Secondary market becomes hotbed of activity

The secondary market in alternative investment funds is sizzling, as institutional investors and managers attempt to clean up their portfolios before the next economic downturn.

Not only are investors selling alternative investment limited partnership interests on the secondary markets but so, too, are fund-of-funds and secondary market fund managers, looking to clean out limited partnership interests in funds that are nearing the end of their very long lives — so-called tail-end funds. These sellers also are selling younger funds of managers with which they don't intend to reinvest and emerging market private equity funds battered by currency volatility.

Sellers are putting their fund interests on the secondary market now while prices are still high and before prices drop in a downturn. Such a drop could force them to hold these aging limited partnership interests for yet another market cycle.

"Many of the new mandates and many of the current deals are (limited partner) portfolio sales," said Gerald Cooper, New York-based partner at Campbell Lutyens & Co. Ltd., a placement agency and secondary market adviser. "It seems like a mad rush to sell assets before the market turns."

Making investors even more eager to sell is that many of these older funds are bringing down the returns of their alternative investment portfolios. The average annual return in years 13 to 15 of the funds' lives was -0.56% as of March 31, compared to 1.12% as of the end of the first quarter of 2017, according to an analysis by secondary market broker NYPPEX.

"In general, tail-end fund returns continue to be very low and, in our view, not worth holding" by pension funds and other asset owners, said Laurence G. Allen, Rye Brook, N.Y.-based managing member and CEO of NYPPEX. But even with the lower returns, the funds can be attractive to managers who think some of the assets could turn a profit.

Fund-of-funds and secondary market managers also are ramping up their sales, amounting to 41% of transactions in 2017, up from 20% in 2016, according to Campbell Lutyens' latest report of estimated 2017 transactions.

"This year, I would expect that percentage to be at the same level or higher," Mr. Cooper said. "We're seeing it across the board from the smallest to some of the largest funds of funds."

Investors additionally are selling interests in older vintage funds of funds, said Kishore Kansal, London-based managing partner of alternative investment secondary market broker PEFOX LLP.

Overall, PEFOX is seeing strong prices on limited partnership interests, he said.

"Some of our funds are pricing at double-digit premiums," Mr. Kansal said.

PEFOX is not the only firm to see record prices across the secondary markets.

"Overall, prices in the secondary market are close to the record level we saw last year, when the average sale price was at a 4% discount to net asset value. This year, it's 5% — the second-narrowest annual average discount we've ever seen," said Mathieu Drean, Paris-based managing partner and global head of secondaries at placement agent and secondary market adviser Triago, in an email. What's more, prices for tail-end funds are higher — a 12% discount to net asset value, up from 19% of net asset value in 2012, Mr. Drean said.

These prices, when combined with the impact of funds raised during the private equity fundraising boom of 2005 through 2008 working their way through the secondary market, are increasing sales of funds that are 10 years old or more on the secondary markets, Mr. Drean said.

There's a lot of capital sunk into these older funds. Tail-end funds have a net asset value of about $570 billion, equal to around 12% of the entire alternative investment fund universe's $4.9 trillion in assets under management, according to Triago data.

Asset owners are using the secondary market to sell limited partnership interests to lock in gains.

"Some LPs are looking at the market and saying, 'It's been a great run. Why don't I sell and lock in gains,'" said a source familiar with the secondary market. As a result, an increasing number of tail-end funds are entering the alternative investment secondary markets. In the first half of 2018, 63% of the transactions — representing 24% of the total value of deals — were tail-end funds, according to Triago. Transactions involving tail-end funds have been growing steadily since 2012 when they accounted for 29% of the transactions and 12% of the total value of secondary market deals, Triago data show.

There were approximately $32 billion in transactions on the secondary market in the first half of 2018, up 18% from the $27 billion in transactions in the first six months of 2017, according to Evercore Inc., a global investment banking advisory firm that also has a secondary market advisory business. There could be between $65 billion and $70 billion in total transactions, surpassing the recored $54 billion in secondary market transactions in 2017, said Nigel Dawn, New York-based senior managing director and co-CEO of the private capital advisory group at Evercore.

In an example of a current deal, the $56.7 billion Los Angeles County Employees Retirement Association, Pasadena, Calif., is finalizing a sale expected to close in December of its interest in The Resolute Fund II, a 2007 vintage buyout fund, for $27 million, and it has another sale in the works, according to a pension fund report.

LACERA had committed $60 million to the fund, which has an uncalled commitment of $5.9 million. The Jordan Co. closed The Resolute Fund II in December 2007 with total capital of $3.6 billion.

LACERA officials began the process in January. At the time, its then-$5.3 billion private equity portfolio included about 130 limited partnership interests valued at $1.4 billion in funds of general partners that are no longer a core part of LACERA's ongoing strategy, according to an RFP it launched for a manager to help it run the sales process.

LACERA is not alone. In the past 12 months, the $52.6 billion Maryland State Retirement & Pension System, Baltimore, and the New Jersey Division of Investment, which makes investments on behalf of the $77 billion New Jersey Pension Fund, Trenton, also said they planned to sell limited private equity partnership interests on the secondary markets.

In the first half of 2018, pension plans were the second most active sellers on the secondary market, after general partners that were not funds of funds or secondary market managers, according to estimates of Toronto-based secondary market broker Setter Capital Inc.

Not all of the sales are of ancient funds. New Jersey is selling its interest in a 2011 vintage fund.

"If you are going to sell a tail-end portfolio, putting in new vintages helps sweeten the pot," Campbell Lutyens' Mr. Cooper said.

"Including 2012, 2013, 2014 vintages in a largely tail-end portfolio is pretty attractive. It helps engage buyers to spend time on the process and it makes the process more competitive."

In the second half of 2018, Setter Capital expects that funds of funds and secondary fund managers will be the biggest sellers.

In the first half, they accounted for 30.5% of total transaction volume.

Fund-of-funds and secondary market managers "are pruning their portfolios given currently attractive secondary prices and available capital," NYPPEX's Mr. Allen said. Secondary funds were the most active buyers, accounting for 82.4% of all purchases on the secondary markets in the first half of 2018, according to Setter Capital data.

Another new trend is that asset owners are beginning to sell emerging manager private equity fund interests on the secondary market, PEFOX's Mr. Kansal said.

"People are desperate to sell (emerging market private equity funds) given the volatility in the currency in those areas," he said.

Most emerging market managers have dollar- and euro-denominated funds but have exposure to local currency in the country in which they invest, Mr. Kansal added.

"Many (emerging markets private equity) funds have underperformed and even those that have done well in local currency terms have seen their dollar and euro equivalent returns eroded by adverse foreign-exchange movements," Mr. Kansal said.

And sellers are having to accept steep discounts compared to the fund interests' net asset values, he said. The net secondary price of a global emerging market private equity fund is 50% of net asset value, according to PEFOX data.