner at Coller Capital. Coller Capital is a secondaries specialist with in excess of $3.5bn under management. Founded in 1990, the firm has acquired venture, buy-out and mezzanine investments based around the world.
	Fred Maynard is a managing director of HarbourVest secondary investments. HarbourVest secondary investments has purchased over $1bn in secondary positions from European, Asian and US institutions since 1986 and currently has $3bn of available capital specifically targeted at the secondaries market.
	Christophe Florin is managing director of secondary funds in Axa Private Equity’s Paris office. Axa’s secondary funds operate on a global basis, across all stages of investment and in a wide range of sectors.
	James Pitt is a managing director in Axa Private Equity’s London office. Axa’s secondary funds operate on a global basis, across all stages of investment and in a wide range of sectors.
	Elly Livingstone is partner at Pantheon Ventures. Pantheon has been operating in the secondaries market for 16 years and invests on a global basis.

Where are you seeing most of your deal flow coming from at the moment?

Jones: ‘The most significant volume of deal flow in the market over the last two years has been from financial institutions in the US and Europe, and to some extent in Asia. These institutions built up very large private equity books over the last decade and for a wide range of reasons have elected to reduce their exposure to the asset class or even to exit entirely. The nature of these portfolios has tended to be typically buy-out orientated and typically European and US focused.

‘In addition to that we are also seeing a lot of high-tech venture portfolios coming to market. These sellers are either disenchanted with technology or are simply looking to rebuild their own businesses and to get rid of anything that is non-core. These types of venture transactions are largely US-based.’

Maynard: ‘Our deal flow is fairly equally divided between Europe and the US at this point in time and the sellers are predominantly financial institutions, be that banks or insurance companies. There are still a small number of high net worth individuals looking to sell their private equity portfolios but that is beginning to tail off now. Corporations are another source of transactions for us. Deal flow is a little bit skewed towards buy-outs rather than venture in terms of value, because venture deals tend to be smaller by definition. But in terms of volume of deal flow there is not much to choose between the two.’

Florin: ‘The most active regions in the secondaries market at the moment are probably the UK, Germany and France. Banks, such as Abbey National and Deutsche Bank, are the most prominent sellers and the majority of transactions are buy-out orientated.’

Pitt: ‘We are also seeing some insurance companies and government institutions looking to sell their private equity portfolios. The one investor type that we haven’t seen much of are the pension funds, although we are starting to see some more activity there, particularly in the US.’

Livingstone: ‘We source our deal flow globally, in the US, Europe and Asia. Our main vendors include banks, investment funds and occasionally individuals. Some deal flow comes via intermediaries.

How has your deal flow changed over the last six months?

Livingstone: ‘We have seen no real change. There has not been a deluge of deal flow but the situation is certainly healthy.’

Jones: ‘The composition has been fairly stable but the volume has continued to grow in terms of the number and size of the deals that we are looking at.’

Pitt: ‘We are busier now than we ever have been and the quality of deal flow is very high.’

How do you expect deal flow to evolve over time?

Maynard: ‘We feel that deal flow will remain strong for at least another a year or so. But it is true that at some stage deal flow will have to level off, if not dip down. Approximately $650bn of private equity was raised between 1998 and 2002 and it is these assets that are just starting to emerge in the secondaries market now. Based on that alone there should be some pretty healthy deal flow going into the future.’

Jones: ‘At the moment our deal flow is driven largely by financial institutions seeking to exit their private equity commitments. In due course this type of deal flow will inevitably start to dry up. That doesn’t mean to say that the secondaries market will grind to an abrupt halt. The secondaries market has been around a long time and there have always been deals to be done.

‘I think that a trend is starting to emerge within the market place where some of the more knowledgeable and sophisticated institutions are using the secondaries market as part of their professional portfolio management. I think that the secondaries market will increasingly be used as an efficient tool for recycling investments and that this will provide the foundations of our deal flow going into the future.’

Livingstone: ‘Over the 16 years that Pantheon has been operating in the secondaries market there have certainly been cyclical highs and lows but there has also been a constant level of turnover provided by the portfolio management needs of investors. Institutions look at their private equity portfolios on a continuous basis and there are always reasons why they wish to turnover parts of their portfolios. It is that need that provides the underlying driving force behind the secondaries market in the long-term.’

Florin: ‘An incredible amount of private equity capital was raised between 1998 and 2001. In that period a lot of newcomers started to invest in the asset class and it is inevitable that some of them will be looking to sell. We estimate that over the next three years approximately $25bn to $35bn of secondaries transactions will come to market.’

How has the nature of secondaries transactions evolved over the years?

Pitt: ‘The complexity of transactions has increased quite significantly since we first began investing in secondaries. Originally sales were very straightforward, you just put in a price and applied a discount. Then it was simply a question of take it or leave it. Now we are seeing a much more structured process. Sellers are attempting to run auctions and are structuring assets to appeal to different buyers. This increased complexity has partly been driven by the increased sophistication of vendors and it is also a sign that the market is starting to grow up. Increasingly complex transactions are being used to bridge the gap between sellers’ expectations and buyers’ requirements. It is a natural maturation of the market.’

Livingstone: ‘There is more of an interest on the part of vendors in exploring the structuring of deals. That can be through the introduction of debt, through the introduction of different payment structures, or through the vendor retaining some kind of upside in the portfolio.’

Jones: ‘It is important to come up with solutions that meet the needs of the seller. These solutions can sometimes be very simple, but sometimes you have to be quite creative because the seller has fairly complex requirements.’

Maynard: ‘The complexity of transactions has definitely increased. Deals have developed from the plain vanilla purchase of limited partnership interests, to highly structured transactions where you may take a combination of partnership interests and direct interests, structure a partnership around that and change the economic sharing between buyer and seller. In this way the transaction ends up as more of a joint venture than a pure purchase and sale. This innovative approach to transaction structuring has been driven, in part, by the need to move to a place where the main stream of the market is not focused. It is a means of differentiation and can help ward off the competition.’

How sustainable is the growth of the secondaries market?

Jones: ‘The secondaries market has obviously grown a lot over the last two years. It may be that too much money was raised and only time will tell. But I believe that as the secondaries market becomes an accepted tool for portfolio management that the market will continue to grow steadily, even if not at the pace it has in the past.’

Livingstone: ‘Recent growth has been fuelled by a group of incumbent players raising larger funds and a small number of new entrants to the market. The secondaries market is here to stay. I have no real concerns for the future. It is a market that has been in existence since the 1980s when Pantheon began investing, and is not going to disappear’

Pitt: ‘Everybody assumes that we are relying on distressed sellers for our deal flow and that this deal flow is finite. In reality, distressed sellers represent just a small number of the transactions that we work on. A far more significant element of our deal flow has come from institutions responding to regulatory changes such as Basle II or the introduction of new accounting standards. We are also just starting to witness the emergence of true liquidity venturing. Buying and holding an asset for up to 12 years can be a very unnatural process. We are living in a fast moving world where people are used to being able to trade in and out of positions and we expect to see more of that happening. So far the market has seen relatively little of this type of portfolio management but that’s going to be a huge part of the market’s future development as distressed sellers tale off.’

Maynard: ‘I don’t see the market getting any smaller. There is a very broad variety of reasons why sellers sell. Every time you think that the market is about to slow down another set of vendors emerges.’

How do you expect the dynamics of the market to develop?

Florin: It is very difficult for new entrants to penetrate the secondaries market today. The market is sufficiently mature now that investors are looking for track record. I would expect no more than one or two to make it through over the next few years.’

Livingstone: ‘I think the market will continue to be dominated by a handful of players. But I also expect that a growing number of houses will begin to look at secondaries as part of their investment strategies but not as a dedicated activity. The dedicated activity will belong to a smaller group of very focused firms and we will see different specialist players adopting different strategies.’

Jones: ‘The core secondaries market has not expanded significantly for a number of years and I don’t expect that to change. What I do expect to see is an increasing amount of differentiation. There will be a small number of large global players who will do any deal anywhere and there will also be niche players who will only look at small country specific transactions. The most crowded space will be the mid-sector. But I still don’t see a huge rush of new players penetrating any part of the market.’

How has the increased involvement of non-specialist investors affected the market?

Livingstone: ‘Non-specialists have an opportunistic approach to the secondaries market. They will acquire individual pieces of individual funds where it works for their strategy. Specialists are more focused, whereas the non-specialists are more opportunistic, occasionally dipping into deals when they emerge. It ultimately comes back to resources and the investor’s approach, focus and depth of knowledge and experience of the secondaries market.’

Florin: ‘There are a number of pension funds that have been trying to develop a secondaries capability. I would say that, with a very small number of exceptions, they simply won’t have the resources to successfully carry out this type of investment. They won’t have the human capabilities to organise transactions.’

Jones: ‘Primary funds have always been investors in secondaries. The very first secondaries transaction was between two primary funds, so this is nothing new. But while there has always been primary capital competing in this space, primary funds tend to only look at a very limited range of transactions.’

What would you say to investors who think that we are in the midst of a secondaries bubble?

Maynard: ‘I remember vividly sitting down with our investors in the very early 90s and saying that I thought that this market had just about played itself out. I am sure that there are those who would say the same thing now. But I was wrong then and I think that it would be an equally shortsighted view to take now. It is true that fundraising levels are relatively low at the moment and that growth in the market is likely to slow or that it may possibly even contract. But private equity forms a part of the investment portfolio of a large number of major institutions around the world and there is always going to be a desire for turnover there. I don’t see it as a bubble. The market has certainly swelled and it may contract as markets do. But I really don’t see what there is to burst.’

Pitt: ‘It’s not natural to expect that investors will be in exactly the same shape ten to 12 years down the line as they were when they made their initial investments in a private equity fund. If you look at the composition of the Footsie 100 over the past ten years, it has changed radically in that period. Companies have been taken over and companies have gone bankrupt. I think there are good reasons why we are going to see more and more liquidity in the private equity market.

‘Turnover of asset value in the private equity market is miniscule. There are nearly a trillion dollars of private equity assets out there. Last year the secondaries market saw a maximum of $7bn of that being turned over. It is a tiny fraction of the overall market that we are seeing today. To me, that means that we are not in a bubble, we are just busier now than we ever have been.’

Jones: ‘Some investors have questioned whether we are experiencing a repeat of the dot com bubble because of the amount of money that has been raised in the secondaries market. Only time will tell whether that is true or not. Undoubtedly a lot of money was raised at the back end of the nineties. Some will succeed in investing that capital well and some won’t.’

Livingstone: ‘There are some very experienced secondaries investors with strong discipline and there are others that may have less experience and less discipline. There are certainly great opportunities out there for investors but they have to look carefully at the teams they are investing with and their track records and investment approach.’

Is it still possible to get good quality assets at a discount?

Maynard: ‘People focus too much on discounts. It is far more important to consider whether you are getting a good price for good quality assets. That could be at a discount or a premium. But we do believe that there are very attractive transactions out there.’

Livingstone: ‘The object of the exercise is to buy quality assets at the right price for the risk involved. That price could be at a discount to a stated valuation or it could even mean a premium. We are value investors. We are looking to buy assets, which can deliver value at the price we’ve paid and yes that is possible.’

Florin: ‘It is not really a question of a discount. It is just a question of paying the right price for good quality assets.’

Pitt: ‘We don’t really think about it in terms of discounts or premiums, our process to price the assets and arrive at a valuation for them. That valuation may or may not be at a discount to what the seller is holding them at in their books.’

Jones: ‘I think that the concept of a discount is totally misleading. You can buy something at a premium to a GP’s valuation if that GP’s valuation is conservative and if the assets are high quality. At the same time a huge discount may not be deep enough if the assets really aren’t worth what they have been valued at. Discount is a measure that is used by people outside of the market as a performance measure but in my view it is irrelevant.’

What do you see as your main challenges going forward?

Pitt: ‘Where do you want us to start? We are busier than we ever have been so I suspect that the challenges that face us are not going to be down to deal flow. As an industry I think that we are going to have to deal with reporting and monitoring issues and changes in accounting standards. Reporting requirements are becoming more stringent, driven both by regulatory changes and also the needs of our investors.

‘Another area of concern is currency management between the Euro and dollar. We have experienced some pretty huge swings recently and that is a tough one to manage given the difficulty in hedging out these positions. Secondaries investing is a global business unlike direct funds which are typically based in the currency of the region they are investing in. For secondaries players currency management remains a major issue.’

Livingstone: Our focus going forward is to bring innovative solutions to vendors that meet their particular liquidity needs.

Jones: ‘The big challenge for us is to maintain our competitive edge in a market that is constantly maturing and growing.’

Maynard: ‘Our main challenge is to maintain the quality of our deal flow.’

How do you expect the market to evolve?

Florin: ‘The market will continue to grow, at least for the next three years. But fundraising has been tough in the private equity market as a whole and a lot will depend on how that situation plays itself out.’

Livingstone: ‘I think the market will continue to be dominated by a small group of players but there will be increasing interest among institutions in participating in the secondaries market on an opportunistic basis.’

 Jones: ‘I think that the market will probably develop in two different directions. A portion of the market will become ever more efficient as professional investors begin to use the market to recycle their commitments. You will also have a portion of the market that will get ever more complex as it is used both by secondaries investors and by sellers to complete highly complex transactions involving different types of assets which are more complex to value and more complex to transfer.’

Copyright © 2004 AltAssets