A recent announcement by the chief investment officer of the California Public Employees' Retirement System is shining a bright light on increasing liquidity in the private equity market. According to Ted Eliopoulos, the $302.2 billion system intends to dramatically reduce the number of external managers it uses to reduce costs and complexity. CalPERS has given no indication that it is rethinking its longtime commitment to private equity, and much of the rationalization will occur in other asset classes. Still, the number of GPs managing the plan's $30 billion-plus of private equity assets is expected to shrink by two-thirds over the next five years.
This move underscores a broader trend toward more liquidity in the private equity market. An already growing secondary market is likely to become larger due to the size of the assets for sale. Given CalPERS' scale and stature, other institutional managers may also follow suit, further increasing the size of the secondary market as well as the level of activity. Indeed, some other institutions like the $106.8 billion Washington State Investment Board have already moved in this direction, albeit with less publicity. If anything, the trend is likely to gain momentum, as it is the logical outcome of a widespread desire for lower costs and greater transparency, both of which have been repeatedly confirmed by institutional investors responding to surveys conducted by SEI in recent years.
As the evolving needs of institutional investors shape today's private equity market, opportunities as well as challenges are being created. In an attempt to better understand various perspectives on liquidity in the private equity market, SEI recently surveyed 70 institutional investors. Survey respondents included 50 traditional limited partners (retirement plans, corporations, family offices, foundations, endowments, sovereign wealth funds, etc.) as well as 20 funds of funds. Six of 10 respondents are based in the U.S., with the remainder hailing primarily from Europe and, to a lesser extent, Asia.
More than a third of the investors surveyed say the private equity market is more liquid than it used to be and continues to become more so. Almost half of the traditional limited partners in the survey have already bought or sold secondaries at some point in the past, and approximately one in five plans to participate in the secondary market at some point in 2015. Transactions involving traditional limited partners are primarily conducted directly or via brokers. About 71% of limited partners plan to sell assets this way in 2015. The percentage of limited partners buying assets directly is slightly lower (64%) due to the fact that many (54%) plan to invest in dedicated secondaries funds. Meanwhile, proliferating platforms and exchanges are playing a small but growing role. While only 18% of traditional limited partners intend to buy secondaries listed on platforms or exchanges, 29% say they plan to dispose of their assets in this way.
The picture is somewhat different among fund of funds. As secondaries specialists, all of them transact directly with buyers, sellers, and brokers. Perhaps more surprising is the level of buying and selling among fund of funds themselves. Illustrating another layer of liquidity in the market, two out of every five fund of funds disposing of assets in 2015 say they intend to sell to a secondaries fund. One out of every five buying assets says they will invest in a dedicated secondaries fund.
Participation in the secondary market used to be frowned upon in some circles, but that attitude is fading. When asked whether they thought there was any taboo associated with selling assets on the secondary market, only a tiny minority of investors said “definitely.” Just under half acknowledged “a little” residual taboo, but they were outnumbered by those who said there was no taboo at all. Changing attitudes are important. If limited partners can participate in the secondary market without fear of offending their general partners or fellow investors and potentially jeopardizing future relationships, a powerful psychological barrier has been removed and paves the way toward greater liquidity.
Valuations can be a challenge, however. Growing activity in the secondary market has driven valuations so high that the majority of investors in the survey said secondaries were overvalued. But more than a third of investors say the secondary market is fairly valued, and a small minority of limited partners even claim it is undervalued. This disparity of opinions highlights a more fundamental issue, which is the difficulty of valuing private equity assets. One of 10 survey respondents say they view the valuation of secondaries as a “frustratingly opaque” process, outnumbering those who say it is “generally fair and accurate.” The majority of investors (about 85% of both traditional limited partners and fund of funds) agree that valuation methodologies can be idiosyncratic and inconsistent, depending largely on the parties and assets involved. Valuations and liquidity are intrinsically linked, but their relationship has a “chicken or the egg” quality. A problematic valuation process will hinder liquidity in the secondary market, and limited activity makes valuations even more difficult. Conversely, more transparent and consistent valuations will boost activity, and greater liquidity will also make valuations simpler and more accurate.
The announcement by CalPERS is likely to have repercussions far beyond that organization and the managers with which it does business. The direct effect will be to amplify liquidity in the secondary market. Perhaps more importantly, it is emblematic of moves by increasingly assertive institutional investors across the country to transform what has traditionally been one of the least liquid asset classes into something else. It comes at a time when evolutionary forces in the private equity market are also percolating from the bottom up, as retail investors and their advisors look for ways to effectively access a market that has served institutional investors well by delivering superior risk adjusted returns. The growth of exchanges, the advent of private equity mutual funds and ETFs, and the promise of crowd funding all hint at a private equity market that is likely to look very different in the future from the one with which we are all familiar.
Jim Cass is a senior vice president and managing director of SEI investment manager services.