Secondary market M&A surge mystifies industry

No one sure if consolidation is behind the uptick

(updated with correction)

Industry insiders can't agree on what is driving the spate of mergers and acquisitions of private equity firms that invest on the secondary markets.

They say it's not clear whether the number of recent M&A deals reflects industry consolidation or a change of partners among secondary firms. What's more, many of the firms that were sold also offered funds of funds, a sector some say is in the midst of a consolidation.

Whether consolidation is happening or not, several factors — including a tough fundraising season, uncertain return expectations and a drop in transaction flow — are providing fodder for other alternative investment managers to gain market share and add new strategies.

Firms sold in the last two years include Parish CapitalAdvisors LLP, Greenpark Capital Ltd., Strategic PartnersInc., Cuyahoga Capital Partners LLC and AlpInvest Partners BV as well as Citigroup Inc.'s private equity business and Credit Suisse Group AG's secondary markets business.

Also during the period, AXA Private Equity became Ardian, as the fund-of-funds and secondary-market unit completed its spinout from insurance company AXA Group. AXA retained a 23% stake and agreed to commit €4.8 billion to new Ardian funds over the next five years. European institutions and French family offices own 31% and company management and employees hold remaining 46% stake, according to a September firm announcement.

“Many funds-of-funds and secondary firms have hit the wall,” said Mark Maruszewski, a partner in the New York office of private equity consulting and investment management firm StepStone Group LP. “These firms have struggled to raise capital, have been hit with regulatory changes, or do not have succession planning in place.”

StepStone has contributed to the trend. The firm is in the process of acquiring Greenpark and acquired Parish Capital in 2011.

Mr. Maruszewski's former firm, SilverBrook Private Equity, a private equity secondary fund and advisory firm, was acquired by StepStone in 2010.

Direct investments

Institutional investors with experience investing on the secondary markets have turned to investing directly, creating further consolidation pressure. For example, in March the C$188.9 billion (US$183.5 billion) Canada Pension Plan Investment Board, Toronto, invested US$468 million to acquire a portfolio of primarily food companies in a HM Capital private equity fund. At the same time, the CPPIB committed US$138 million to a new private equity fund managed by HM Capital successor firm, Kainos Capital Partners LLC.

Private equity firms investing in the secondary markets also have been squeezed by the weaker transaction flow. Private equity transactions in the secondary market dropped to about $7 billion in the first half of this year, down from $13 billion in the first half of 2012 and $14 billion in the first half of 2011, according to Dallas-based private equity secondary market brokerage firm Cogent Partners. Toronto-based secondary market broker Setter Capital estimates transaction flow at $15 billion by pro-rating the $6.7 billion transactions reported in its survey to the entire universe including secondary market participants who didn't respond to its August survey of 100 active secondary market participants.

“There have been significantly fewer transactions this year than in the past three,” said David Fann, president and CEO of private equity consulting firm, TorreyCove Capital Partners, La Jolla, Calif.

There are fewer forced sellers around the world, he said.

“Also, the private equity industry has provided investors with significant liquidity” in the form of increased distributions, Mr. Fann said. If investors have sufficient liquidity they don't need to sell off limited partnership interests in the private equity secondary market.

What's more, prices in the secondary markets have firmed, so there are fewer bargains for buyers.

“Finally, in general, the stock market has risen considerably, increasing the size of the investor's asset base, or denominator. As a result, private equity allocations as a percentage of overall assets have declined for most investors, thus alleviating the pressure to sell,” Mr. Fann said.

Handful will remain

Industry insiders predict that when the dust settles from these mergers and acquisitions, a handful of private equity firms that invest on the secondary market will remain. Currently, there are 28 secondary funds in the market seeking $21 billion in capital, according to Nicholas Jelfs, spokesman for London-based alternative investment research firm Preqin.

By contrast, only a small group of private equity firms that invest on the secondary market closed funds this year. They are: OHA Newbury Partners, which closed at $1.2 billion, Adams Street Global Secondary Fund 5, $1 billion; Hamilton Lane Secondary Fund III, $900 million; J.P. Morgan Secondary Private Equity, $598 million; StepStone Secondary Opportunities Fund II, $450 million; and RCP Advisors' RCP Secondary Opportunity Fund II, $404 million, according to Seattle-baseddata provider PitchBook Inc.

As of Oct. 10, 13 funds have closed on $10.8 billion compared to 14 funds that closed on $20.6 billion in all of last year, according to data provided by London-based alternative investment research firm Preqin Ltd.

Government regulation and investor demand for greater transparency have substantially increased the cost of running a money management firm from a few years ago, Mr. Fann said. “As a result, subscale players are under greater financial pressures. One natural consequence is industry consolidation,” he said. “Mergers and acquisitions will increase dramatically in financial services as firms need to scale.”

But not everyone believes that the burgeoning M&A trend points to long-term industry consolidation.

Todd Miller, Dallas-based managing director of secondary brokerage firm Cogent Partners, does not think the recent deals mark the beginning of an industry consolidation. AlpInvest, now part of Washington-based alternative investment firm Carlyle Group, is in the midst of raising a $4.5 billionsecondary fund. Credit Suisse's secondary group, now owned by Blackstone, is also raising new capital — a $3.5 billion sixth fund, sources said. Meanwhile Lexington Partners LP has spent its last $7 billion fund and is raising a new fund reportedly of equal size. (Lexington Partners closed the $1.57 billion Lexington Co-Investment Partners III in July.) Rebecca John, spokeswoman, could not be reached by deadline.

Change in ownership

Michael Forestner, partner, Mercer Investment Consulting in Atlanta, likewise doesn't see a consolidation. Rather, just a switch up in firm ownership. Indeed, industry executives say that the M&A mergers and acquisition activity is fallout from investors' search for customized solutions.

Blackstone bought Credit Suisse's secondary unit and Carlyle is buying real estate secondary market investment firm Metropolitan Real Estate Equity Management, Mr. Forestner noted. “Is it consolidation if they end up raising new funds?” Mr. Forestner queried.

“We believe that an important trend in today's private equity market is customization,” said StepStone's Mr. Maruszewski. “Every institution has a different risk-return requirement, time horizon, geographic strategy or performance requirements, and portfolios should be built to address these differences.” n

This article originally appeared in the October 14, 2013 print issue as, "Secondary market M&A surge mystifies industry".