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Secondary market no longer seeing bargains

Kishore Kansal
Kishore Kansal said many investors are selling into the secondary market to trim manager rosters.

Discounts to the alternatives secondary market have disappeared, and prices remain higher in the face of upcoming European elections as well as the aftermath of the election of Donald J. Trump and Britain's vote to withdraw from the European Union.

High prices are good news for sellers, but gone are the big discounts secondary market buyers had enjoyed in the years after the financial crisis. Executives of the San Diego City Employees' Retirement System have noticed the change.

Now, “we are happy if we can get 10%; sometimes it's flat,” said Liza Crisafi, chief investment officer of the $7.1 billion pension fund. “Expected returns are much less than they were.”

“It (secondaries) did really well for us. We never had a J-curve,” she added, referring to the low or sometimes negative returns of funds in their early years.

The San Diego fund built its private equity portfolio through secondary markets when it began investing in the asset class in 2009, she said. Back then, the pension fund enjoyed 30% discounts to net asset values while avoiding the J-curve. Secondaries now account for about 22% of the pension fund's private equity exposure, she said.

Still, Ms. Crisafi said the market remains attractive because older funds will return cash faster than new funds.

Current investor interest combined with the amount of capital raised in recent years also has helped drive up prices and transaction volume. The U.K.'s Brexit vote caused secondary market transactions to stall temporarily, but now movement is revving up across asset classes as sellers rush to take advantage of high prices before the coming elections in France, Germany, the Netherlands and elsewhere across Europe as well as the Dec. 6 referendum to amend Italy's constitution.

There are a lot of older funds to buy just now, said Kishore Kansal, managing partner, of London-based secondary markets broker PEFOX. Many pension funds are selling interests in older funds to pare their roster of alternative investment firms and to get cash for their limited partnership interests now rather than wait for the fund to wind down, Mr. Kishore said.

While prices are generally high, there can be wide spreads between the low and high bids, he said. This could be because limited partners differ on the outlook for the funds' underlying assets. However, secondaries fund managers flush with capital commitments are eager to spend it to attract even more capital.

“Some (general partner) buyers, for instance, regard it as an existential issue,” Mr. Kansal said. “Quite simply, if they don't do deals, LPs will be unlikely to give them more money in their next fundraising.”

"Pricing is strong'

“Deals were postponed at the beginning of the year ... but now pricing is strong and sellers are keen to take advantage of the pricing. Knowing the backdrop of Trump, Brexit and coming elections in Europe, they think that maybe these conditions will not last forever,” said Alistair Watson, senior investment manager, private equity secondaries, who is based in the Edinburgh office of Aberdeen Asset Management PLC.

Prices on alternative investment secondary markets have remained high most of this year, said Andy T. Nick, managing director in the San Francisco office of alternative investment secondary market brokerage firm Greenhill Cogent, a subsidiary of investment bank Greenhill & Co. Inc.

But there might be more fallout after Mr. Trump takes office in January. “I think it's fair to say that the one thing most people are agreed upon is uncertainty,” said Mr. Kansal. If Mr. Trump decides to push Congress to change the tax treatment of carried interest as part of his tax code overhaul, it could affect the team stability at many U.S. alternative investment firms, he added.

Despite the higher prices, managers that invest on the secondary markets are banking on continued investor interest. There were 44 secondaries funds in the market seeking a combined $32 billion, data from London-based research firm Preqin show. In the first three quarters of the year, managers that invest on the secondary markets have raised a total of $18.5 billion, the most capital raised by funds that invest on the alternative investments secondary markets at that point in the year.

“The market has to some extent bifurcated. There is a lot of dry powder for secondary investing held by a small number of secondary players,” Mr. Watson said. The 10-largest secondaries managers have a combined $54.8 billion in uncalled capital as of Sept. 30, according to Preqin.

But asset owners also are switching up their games. Investors on secondary markets are expanding from private equity to real estate, infrastructure and dedicated venture capital secondaries.

In November, the San Diego city fund made its first investment in real estate secondaries, committing $20 million to Landmark Real Estate Partners VIII, a fund of funds. SDCERS officials expect the investment to provide cash flow and help diversify the system's real estate portfolio, Ms. Crisafi said.

And the real estate secondary fund market is getting hotter. Landmark Partners is raising this new fund about a year after it closed the $1.6 billion Landmark Real Estate Fund VII.

Indeed, the largest secondaries fund to close in the third quarter was a fund investing on the real estate secondary market. Strategic Partners Fund Solutions, the secondary investment unit of Blackstone Group LP, in September closed Strategic Partners Real Estate Fund VI LP at its $1.3 billion hard cap. The latest fund is more than 300% larger than Blackstone's last real estate secondary fund, which closed in 2012 at $300 million.

Investors are able to get more attractive prices on the real estate secondary market because there is less competition, said Dimme Lucassen, a London-based investment manager who leads the secondaries group within the real estate multimanager unit of Aberdeen Asset Management.

And there is more deal flow as consolidation of pension plans, especially in the U.K. and the Netherlands, results in sales of limited partnership interests on the secondary markets.

Although the deal flow is hard to determine, real estate secondary brokers have come up with a rough estimate of about e10 billion to e12 billion over the next 10 years, he said.

Investors also are seeing opportunity in venture capital secondary markets.

In June, San Francisco-based Industry Ventures LLC closed its $500 million Industry Ventures Secondary VIII, a secondary fund focused on the venture capital secondary market. The $24.9 billion Texas Employees Retirement System, Austin, is an investor. Also this year, Top Tier Partners closed its $404 million Top Tier Venture Velocity Fund, a venture capital fund of funds that also invests on the venture capital secondary market.

The $7.5 billion New Hampshire Retirement System, Concord, and the $1.1 billion Baton Rouge (La.) & Parish of East Baton Rouge Employees' Retirement System are investors in Top Tier Venture Velocity Fund.

In November, the New Mexico Educational Retirement Board, Santa Fe, committed $100 million to a venture capital separate account managed by Top Tier Capital Partners for a fund of funds, co-investment and secondary market portfolio, said Ed Jacksha, chief investment officer for the $11.7 billion pension fund.

Attraction is threefold

The attraction of the secondary market is threefold: returns, cash flow and access to top venture capital funds that are oversubscribed when they are new, Mr. Jacksha said.

Some investors are buying limited partnership interests directly on the secondary market rather than getting exposure solely through commingled funds. At the same time, many investors are taking advantage of high prices by selling slices of limited partnership interests rather than large portfolios.

“There are new entrants coming to market that may have longer term time horizons or lower cost of capital, which is a positive to the market at the larger end,” Aberdeen's Mr. Watson said.

These investors have strong views on the kinds of funds they would like to add to their portfolios, Mr. Lucassen said. “They are willing to accept what we believe is a low return. It doesn't mean it is a bad deal for them; they have a longer horizon.”

Secondary managers are more likely to buy portfolios than asset owners, Mr. Lucassen said.

For example, in the third quarter APG Asset Management, Heerlen, Netherlands, which oversees e424 billion ($460 billion) in assets, bought interests in Arcus European Infrastructure Fund I from the 886 million ($1.1 billion) London Borough of Enfield Pension Scheme.

This article originally appeared in the November 28, 2016 print issue as, "Secondary market no longer seeing bargains".