Secondaries are increasing the attractiveness of emerging markets to private equity investors

The global private equity secondary market, which provides investors with liquidity in an extremely illiquid asset class, has exploded into growth in the last few years. Increasingly sophisticated LPs have been using the flexibility that secondaries offer to alter investment strategies, modify asset allocation policies, respond to changes in public markets, and manage liquidity. Now, demand for similar levels of liquidity in emerging markets is making itself felt.

Growth of the secondary market

Private equity firms have raised more than $1.8 trillion globally since 1990 - most of it since 1997 - and the secondary market has exploded into growth in response to this huge surge in primary funds. After raising a total of just $3.7 billion between 1991 and 1997, secondary firms raised over $5 billion a year in 2004 and 2005, and expect to exceed this in 2006.

There are some common misconceptions about secondaries. Some commentators have suggested that the secondary market is a temporary phenomenon - a consequence of the 'internet bubble', which, they say, forced investors to sell private equity portfolios cheaply.

In fact such 'fire sales' have always been relatively rare. Investors sell for many reasons: to rebalance their portfolios after fluctuations in public markets; to raise cash for investment in new funds; to finance future cash calls; or to restructure their businesses following a merger or acquisition. Banks, especially, have had their own reasons for selling: to reduce the volatility of their returns or to strengthen their focus on core activities.

Although the frenetic pace of recent growth may slacken, it is likely to continue in the medium and long-term in both the primary and secondary markets. Private equity fund-raising will remain buoyant because bonds and equities alone are unlikely to provide the returns and the portfolio diversification that institutional investors now require. Alternative asset classes - such as hedge funds, private equity, and high-yield and emerging market debt - will increasingly be employed to enhance, and improve the consistency of, returns.

Emerging markets appeal

In recent years, emerging markets have become more fertile ground for private equity - structural reforms have led to substantial improvements in the economic stability of some developing countries; western-trained managers have begun to run local companies; corporate governance standards have been rising, and political, regulatory and legal environments have been improving.

With institutional investors eager to increase their overall allocations to private equity, and intensifying competition for deals in North America and Western Europe, General Partners have expanded the geographical scope of their activities - increasing the amount of capital they put to work in less developed markets by opening local offices and hiring local teams.

This growing engagement of private equity is evident, too, in the secondary market. For example, in the early years of this decade, the team at Coller Capital acquired emerging market assets only by buying positions in regional funds - pan-Asian funds, say - whereas, more recently, we have also bought positions in funds focused on individual countries - in Asia, in Central and Eastern Europe, in Africa, and in Latin America.

Conclusion

The advent of secondaries in emerging markets is undoubtedly a good thing, and not only for individual investors. It is also a positive development for the engagement of private equity with emerging markets overall. A robust secondaries market actively encourages LPs to experiment with new areas by guaranteeing them liquidity for their investments in the event that their needs or strategies change.

By Daniel Dupont, partner, Coller Capital.

Coller Capital, founded in 1990, is the leading global investor in private equity secondaries - the purchase of original investors' stakes in private equity funds (venture capital, buyout and mezzanine) or the acquisition of portfolios of companies from corporate owners/backers. The firm currently has positions in more than 150 private equity funds and stakes in over 1500 private companies throughout the world. Coller Capital funds invest from $1 million to more than $1 billion in individual transactions.