Second to None

Real Deals

Private equity deal flow may have been obliterated, but the private equity secondaries industry is gearing up for its busiest season ever. The financial collapse that has ravaged many institutional investors in the asset class is creating a glut of opportunities for those that are prepared to take fund interests off limited partners hands.

The first post-credit crunch wave of sellers to appear on the market earlier this year were inevitably the investment banks and other struggling financial institutions, among them Lehman Brothers and AIG. "The first wave of deal flow came when the credit crisis forced banks to consolidate their balance sheets and focus on core business," says Oliver Gardey, partner at Adams Street Partners.

"They looked hard at private equity and other non-core operations that were tying up their capital ratios and began to consider sell-offs. Bank of America, ABN Amro and the Royal Bank of Scotland were all involved in spin-outs. There will be more to come."

Less expected has been the spate of sale mandates emanating from endowments, public pension funds and a host of other investors that have run up against liquidity issues or have become over-allocated to private equity, particularly those that were running over-commitment programmes.

US endowment Harvard has put a $1.5bn slug of its $36.9bn under management on the block, including interests in funds managed by KKR, Madison Dearborn and Terra Firma. Columbia University and Duke University are just two others known to have followed suit.

Charitable foundation the Wellcome Trust, meanwhile, is showcasing £3.8bn of private equity interests as it seeks to exploit the dollar's strength against the pound, another key driver of deal flow.

"With portfolios suffering from both the denominator effect and the distributions drought, LPs have three options – to increase their allocations to private equity, cut their commitments or seek liquidity through secondaries," says Jeremy Coller, founder and CEO of Coller Capital.

In some cases these vendors are merely conducting pricing exercises. "Financial institutions, endowments, family offices – everyone is considering their holdings," says Brenlen Jinkens, managing director of secondaries advisory firm Cogent Partners. "Often it will be liquidity that is the driver. But in other cases, someone, somewhere in the organisation is simply asking questions about value."

In other instances vendors are reallocating capital away from strategies and vintages they expect to underperform, and into more promising areas. But some of these secondaries sales do involve institutions that are looking to scale back from the asset class altogether.

"The Wellcome Trust is looking to redeploy in the public markets," says Alexander Apponyi of placement agent Berchwood Partners. "There is an argument that the accounting principles now employed in private equity mean the asset class is converging with listed equities. Some investors are saying, in that case, why put up with the illiquidity?"

And while it is the vast, and publicly accountable, institutions which have made the headlines with their secondaries sales, vendors are emerging from all corners. Wealthy individuals, family offices and even funds of funds have been approaching secondaries players, according to Paul Ward, a partner at Pantheon.

"Funds of funds may have fully drawn down capital from their investors, but they still have capital calls of their own to meet," he says.

"The leverage that they had in place to cope with this scenario has been pulled. This is a really common type of deal for us."

Gardey predicts that a third wave of investment opportunities is now also on its way, driven by regulatory restrictions on the ability of pension funds and insurance companies to hold private equity interests.

But while distressed and regulation-constrained vendors have made a dramatic comeback in the secondaries market, the type of portfolio management exercises that had been gaining prominence over the past couple of years have taken a back seat.

"There has been some pullback from pension funds which were previously very active in using secondaries to rebalance their portfolios," says Ward. "They were happy while they were getting attractive prices, but now, of course, they are not. But these vendors have been more than replaced by forced sellers."

Apponyi believes that secondaries turnover will more than double from between three and four per cent of primary commitments to ten per cent over the year ahead.

Pricing implications
The surge of potential secondaries sales flooding the market has, of course, had implications for pricing. At the top of the market, interests in leading big buyout houses frequently went for premiums of 20 per cent and above. Now pricing discussions tend to accept discounts of at least 50 to 60 per cent as inevitable.

Gardey also claims that the spread in pricing is as great as he has ever known it. "In the four years up until 2007, pricing spreads were getting gradually tighter as the market became more efficient," he says. "Increasing uncertainty means that that has now changed. The only secondaries getting done are those where the buyer has high confidence in pricing. Every buyer has their pet GP, where they have greater confidence and are willing to pay more."

Meanwhile, Peter Wilson, managing director at HarbourVest, says that while few deals are actually completing, some of the pricing talks that the firm is seeing are at close to zero. "If they came off any more it would mean investors paying us to take fund interests off their hands."

Anecdotally, this is exactly what is happening. Rumours of LPs prepared to pay to be let off their unfunded commitments abound. In reality, however, as Wilson says, many of these deals are not actually being completed, so pricing remains hypothetical.

Nevertheless, many transactions may be reignited by December valuations, when significant writedowns are anticipated.

"The discounts that are on offer may feel big at the moment, but when the writedowns go through, that discount shrinks, which psychologically speaking is more acceptable for the vendor," says Ward.

The issue of valuations in the secondaries market is an interesting one. The last time the private equity industry found itself at anything like this point in the cycle, the process of valuation was considerably more opaque, which created both an opportunity and a challenge for secondaries investors. The introduction of fair value directive FAS157 – in short – has shifted the goal posts.

"When valuations were opaque, secondaries players were able to spot value where it hadn't been revealed on the balance sheet, or alternatively avoid deals altogether where the discount would be too big psychologically for the vendor," says Ward. "Now discounts may feel big initially, but the margin narrows when writedowns occur, which means that many deals that would never have been done now go through."

"Fair value sets the tone for people doing deals," adds Jinkens. "It introduces more volatility to NAVs, which on balance means deals are more likely."

Sellers may, for example, be willing to accept the same numerical figure that they turned down in September in December, when writedowns have gone through. "Rationally it makes little difference," he says, "but psychologically it feels like good news."

Joanna Jordan, co-founder of Green Park Capital, agrees that the new year will bring new deals. "Fair value can create opportunities because expectations are more realistic," she says. However, Wilson adds that fair value remains something of an unknown.

"FAS157 hasn't reduced the degree of interpretation," he says. "As a result, come December, we will see different GPs valuing assets very differently, so there is still a degree of uncertainty."

Shunning the young
Uncertainty also continues to surround the question of what will happen to commitments made by limited partners that have not yet been drawn down. It is, of course, investors' inability to honour these capital calls that has prompted rumours of LP defaults.

Historically, secondaries firms' appetite for young funds, with a substantial proportion of unfunded commitments, has been limited. Axa Private Equity is a rare example of a firm with a dedicated early secondaries arm.

"On average over all our three funds, we have acquired investments that have been 80 per cent funded at purchase, which has provided us with excellent visibility of assets," says Jordan.

"The deals we tend to do are between 70 and 80 per cent funded," adds Ward. "But what most investors are looking to sell involves portfolios that include large sums of unfunded commitments. Funds that are less than 50 per cent invested do not represent an attractive market for us, because they defeat our objective of mitigating the J-curve and returning money quickly."

Ward adds that even funds that are between 70 and 80 per cent invested still present a conundrum for secondaries players in the current market, because many will be weighted to 2006 and 2007 deals, which will take a long time to exit. "So even when a deal is mature from a funding perspective, it may still be immature from an asset perspective," he says, "which is not a key area of focus for Pantheon."

Secondaries players are busy developing innovative structures to accommodate unfunded commitments, however. Few, if any of these deals has yet been completed, but a plethora are expected next year.

"There is a lot more discussion going on regarding structures that will allow investors to move unfunded commitments – structures that focus on meeting that objective rather than a pricing objective," says Jinkens. "But there has been a lot more talk than action so far. It is more a story for 2009."

One scenario would involve the secondaries investor taking over the unfunded commitments, but with financial protection in place. The unfunded commitments would be rolled into an SPV but the secondaries player would not pay anything upfront. Once a certain threshold had been reached, however, the firm would share the upside with the vendor. Alternatively, a deal may involve a deferred purchase payment due when a given percentage of the unfunded capital has been drawn down.

Remembering GPs
Even if structures satisfactory to both secondaries buyer and limited partner seller
can be achieved, however, there is still one more party to consider – the GP. Private equity firms' negotiating positions have certainly been considerably weakened, but theoretically they do retain transfer rights, and are therefore able to veto secondaries sales.

Thomas Liaudet, principal of placement agents and secondaries advisory firm Campbell Lutyens, is sceptical about how rigorously these rights will be enforced. "GPs used to worry about the long term. Now they just want LPs who can meet capital calls," he says. "Private equity firms are being far more flexible about who they will welcome. The luxury of being selective has vanished."

Jinkens agrees that private equity investors are rarely exercising their right to block sales. "GPs are being very co-operative," he says.

"Most are commercial animals. If an LP steps up and says they want to sell, 99 per cent won't stand in their way."

However, others believe that default horror stories are having the opposite effect – that they are, in fact, prompting GPs to think very carefully about the make-up of their investor bases.

"Six months ago, endowments were considered the best LPs a general partner could have. They rarely sold and they could scale with you," says Ward. "GPs are now very concerned about who is buying those interests."

Jordan insists general partners would rather have secondaries investors that want to be there than primary investors that have no choice. "I have been to investor meetings before and run into quite a number of our competitors," she says. "In my view, GPs are pleased to have happy secondaries investors rather than unhappy primary ones. There has been a shift though," she adds. "The current market turmoil will mean there will need to be a big focus on managing your investor base going forward."

Indeed, while for many, short-term necessities dominate, the prospect of a barren fundraising market means that every GP has its eye firmly on long-term certainty of capital. It is theoretically possible, given the glut of secondaries sales on the market, that funds may end up disproportionately weighted with secondaries players. Private equity firms are therefore inevitably favouring secondaries houses with a primary capability.

Several have dedicated funds of funds operating alongside their secondaries business.

"Vendors certainly favour those firms with a primary capability, and are excluding others," says Ward, adding that while stapled secondaries – where a follow-on primary commitment is contractually tied to the secondaries deal – are rare in the current market, the potential for future capital is very important to the GP.

"Having primary investment capacity is important," says Wilson. "As a result, we expect to see specialists raising capital with a primary capability." Greenpark and Coller are two firms that have adopted this strategy. "The question is whether that will be in the best interest of their LPs, who are investing with them for secondaries exposure."

The need to build an investor base capable, and willing, to support a private equity firm over the long term, may also provide an opportunity for any substantial institutional investor that has managed to survive 2008 with its private equity operations intact to aggressively enter the secondaries space.

Second in command
Few segments of the private equity industry are better positioned at this point in the cycle than secondaries players. However, this small corner of the asset class is not without its concerns.

Several of the biggest secondaries specialists are themselves on the fundraising trail, and all have the prospect of distress among their existing LPs to contend with.

Harbourvest, for example, is currently on the road, although Wilson says the firm is fortunate that it was early to market.

"We held a first close at the end of 2007 and are now close to our hard cap at €2.9bn," he says. "LPs are interested in the secondaries market, but the challenge is to convert interest into commitments, given that so many LPs are constrained by the denominator effect."

Pantheon is also in the process of fundraising, and Ward agrees that LPs' appetite is focused strongly on secondaries, distressed investment and mezzanine. But he, too, sounds a warning. "Appetite means nothing if the money is not there."

Secondaries houses are nevertheless in that fortunate counter-cyclical position that means their deal flow is soaring, and prices are tumbling. Those that react to this unique economic environment – and in particular to the unprecedented spectre of defaulting LPs – with innovation, speed and creativity may well find that in 2009 it is secondaries that gets first place.