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Private Equity

Investors seeing big promises from secondary market

Many avoid early period when returns are negative

Melissa J. Ma of Asia Alternatives Management
Melissa J. Ma said the secondary market is the best way to avoid the J curve.

The private equity secondary market has become a white-hot investment sector, with managers raising record amounts of capital as global investors fill out private equity allocations.

Firms from alternatives investors like Blackstone and Hamilton Lane to longtime secondary markets players like Lexington Partners LP are raising billions. Investors are gravitating toward secondaries as managers tout the potential added yield without the J curve — the early part of a fund's life when returns are negative.

Some managers that invest on the secondary markets also are trying to capture the flows from investors new to private equity, mainly those based in Latin America, Asia and parts of Europe.

Investors in secondary funds end up paying a double layer of fees, paying the fees for the secondary fund as well as for the underlying funds in the portfolio.

Still, investors are putting their money into the funds. Fourteen global secondaries funds raised a total of $23.2 billion in the first half of this year, substantially more than the $17.7 billion raised by 11 funds in the first half of last year, ​ according to Preqin. This is the most capital raised for alternative investment secondary market strategies since 2012, Preqin data show.

The secondary market is the best way for investors to avoid the J curve, said Melissa J. Ma, co-founder and managing partner in the San Francisco and Hong Kong offices of private equity fund-of-funds firm Asia Alternatives Management LLC.​

On Sept. 13, Asia Alternatives closed on a combined $1.8 billion in a private equity fund of funds and separately managed accounts. The fund of funds also invests on the secondary market.

There's a lot of new money globally coming into private equity, Ms. Ma said. It's less from institutions in the U.S. and Europe, which have been investing in the asset class for years. The money is coming more from Latin America, China and Japan including the Tokyo-based 132.1 trillion ($1.2 trillion) Government Pension Investment Fund, she said.

Access to funds on the secondary market is "giving a lot of institutions the courage to dip into private equity," Ms. Ma said. "Institutions that are just starting want to cut the J curve from day one. The secondary market is the best way to mitigate the J curve."

Poised for growth

A soon-to-be released white paper on the private equity secondary market by New York-based The Blackstone Group LP asserts that despite a 10% decline in transaction volume in 2016, to $37 billion, the private equity secondary market is poised for growth in the long term. The report cites:

  • the growing universe of buyers and sellers;
  • a broadening of assets available, including sales by funds of funds; and
  • general partners increasingly are leading secondary transactions — 18% of all deals in 2016 and at $9 billion, close to 25% of the total secondary market.

"There is still a significant amount of unrealized assets remaining in 2005-2008 vintage year funds that are approaching their 10-year terms or extension periods," said Verdun S. Perry, senior managing director and co-head of Blackstone's secondary funds of funds business, which it acquired from Credit Suisse in August 2013.

The drop in transactions last year means managers are sitting on a massive amount of dry powder, more than $100 billion as of June 30, according to Greenhill & Co.,Inc., a secondary market broker and adviser.

"The secondary market has ... grown exponentially from $2 billion in 2000 to an estimated $45 billion by the end of 2017, based on activity from the first half of the year," Mr. Perry said.

These days asset owners of all types — banks, pension plans, family offices and sovereign wealth funds — are selling on the private equity secondary markets, he said.

"Banks are selling to free up capital; university endowments and pension funds are selling to lock in gains or actively manage their portfolios," Mr. Perry said. "Many sellers simply are consolidating relationships, going with their best-of-breed managers and selling the rest on the secondary market."

For example, in the first quarter, the Dallas Police & Fire Pension System sold about $43 million in limited partnership interests in seven managers on the secondary market to provide liquidity needed due to increasing withdrawals from the pension fund's deferred retirement option plan. The $2.1 billion pension fund has targeted 5% each to private equity and to private debt. As of Aug. 31, 10.82% of plan assets was invested in private equity and private debt, 0.83%.

Blackstone also is seeing fund-of-funds managers selling limited partnership interests in older funds — especially 2001-2003 vintages — on the secondary markets. Meanwhile, sovereign wealth funds are selling because the price of oil is down and many sovereign wealth funds are funded by oil reserves, or they are consolidating their managers, he said.

For example, in April, Mubadala Capital, the investment unit of sovereign wealth fund Mubadala Development Co., Abu Dhabi, sold a majority stake in its $2.5 billion private equity portfolio to private equity firm Ardian. The sale was part of a larger transaction that resulted in Mubadala Capital managing third-party capital for the first time.

Some managers worry the capital poised to invest on the secondary markets is overwhelming the opportunity set.

"The challenge is there is too much money chasing too few deals," Asia Alternatives' Ms. Ma said. "The amount raised far outpaces the supply of well-priced secondaries."

While this is good news for sellers, earning good returns on the alternative investment secondary markets is dependent on the assets' purchase price, she said.

Others agreed. "The secondary market for limited partnership interests is quite active, and has been for the past three years," said Paul Lanna, a partner in the New York office of Coller Capital Ltd. . "There is strong pricing in the market, so if you are going to sell, this is a good time to do it. We are seeing both public and private pension funds testing the market."

Pension funds are "opportunistically looking to sell if they get their price," Mr. Lanna said. "Funds of funds that raised capital before 2009 are looking to wind down their vehicles by selling (limited partner) interests."

Tom Kerr, managing director for the U.S. secondary team at Hamilton Lane Inc., Bala Cynwyd, Pa., said his firm does not lack for investment opportunity on the secondary market.

"Deal flow is as robust as it has ever been," he said."For us, the amount of capital we are managing in the secondary space has continued to grow."

But, he added, it is important to "right-size" the amount of capital raised so as not to raise more capital than the firm can invest.

Even so, Mr. Kerr said he does not think there is too much money being raised for the opportunity set.

There is a total of $2 billion in net asset value of existing private equity funds. That puts the roughly $100 billion in dry powder aiming to invest in the secondary market, he said. And he expects transactions to pick up in 2017.

Caution needed

While many investors are using the secondary market as their first entry into private equity, some managers urge caution.

Steve Baker, managing director and head of private equity at Cincinnati-based Fort Washington Capital Partners Group, the institutional private equity division of Fort Washington Investment Advisors Inc., warned that investing on the secondary private equity markets "is not private equity-lite or private equity with training wheels."

There are opportunities, investors just have to pick their spots, he said. Some managers are using leverage to buy portfolios of limited partnership interests to enhance returns, which adds risk to the investment.

"Some people are pulling back from traditional secondaries because they feel the market is overheated and leveraged," Mr. Baker said. "We think we can find our way through the jungle by focusing on structured transactions."

Even though limited partnership interests are selling for 90% to 95% of net asset value, Mr. Baker said he still sees opportunities.

"It's a little rich but there's not anything in the economics that give me pause" about secondary transactions overall, he said.

Ryan T. McGovern, managing director of private equity firm Star Mountain Capital LLC, New York, said his firm invests in the small end of the middle market, in which there is less money chasing deals.

"The larger part of the secondary market is very competitive," he said.