6
The Secondary Market
Secondary transactions refer to the buying and selling of pre-existing limited partnership interests in private equity and other alternative investment funds. These interests include both commitments that have already been drawn down by the GP and unfunded commitments. Importantly, the transfer of investor commitments between LPs in the secondary market must not be confused with secondary buyouts or similar transactions where a deal is exited by selling the underlying portfolio company to another fund.
The emergence of a secondary market for stakes in limited partnerships has been hailed as the advent of liquidity in an otherwise illiquid asset class. With liquidity risk being reduced, it is generally expected that the broadening and deepening of the secondary market will help fuel the growth of the primary market for investments in private equity and real assets. While long-term allocators who are already exposed to these asset classes may be encouraged to increase their current allocations, a higher degree of liquidity, so the argument goes, could expand the universe of potential investors who would otherwise be constrained by the liability profile of their balance sheets. Furthermore, the growth in secondary transactions has often – and mistakenly – been viewed as a superior means of price discovery compared with subjective NAV estimates of invested capital.
Indeed, the secondary market for fund investments has gained substantial momentum over the last decade and represents one of the most important developments in the recent history of alternative investing. Undoubtedly, the secondary market would not have reached its current level of significance if it had not brought about important advantages for both sellers and buyers of interests in limited partnerships. However, as we caution in this chapter, the secondary market has not materially altered the fundamental characteristics of fund investments and hence the challenges investors face in measuring and managing the particular risks that come with commitments to limited partnerships remain essentially unchanged.
Our discussion starts with a brief description of the micro structure of the secondary market, introducing the different actors on both sides of the market and discussing the intermediation of transactions between sellers and buyers. Next, we debate the different factors that motivate private equity investors to sell and buy assets in the secondary market. These factors have a considerable impact on the supply of, and the demand for, funds in the secondary market. Pricing of stakes in a fund or a portfolio of funds is of particular interest, as the price reflects the valuation of the acquisitions the funds have already made as well as the unfunded commitments to this fund or the portfolio of funds. Then, we look at the behaviour of secondary prices over the cycle and the volume of assets that changed hands over the past decade. Finally, we discuss the interactions between the primary and secondary markets and their impact on portfolio construction under risk considerations.
6.1 THE STRUCTURE OF THE SECONDARY MARKET
6.1.1 Sellers and their motivations to sell
Sellers in the secondary market are LPs in private equity funds or similar structures set up to invest in real assets. There are different reasons why LPs decide to sell their stakes in such funds. Broadly speaking, we may differentiate between sales that are motivated primarily by liquidity constraints and those that are related to the strategic repositioning of an investor's portfolio. Understanding these different reasons is important to assess the informational content of transaction prices in the secondary market.
Liquidity-motivated sales
As far as liquidity-motivated sales are concerned, the desire to transfer stakes in a limited partnership is usually cyclical. Box 6.1 discusses the case of the Harvard Management Company, which attracted considerable public attention as it decided to sell a portfolio of illiquid fund stakes worth USD 1 billion during the recent financial crisis. To be sure, the endowment of Harvard University was not alone. In fact, many other LPs with a substantial exposure to private equity and other illiquid asset classes found themselves in a situation where distributions dried up at a time when margin calls on other investments, such as hedge funds, rose and redemptions were reduced or even excluded. In this situation, a number of LPs with large unfunded commitments ran a significant risk of defaulting on possible capital calls and decided to liquidate their position partially or even entirely.
Such fire sales are not new. As a matter of fact, liquidity risk has played an important role for the secondary market to come into existence in the first place. As Talmor and Vasvari (2011) argue, secondary transactions started to emerge after the stock market crash in the fall of 1987 and the global recession at the beginning of the 1990s when economic conditions resulted in an intensive need for liquidity among investors. For the same reason, investors also wished to reduce their funding obligations on committed capital, as their inability to meet the capital calls of the GPs would have implied a default with serious consequences. As the demand for illiquid assets is typically weak in periods of economic turmoil, sellers usually have to accept significant discounts to the NAV in distressed transactions, an issue we return to in Section 6.3.
Strategic sales
As the secondary market has matured, it has been increasingly used by private equity investors to manage their portfolio holdings actively. Sell-side LPs may decide to divest their entire stake in a particular fund or even offer their entire portfolio of fund investments. Others, however, may decide to sell only a certain share of their stake in a partnership, signalling their continued confidence in the fund manager. Which option sell-side LPs pursue essentially depends on their individual objectives.
Sometimes, LPs are dissatisfied with the performance of a fund or a portfolio of funds and lose confidence in a management team. Selling their stakes in such funds can generate capital that may be redeployed into new opportunities (Meyer and Mathonet, 2005). Conversely, a LP may want to lock in returns if he believes that the fund manager is not likely to materially increase the performance of the underlying portfolio companies further during the remainder of the lifetime of the fund (Almeida Capital, 2002).
Another strategic reason to sell may lie in an unintended overexposure to private equity. This so-called denominator effect usually arises in periods of financial stress when prices of marketable instruments adjust much faster than valuations of illiquid investments, resulting in a higher-than-targeted share of the latter. In fact, many investors prefer to apply ranges to target allocations for their illiquid asset classes, which is a pragmatic approach to avoid over-reacting to relatively short-term developments in public markets. Bringing the actual portfolio weights in line with an investor's asset allocation targets may prompt a sell-off of parts of his illiquid investments. Alternatively, an investor may allow the portfolio to readjust more gradually by postponing new commitments to asset classes to which he is overexposed. However, investors who choose this route risk having underdiversified portfolios in terms of vintage years, a particularly important dimension of diversification.
Related to this are adjustments and “tactical” shifts in an investor's approach. For instance, while many pension funds have built up highly (even overly) diversified investment portfolios over many years, some have decided to rationalize these portfolios by focusing on their core relationships and utilizing their resources more efficiently.
Furthermore, there may be regulatory reasons for LPs to seek early exits through the secondary market. Regulatory changes, such as those pertaining to banks (Basel III, European Capital Adequacy Directive IV, Volcker Rule), insurance companies (Solvency II) and pension funds (IORP Directive), may impose quantitative restrictions on certain asset classes or affect their attractiveness through changes in specific capital requirements to protect an investor's portfolio against possible but unexpected losses due to financial shocks. As the opportunity costs of holding illiquid investments rise as a result, the investor may decide to sell in the secondary market. Importantly, secondary transaction volume has consistently been led by financial institutions between 2008 and 2011 (Figure 6.1).
Secondary sales may also be considered in the context of a broader reorientation of an investor's portfolio of fund investments. For instance, in cases where overall allocation targets are already met, a restructuring in favour of particular market segments, such as emerging markets, could be achieved much faster through a sale of funds targeting private equity and real assets in advanced economies.
Finally, sales are sometimes motivated by a change in group strategy, which often occurs following a period of poor investment results in challenging market conditions and in the context of changes in corporate control, senior management shifts or other corporate-level events (Meyer and Mathonet, 2005). In such situations, LPs sometimes decide to sell their fund investment portfolios wholesale, exiting entire asset classes or at least sub-asset classes, such as VC after the tech bubble burst in the early 2000s.
6.1.2 Buyers and their motivations to buy
On the buy side, the secondary market has historically been dominated by dedicated secondary funds and other funds-of-funds. In recent years, however, a growing number of non-traditional buyers have entered the market, including pension funds, insurance companies, endowments, foundations, family offices, SWFs as well as hedge funds. Their reasons to buy illiquid assets through secondary transactions are as diverse as those for sellers to dispose of their holdings. To begin with, in certain market conditions there are distressed assets offered at significant discounts – for those who have at their disposal a sufficient degree of liquidity to meet the unfunded commitments of the fund investments.
An important advantage in this context is the fact that secondary investments are subject to less uncertainty when compared with commitments to primary funds, which represent “blind pools” of capital. At the time of making a commitment, a primary investor does not know how his capital will eventually be deployed by the fund – apart from the broad investment guidelines specified in the limited partnership agreement. By the time a secondary transaction takes place, a significant share of the fund's capital has already been invested in portfolio companies. Prospective buyers can analyse them in detail and already have indicators that help to distinguish between companies which developed according to plan and those which did not.
Note, however, that this advantage can be significantly reduced, and even eliminated, in early secondary transactions. Sometimes called “purchased primaries”, such transactions take place at a very early stage of the fund. In extreme cases, the buyer agrees to buy the seller's commitment at a point in time when the fund has not yet made any acquisitions at all. Purchased primary transactions are often distressed sales, which allow the buyer to acquire a stake in a fund or portfolio of funds from an LP who faces a non-trivial risk to default on future capital calls from the fund managers. These transactions were mainly seen during the financial crisis of 2009, but their volume has decreased significantly over recent years.
Other LPs might be interested primarily in secondary transactions as a means to get exposure to private equity and real assets quickly without committing capital over a period of 10 to 12 years, which is typical for primary fund investors. Given that it normally takes several years for a fund to reach the cash flow break-even point, a secondary acquisition of a 4-year-old fund reduces this period significantly and potentially even eliminates it. Furthermore, the entire holding period is typically reduced to 6 to 8 years before the fund liquidates itself. The different dynamic in the secondary market can be employed as a means to counteract the J-curve effect of primary fund investments. This effect describes a well-known phenomenon in private equity and similar asset classes, whereby capital outflows at the beginning of the lifetime of a fund results in negative IRRs, before turning positive when the fund begins to divest assets, resulting in capital inflows for the LP (see Figure 6.2 and Box 6.2). This mitigating effect is of particular relevance for investors with a relatively young portfolio, where positive net cash flows can be expected only in the medium term. Take, for example, secondary transactions that were realized and intermediated by UBS (Figure 6.3). Almost one-third of the funds in which stakes were acquired in the secondary market in 2011 was from the vintage year 2007. If we add funds from the vintage years 2006 and 2008, almost three-quarters of the funds in which stakes were acquired in 2011 were between 3 and 5 years old.
Figure 6.2 J-curve and typical timing of secondary transaction.
Figure 6.3 Global private equity fundraising and relative vintage distribution of 2011 secondary transaction volume.
Source: UBS; AlpInvest Partners.
Moreover, investments in the secondary market allow LPs to reach their target allocation of private equity and real assets significantly faster than commitments to primary funds only. In addition, given the substantial cyclicality in the fundraising market, secondary investments offer LPs an opportunity to maintain a more steady investment pace.
Further, it is sometimes argued that secondary investments may help LPs gain access to oversubscribed funds in the primary market. Particularly successful funds with an outstanding track record frequently do not accept investors unless they have already committed capital to previous funds. In fact, sometimes secondary transactions are closely linked to the raising of a new fund by the GP. In a stapled transaction, a secondary buyer acquires an interest in an existing fund from a current LP and, at the same time, makes a commitment to the new fund being raised by the GP. However, whether or not a secondary investment qualifies an LP as an existing investor is up to the GP. Even if the GP agrees on the secondary transaction concerning existing partnerships, there is no guarantee that he admits the LP to his successor funds.
Finally, secondary investments also improve investors' ability to build diversified portfolios. While in the primary market the potential to diversify across geographies, industries, fund sizes, investment strategies and vintage years is limited to current and future vintage years, investments in the secondary market enlarge this potential to past vintage year – albeit at valuations that reflect the set of information at the time of the transaction.
6.1.3 Intermediation in the secondary market
Although the secondary market has seen a significant increase in volume of transactions over the last 10–15 years (see next section), it has remained highly opaque. At the most fundamental level, potential sellers need to find a potential buyer and those who are eager to purchase stakes in private equity and real asset funds in the secondary market need to identify potential sellers. Importantly, while transactions in secondary markets are usually initiated by sellers, in the secondary market for stakes in private equity funds it is not uncommon for buy-side LPs to pro-actively source deals. However, market transparency has generally remained low, despite recent efforts by various data vendors to build specific internet platforms for secondary transactions. Information about market conditions is often spurious, and little is known about prices at which transactions finally settle.
Furthermore, the secondary sales process in and of itself can be highly complex and time-consuming. While transactions involving individual funds or small portfolios are usually negotiated bilaterally, intermediated auctions have become increasingly common for larger and more complex transactions. This process is facilitated by financial intermediaries who are today involved in the majority of deals in the secondary market. Used mainly by sellers, intermediaries help identify buyers and structure fund interest offerings. Financial intermediaries are either specialized secondary advisors (e.g., Campbell Lutyens, Cogent Partners, UBS) or placement agents, generally charging a transaction fee between 1% and 2% of the value of the transaction (Talmor and Vasvari, 2011).
Financial intermediaries ensure that the sales process is competitive. Typically, a number of LPs are contacted to sound out their potential interest. In cases where a large portfolio is sold, intermediaries may divide it into different subsets to improve the chances of finding interested buyers. LPs make bids in a managed auction for the particular stakes they want to purchase, which are based on confidential information the intermediary provides about the holdings of the fund(s) and their valuation. Many secondary auctions involve two rounds. After a first round of bidding, a subgroup of potential buyers is invited by the seller and the intermediary to the second round. In the second round, interested buyers have the opportunity to revise their bids in light of new information they might have acquired in the process. While the set of information the intermediary provides is the same for all interested buyers, large LPs with diversified portfolios often have an important competitive advantage in the sense that they have superior proprietary information about the fund manager, his previous track record and the quality of the current investments.
Taking into account the diverse motivations of buyers and sellers, intermediation in the secondary market has become increasingly complex. Although traditional secondary transactions account for the majority of deals, structured secondaries have gained in importance in recent years. Structured secondaries may entail the creation of a new structure to hold the assets, the delegation of managing the assets to a new team, different payment structures or the seller's participation in the upside of the portfolio. For example, as Talmor and Vasvari (2011) explain, the seller may keep some or all of the fund interest on its balance sheet, with the buyer agreeing “to fund all future capital calls of the seller's portfolio in exchange for a preferred return against future distributions of the seller's portfolio.”
6.2 MARKET SIZE
The secondary market has grown significantly over the last 10 to 15 years, as the primary market has expanded substantially during the period and sellers and buyers have pursued a more active management approach of their alternative investment portfolios.
6.2.1 Transaction volume
It is estimated that the global volume of secondary transactions increased 10-fold between the turn of the century and 2011 (Figure 6.4). According to Cogent Partners (2012), a financial intermediary, stakes in private equity funds valued at around USD 23 billion changed hands in 2011, the second straight year in which the market volume eclipsed USD 20 billion. It is important to emphasize that the total supply was significantly larger, however. Partners Group (2011), for instance, notes that they had sourced a secondary deal flow of over USD 60 billion in 2010, implying that around two-thirds of the assets LPs wanted to dispose of in 2010 failed to find a buyer.
The failure to find a buyer for a transaction implies that the price does not fall far enough to clear the market, an issue we return to in Section 6.3. A key issue is information asymmetries, which give rise to the “lemons problem” we introduced in Section 3.3.2. Typically, the seller knows much more about the quality of his portfolio than the potential buyer, who in the absence of better information may assume that the fund or portfolio of funds he is offered to buy is of average quality. This means that the seller of a high-quality portfolio may be unable to get a sufficiently high price to make selling the portfolio worthwhile. Thus, the “lemons problem” may prevent a transaction from happening, explaining why the offered amount in individual years has by far exceeded the amount of commitments that actually changed hands. Note that the “lemons problem” has been an important impediment despite the fact that potential buyers are normally confined to large and sophisticated investors who often know the portfolios they are offered well, for example, because of primary commitments to the same partnerships.
Historically, around 3–5% of outstanding LP exposure comes to market, which represents the pool from which potential buyers can fish. In the end, 1.3–1.6% of the outstanding exposure – calculated as the sum of NAV and unfunded commitments – is actually traded each year (Figure 6.5). Thus, the rapid growth in the secondary market mirrors the substantial expansion in the primary fundraising market in past years. Note that a significant part of the total underlying pool of assets in 2011 is due to partnerships formed during the peak years between 2005 and 2008. In these four years, commitments to private equity funds (excluding real asset funds) totalled nearly USD 1.7 trillion. As we showed in Figure 6.3, these vintage years accounted for around three-quarters of the total transaction volume in the secondary market in 2011.
Figure 6.5 Asset pool and transaction volume, 2010.
Source: AlpInvest Partners; Partners Group; UBS.
The rapid growth in secondary transactions has not followed a steady trajectory, however. Instead, there have been important fluctuations around the longer-term trend. For instance, in 2003 the volume of transactions nearly tripled in absolute terms and increased 2.5-fold relative to the underlying base pool of assets. This jump is explained by a combination of factors. First of all, the overall volume during that year reflects one of the largest deals in the history of the secondary market – the acquisition of Deutsche Bank's private equity investments in the United States and Europe by MidOcean Partners, a firm formed in the same year through a management spinout transaction. Several investors provided the capital to acquire Deutsche Bank's private equity assets, including some of the largest players in the secondary market (e.g., AlpInvest Partners, Coller Capital, Harbourvest Partners and Paul Capital Partners, as well as some large pension funds). This single transaction alone amounted to more than USD 1.8 billion, or nearly one-third of the total transaction volume during that year.
Although unique in terms of its size, the Deutsche Bank/MidOcean transaction was probably motivated by similar reasons that also encouraged others to sell at least part of their private equity portfolios or even exit the asset class altogether. Despite the economic recovery from the recession at the beginning of the decade, many LPs had growing doubts about the performance of their private equity portfolios, which typically included a significant or even dominant share of VC funds. While such funds had performed spectacularly well in the run-up to the tech bubble, after the bursting of the bubble a growing number of LPs lost confidence that the pre-bubble performance could be repeated. At the same time, commitments to primary private equity funds dried up and started to recover in earnest only in 2004. Importantly, for the first time the sellers in the secondary market included a pension fund, the State of Connecticut Retirement Plans and Trust. The sellers were willing to accept significant discounts relative to the NAV, an issue we shall return to in the following section.
Conversely, the volume of secondary transactions more than halved in 2009 compared with the previous year before returning to its previous level in the following year. At the beginning of 2009, global market conditions had deteriorated to unprecedented levels in response to the largest bankruptcy in history, the collapse of Lehman Brothers in the fall of 2008. Prices for risky assets deteriorated sharply and correlations jumped, triggering a massive flight to safety, with yields on US Treasuries pushed to record lows. The interbank market essentially froze, prompting central banks around the world to inject massive amounts of liquidity through unconventional measures. Investors' cash flow models were generally not designed to cope with this tail risk, and many long-term asset allocators found themselves short of liquidity as margin calls were raised, distributions dried up and many hedge funds limited redemptions.
In this environment, the supply of stakes in private equity funds skyrocketed, but given the huge amount of macroeconomic uncertainty, the profound lack of liquidity in the market and the massive degree of risk aversion among investors, there were few potential buyers. As NAVs were only gradually adjusted in line with the rapidly deteriorating operating performance of underlying portfolio companies and the continued decline in public markets, there was a wide gap between sellers' and buyers' price expectations. In the first half of 2009, this gap proved unbridgeable for many portfolios, except for a few transactions where sellers were particularly distressed. Only when global markets stabilized around the middle of the year and NAVs caught up with economic reality did transaction volumes in the secondary market regain momentum.
6.2.2 Fundraising
While commitments to private equity funds in the past determine the pool of assets that might be supplied today, on the buy side the secondary market has also seen substantial growth in recent years. In the post-crisis years 2009–2011, institutional investors made commitments of around USD 42 billion to specialist secondary funds, the largest amount in any 3-year period since the secondary market started to emerge (Figure 6.6). Although the history of the secondary market is still quite short, it appears that commitments to secondary funds have been less cyclical than commitments to primary funds. Instead, fundraising has followed an upward trend, with significant year-on-year variations. For instance, whereas commitments in the primary fundraising market fell sharply in 2001–2003, commitments to secondary funds continued to increase. As a result, the share of secondary funds in the overall fundraising market surged from less than 1% in 2000 to more than 5% in 2003. Although the upward trend of capital flowing into secondary funds remained intact during the boom years 2005–2007, commitments to such partnerships were dwarfed by funds committed in the primary market. Thus, the share of secondary funds in the overall fundraising market fell back to less than 2%. More recently, however, the secondary market reached new highs as the commitments to primary funds remained subdued in the post-crisis era.
Preqin estimates that specialist secondary funds had at their disposal resources of more than USD 30 billion at the end of the first quarter of 2012. This dry powder reflects commitments investors had already made, but which had not yet been drawn down by the fund managers. Note that this amount does not include potential resources from non-traditional buyers, nor does it include new commitments to secondary funds. As regards the latter, Preqin reports that there were 26 secondary funds in the market at the end of the first quarter of 2012, targeting a total amount of almost USD 23 billion. Of these funds, almost 50% already had at least a first close. Thus, from a buyer's standpoint the market seems to be poised for further growth, subject to cyclical variations around a longer-term trajectory.
6.3 PRICE FORMATION AND RETURNS
6.3.1 Pricing secondary transactions
Prices serve a critical function in markets by balancing supply and demand. In market conditions where supply exceeds demand, prices tend to adjust downwards to attract additional buyers and discourage sellers just enough to achieve a market equilibrium. Conversely, if demand exceeds supply prices are pushed upwards, attracting additional sellers and discouraging buyers until supply and demand are equated. While this general principle also applies to the secondary market for stakes in private equity and real asset funds, it is important to identify the peculiarities of that market to understand the informational content of secondary pricing. Specifically, investors, risk managers and regulators alike are interested in the following question: To what extent do secondary prices reveal fair market values that can be used to price portfolio holdings in illiquid assets for which there are no market prices?
Traditionally, fair market values are determined on the basis of the NAV of a fund or portfolio of funds. As Meyer and Mathonet (2005) point out, NAVs can be considered fair only if they are equal to the present value of the fund's overall expected cash flows. However, these cash flows include not only those that are related to the investments a fund has already made, but also future cash flows that are associated with the undrawn commitments the buyer needs to fund. While prices in the secondary markets are generally expressed in terms of discounts or premiums relative to the fair market value, sellers and buyers may have different views about the benchmark against which such discounts or premiums apply. As far as the former are concerned, the reference is usually the NAV of the capital that has already been invested by the fund manager. Conversely, potential buyers tend to view the fair value of a fund as applying to the total commitment – including those that have yet to be funded.
From the perspective of a potential buyer, one method to assess the fair value of a secondary transaction is based on a top-down analysis, using historic cash flows of a large number of funds from internal or public databases (Meyer and Mathonet, 2005; Diller and Herger, 2009). These historic cash flows are employed to model future cash flows, taking into account specific assumptions about the funds' characteristics. Such assumptions may be derived from internal grading systems (see Chapter 14 for details), with the economic value of the portfolio being determined under alternative scenarios. The secondary price from a buyer's perspective is then estimated by discounting the expected future cash flows, based on the buyer's expectations about the asset's performance:
with P0 denoting the secondary price offered by the buyer, CFi the fund's expected cash flow at time i, n the fund's maturity and IRRbuyer the buyer's expected IRR.
With the price a potential buyer is willing to pay reflecting expected cash flows from both funded and unfunded commitments, the buyer's offer will generally be different from the NAV reported by the GP, which is usually the reference point for the seller. The discount can be expressed as follows:
Few players will rely exclusively on a top-down analysis. Instead, most buyers of secondary assets will determine the price they are willing to pay for a given portfolio on the basis of a bottom-up analysis. In this analysis, the NAV reported by the GPs is of limited relevance, as the underlying assets are sold only in the future. Instead, the analysis takes into account the expected exit value and exit timing for current portfolio investments, projected future capital calls and the return on future investments made using such drawdowns, and the legal structure of the fund. These variables are used to conduct a discounted cash flow (DCF) analysis, helping determine the buyer's desired return on the transaction (target return of discount rate).
Following a bottom-up approach to determining the price for a given portfolio can be extremely resource-intensive. For instance, to determine the expected value of a privately held company at the time of sale, the buyer needs to analyse a set of key variables for each company in the portfolio, such as EBITDA, the company's degree of indebtedness (net of excess cash on the balance sheet) and the fund's ownership in the company. Further, the buyer must make critical assumptions about the remaining holding periods of the companies, the EBITDA growth rate, the rate of debt paydown and the future EBITDA multiple. While previous investments by the GP may provide some guidance, for example, with regard to typical holding periods, the outcome of this analysis can be highly sensitive to the underlying assumptions. Thus, buyers typically find it advisable to subject their estimates to different scenarios about the macro-economic environment and its implications for EBITDA growth rates, interest rates and exit multiples.
If valuations of buyout portfolios are already difficult and subject to substantial uncertainty, valuing venture portfolios is even more challenging by an order of magnitude. As we discuss in different parts of this book, venture investments typically have a wide range of potential outcomes, with a significant number of write-downs and write-offs offset by a few successful and highly successful transactions. For LPs it is generally not possible to assess the probability of individual companies falling into either category. Thus, secondary buyers considering VC assets are generally much more reliant on information they receive from the fund manager and are usually guided by his reputation and track record.
As far as unfunded commitments are concerned, buyers usually first determine the split between commitments used for future investments as opposed to those used for fund fees and expenses. In determining the value future capital calls may generate, a buyer will closely examine the GP's quality and historical returns. Depending on these factors, the unfunded part may be considered to be an asset or a liability. As far as the expected speed of the future capital calls are concerned, the buyer will typically be guided by historical data.
Finally, based on his analysis the buyer needs to determine his target rate of return, or the discount rate. This target rate varies across market segments, with mezzanine funds usually having a lower target rate than buyout funds, which in turn have a lower target rate than VC funds, reflecting their specific risk characteristics. Furthermore, target rates mirror market conditions, which vary over time. Target rates dropped on average below 15% at the peak of the last cycle, according to Cogent Partners' semi-annual trend analysis, but they climbed to 30% in late 2008 and early 2009 amid extreme uncertainty about the macroeconomic outlook and the global financial markets. While these numbers might have fallen for larger players participating in auctions, the target rate is generally viewed to be still high for other market segments. For example, at the smaller end of the market with less intermediation and transparency, target returns are believed to be less cyclical and typically at a higher level.
In this context, tactical considerations may also play a role. As Talmor and Vasvari (2011) note, for example, buyers have not been in a rush to bid aggressively for mega-funds raised in 2007 and 2008, given the huge amount of capital committed to these partnerships. Assuming that a certain percentage of the stakes will eventually come to market, they can simply wait in the hope of purchasing the assets at a more attractive price. Further, some LPs may have been investors in a fund through a primary transaction. While this increases their visibility and may provide an important competitive advantage, they may face constraints by exceeding self-imposed concentration limits.
Let us turn now to the seller's side. From a seller's perspective, a key issue is the deviation of the price a buyer offers from the fund's NAV provided by the GP. In the case where a buyer is offering to purchase a stake in a fund at a discount to the partnership's most recently reported NAV, a transaction at that discount would create a loss on the seller's books. While realizing a loss is painful for any investor, Talmor and Vasvari (2011, p. 201) point out that this issue may be particularly important for alternative asset allocators as their compensation is typically tied more closely to performance. Finding a market-clearing price may be aggravated further by different target rates of return used by sellers and buyers. The former tend to employ lower discount rates than potential buyers, which reflects, inter alia, a risk premium indicative of their informational disadvantage. This discrepancy may be particularly large if the seller is a pension fund which, for actuarial reasons, uses a low target rate of return.
Reflecting the different supply and demand dynamics and the formation of price expectations among sellers and buyers, prices have varied significantly over the cycle (Figure 6.7). In 2003, the average high first round bid for assets intermediated by Cogent Partners hovered around 70% relative to the NAV. Despite this large discount, the transaction volume jumped almost threefold as shown in Figure 6.4. Obviously, sellers were willing to accept even large losses as they were seeking liquidity and restructuring their portfolios for strategic reasons. In the first half of 2009, the gap between the average high first round bid and the NAV widened to a record high of around 60%. At the same time, bid spreads (defined as the average high bid for a given asset divided by the average low bid for such asset) increased to record levels, reflecting the huge degree of uncertainty in valuing assets and the large variety in the perceived quality of the supply pool, with unfunded commitments representing a substantial share. However, in this buyers' market, the huge discounts offered by potential purchasers were accepted only by a few distressed sellers who were forced to liquidate assets. Others, however, who were less desperate decided not to sell. Thus, a large amount of assets potentially up for sale failed to find a buyer, with the volume of transactions falling by more than 50% compared with the previous year.
As Partners Group (2011, p. 5) points out, a key issue in the price formation process lies in the inertia of NAV reporting. Discounts offered by buyers were particularly large at the peak of the crisis, as many of the deals brought to market were still priced off September and December 2008 NAVs. However, given the further large drop in public valuations and the rapid deterioration in macroeconomic and financial market conditions, these NAVs were quickly outdated. However, as NAVs were increasingly adjusted downwards by GPs in line with prevailing market conditions, bid–ask spreads in the secondary market narrowed again and set the stage for a recovery in the volume of transactions. More recently, discounts have stabilized around 80% for first-round bids, with settlement prices presumably exceeding such bids by a non-trivial margin. At the same time, bid spreads have narrowed again, as the quality of supply has become more consistent and macroeconomic uncertainty has receded.
We may juxtapose the bids in the secondary market with the premiums and discounts at which listed private equity vehicles trade (Figure 6.8). Compiled by Preqin, these discounts/premiums are generally based on the latest available NAV and are composed of just 100 listed vehicles. The overall picture is fundamentally the same as the one depicted in Figure 6.7. Following a period of small premia for buyout and VC funds during the peak years, large discounts emerged in 2008 which troughed in the first quarter of 2009 at the height of macroeconomic and financial uncertainty. Thereafter, discounts narrowed, trading at around 20% – more or less in line with what is observed in the secondary market.
6.3.2 Returns from secondary investments
Returns from secondary investments are driven by the supply/demand conditions in the secondary market at the time when the secondary transaction takes place. Portfolio companies held by the fund(s) under consideration are valued in light of the information that is available when the stake(s) in the fund is (are) offered to the potential buyer, resulting in a possible discount or premium to the NAV. While unfunded commitments are generally treated in finance theory as NPV = 0, potential buyers, as we have argued above, might attach a different value to them. This value takes into account information about the fund manager that was not available at the time when the primary investment was undertaken. Thus, it is important to recognize that secondary investments are unable to rewrite history by providing access to market opportunities at historic valuations. Instead, secondaries represent a stand-alone market segment that should be seen as a complement to a primary fund programme.
Given the valuation dynamics in the secondary market, how do returns compare with primary fund investments? In addressing this issue, we focus on returns of secondary funds expressed as IRR as well as TVPI. These returns are benchmarked against a portfolio consisting of all private equity funds raised in a given year for which cash flow data is available. The data are taken from Preqin, a leading data vendor, and refer to partnerships in the area of buyouts, venture capital, growth capital, mezzanine, turnaround, special situations and distressed. Essentially, our benchmark aims to mirror the broadest possible universe of investment opportunities a LP could have chosen from. Our sample period ranges from 1998 to 2008. The results are shown in Table 6.1.
Table 6.1 Performance of secondary funds
On a capital-weighted basis, secondary funds have outperformed our benchmark in most vintage years when returns are measured by the funds' IRRs. While their TVPIs are generally lower due to their shorter life, the strong IRR performance has contributed significantly to the rising amount of commitments to secondary funds in recent years. Essentially, LPs who are faced with the decision of where to allocate capital compare expected returns from secondary funds with those in their primary fund programme. What is interesting from the point of view of our discussion in this chapter, however, is that the returns generated by secondary funds in a given vintage year are related to purchases of stakes in primary funds raised in previous years. Take, for example, secondary funds raised in 2004. Weighted by the capital they raised, secondary funds returned an IRR of 21.2%. A substantial share of their acquisitions consisted of stakes in primary funds raised between 1998 and 2001. Their performance, however, was comparatively significantly weaker, ranging from 6.7% in 1998 to 18.6% in 2001. This gap is explained by the particular market characteristics of the secondary market and confirms that returns reflect the set of information that was available to the sellers and buyers at the time of the secondary transaction rather than the fundamental value of the underlying assets.
6.4 CONCLUSIONS
As we have discussed in this chapter, a secondary market has emerged over the past two decades that allows investors to sell their commitments to limited partnerships in order to generate liquidity or pursue strategic objectives. These commitments usually include those that have already been drawn down by the GP as well as those that are still unfunded. Often intermediated by specialized investment banks, these commitments are bought by investors who are primarily attracted by the potential discount at which a transaction may take place, the shorter period during which the invested capital is locked in and the portfolio diversification properties of secondaries.
The emergence of secondary transactions has usually been portrayed as a market response to the illiquidity of fund investments that constrains the universe of investors to those with appropriate liability profiles. As significant as the development of the secondary market may be for constructing efficient portfolios, this chapter has cautioned that it should not be perceived as a game changer in terms of risk management in illiquid investments. To begin with, although the secondary market has expanded rapidly in recent years, it has remained small relative to the primary market, with only a few percent of primary commitments being transacted in the secondary market. Second, the secondary market, just as other financial markets, may dry up precisely at the time when it is needed most. The year 2009 provides an important example. Although a maximum amount of supply came to market, the actual transaction volume collapsed as sellers were not prepared to accept discounts of 60% and in individual cases even more, unless they were under exceptional pressure to create liquidity.
For similar reasons, it appears doubtful that secondary market prices can be used as benchmarks for fair market value. Secondary prices are not observable. Transactions are confidential and the final settlement price is generally known only to the buyer and the seller (and the intermediary to the extent that a transaction has been facilitated by a specialist agent). The secondary market price reflects current market conditions for those who participate in the market, either as sellers or as buyers. But this tells us little about the underlying value of the portfolio which is held until maturity. While distressed sellers are forced to accept substantial discounts from buyers that are less constrained, the observed dynamic in the secondary market rather underlines the importance of appropriate risk management.
1 Karmin and Lublin, “Calpers sells stock amid rout to raise cash for obligations”, Wall Street Journal, 25 October 2008.