Some perceive warning signs in secondaries

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Laurence G. Allen said investors are not pricing risk correctly.

A huge number of exits, and the record amount of dry powder secondary investors hold, are driving up private equity secondary market prices, raising concerns about what the future holds.

At one extreme are researchers at NYPPEX LLC, a Rye Brook, N.Y.-based private equity secondary market brokerage firm. Officials there expect a price correction of 5% to 7% in the private equity secondary market sometime in the second half of this year. The problem, they say, is that investors are failing to appropriately price risk.

Not everyone goes that far.

David Fann, president and CEO of private equity consulting firm TorreyCove Capital Partners, San Diego, and Thomas J. Kerr, managing director of consulting and money management firm Hamilton Lane Advisors LLC, Bala Cynwyd, Pa., do not see a bubble about to burst, but both agree the private equity secondary market is frothy.

“I think there are more buyers of secondaries than sellers right now. In order for a correction to occur, the supply demand characteristics need to shift,” Mr. Fann said.

And this shift will occur as a byproduct of trouble in the global market, they say.

“The secondary market won't correct absent a correction in the broader markets,” Mr. Kerr said. “The exit environment for PE-backed companies remains very attractive and, until that changes, the market will continue to be robust.“

At least $37 billion of unspent capital commitments exist in the private equity secondary market, NYPPEX officials estimate, with a crop of new buyers — including sovereign wealth funds and new private equity managers that specialize in the secondary market — driving prices ever skyward. Meanwhile, many firms are piling debt onto their positions in private equity fund limited partnership interests, adding more leverage to an already leveraged investment, industry experts note. ”Pricing has continued to increase, fueled by cheap financing, record levels of fundraising and the expectation that markets will continue to rise,” Mr. Kerr in an e-mailed response to questions. “High prices bring about more sellers, and there are plenty of buyers eager to put capital to work.”

At the same time, the spread between private equity funds on the secondary market and U.S. government bonds is the tightest since 2007, said Laurence G. Allen, managing member of NYPPEX. This tight spread between high-risk and low-risk assets is one indication that there is bubble in the private equity secondary market, leading to a market correction later this year, he said.

“Investors are not adequately pricing risk, which is driving secondary prices higher,” Mr. Allen said.

In the first half of this year, for example, the secondary high price of private equity fund-of-funds limited partnership interests was 104.15% of net asset values, up from 83.09% as recently as of Dec. 31.

"Leverage is back'

Neil Campbell, global head of alternative investments of Tullett Prebon Alternative Investments, a brokerage firm in London, said a correction won't happen until the IPO market and capital markets cool down as prices have been driven up by a huge number of exits and dry powder. But the markets are not without risk.

“The risk-free rate is almost zero and leverage is back in a big way,” he said. “It's getting scary.” Some private equity secondary market managers are topping off their investment with leverage, adding debt to private equity that is already leveraged, Mr. Campbell said.

“Investors are being promised huge returns, and secondary funds are charging fees upon fees,” Mr. Campbell said. “If you are a private equity fund that is levered, could be five times, and you are investing with a secondary guy and he is leveraging three or four times, that is pretty high octane.”

NYPPEX executives are not the only ones to notice the high prices. Institutional investors are eager to sell on the secondary market, but not so ready to buy. The State of Wisconsin Investment Board, Madison, which oversees $104.1 billion, is selling to take advantage of the high prices, said John A. Drake, senior investment officer, private equity.

“NAV is up meaningfully and pricing off the NAV is up meaningfully,” Mr. Drake said. “We have taken advantage of the market and exited some legacy, older vintage positions.”

SWIB has been selling a portfolio of legacy private equity limited partnership interests valued around $203 million, according to information released at a June SWIB meeting. Mr. Drake declined to comment on the sale. Wisconsin had $6.3 billion in private equity as of Dec. 31.

Indeed, volume on the private equity secondary market was up 33% in the first half of 2014 to $16 billion, according to a report from Setter Capital Inc., a brokerage firm in Toronto.

In the first half of this year, pension plans were the most active sellers on the secondary market, accounting for 25% of sales. Secondary market funds were the most active buyers in 71% of transactions, according to Setter Capital. “It's an aggressive market,” said Peter McGrath, managing director of Setter Capital. “Investors can sell older funds — where there's not as much upside in them — for NAV or close to it.”

The private equity secondary market is awash in capital that has to be invested now. “It's not just dry powder of the usual suspects,” Mr. McGrath said. “There are so many more buyers today than two or three years ago.”

Three years ago, Setter Capital tracked at most 300 buyers. Now there are more than 1,000, including sovereign wealth funds that have hired staffs directed to invest on the secondary markets, pension plans that have expanded their mandates to include secondary market investments and new managers investing on the secondary markets.

Large funds

Managers of secondary market funds have been consistently raising large funds. They closed on a combined $57 billion as of July 31, up from $42 billion three years ago, according to data from London-based alternative investment research firm Preqin. Private equity secondary funds raised a combined $14.8 billion through July 31, compared to $20.8 billion raised by 23 funds in all of 2013.

In April, Ardian, closed a secondary fund with the largest amount of capital ever raised — the $9 billion Ardian Secondary Fund VI.

Preqin estimates that as of July 31, the 10 top secondary fund managers had $40 billion of unspent capital to invest. And all this capital that the secondary market managers have raised has to be invested in a certain amount of time.

“The secondary guys have raised so much money and they've got to get it into the ground,” Tullett Prebon's Mr. Campbell said. So they buy positions in megabuyout funds, which allow secondary market fund managers to invest more and take larger positions in a particular fund, he said.

Of the $11.3 billion in private equity purchases on the secondary market in the first half of 2014, 73.1% were leveraged buyout funds, according to Setter Capital's report.

“Some of these funds, instead of buying at 110% (of NAV) should sell at 110% of NAV and find other things like bombed-out venture capital funds ... rather than buying blue-chip names,” Mr. Campbell said. n

This article originally appeared in the August 18, 2014 print issue as, "Some perceive warning signs in secondaries".