Institutions turn to secondary market to secure their gains

Private equity portfolio values skyrocketed in 2021, and now a growing number of investors are considering selling their limited partnership interests on the secondary market to lock in those gains.

The asset class' strong year has also brought many investors' private equity portfolios at or near their target allocations. For limited partners, the question is when those returns will result in cash distributions to their portfolios, industry experts said.

That's especially true when exits occur through an initial public offering. Managers that take a portfolio company public then have to sell the stock or distribute shares to limited partners in lieu of cash, which can take more than a bit of time.

The Oregon Investment Council, which manages the $96.5 billion Oregon Public Employees Retirement Fund, Tigard, is exploring additional sales on the secondary market.

Like other large private equity investors, Oregon saw big gains in its private equity portfolio as of Sept. 30, prompting the council to recently increase its target allocation to 20% from 17.5%.

However, in a private equity world that is demanding bigger commitments and with managers raising funds at shorter intervals, Oregon has a choice to make: If distributions don't start pouring in, the council will have to chose whether to cut back on contributions to new funds or sell limited partnership interests on the secondary markets, executives were advised during a council meeting on Jan. 26.

"The appreciation in your portfolio and how it has impacted the asset allocation is not unique to you," said Thomas Martin, global head of private equity and real assets strategies at Aksia, the council's private equity consultant. "It's a universal problem with private equity investors of scale."

The pension plan's $25 billion private equity portfolio earned a 41.8% internal rate of return for the year ended Sept. 30, well above its benchmark of 36.3%.

Most large private equity investors are trying to address this liquidity issue going forward, Mr. Martin said.

If high private equity returns continue, "distributions will be huge," said Michael Langdon, director of private markets of the Oregon State Treasury investment division during the council meeting's private equity portfolio annual review. But while managers have a big incentive to see those paper gains turned to cash to help them launch new funds, if that doesn't happen, the council should consider gaining liquidity by selling portfolios on the private equity secondary market, Mr. Langdon said.

In the five-years ended Sept. 30, Oregon received a total of $22 billion in distributions including proceeds from secondary market sales, compared to a combined $16 billion in capital calls, according to a staff report. In calendar year 2021, capital calls of $5.5 billion and distributions including secondary market sales of $7.6 billion were both "massively ahead of plan" of $3 billion and $4.5 billion, respectively, the report stated.

The last resort would be to pull back on its pacing plan to commit about $3 billion per year, Mr. Langdon said. Oregon's current pacing plan is to commit $2.5 billion to $3.5 billion per year to between 10 to 15 investment opportunities. The pension fund committed $3.6 billion in the year ended Sept. 30.

The council sold portfolios, mostly of older limited partnership interests in 2020 on the secondary market, and a mixture of LP interests in 2021, Mr. Langdon said.

The 2020 portfolio sale contained some of the fund's oldest limited partnership interests, which "by definition sold at a discount," he said. It was also an uncertain year, and there weren't a lot of transactions, but "we were able to fix our tail-end issue," he said.

In 2021, the secondary markets had normalized and "we did a lot better than expected," Mr. Langdon said.

"We nailed it on that one" with the limited partnership interests in younger funds selling above par, he added.

Other asset owners, too, are considering selling interests in the secondary market, Aksia's Mr. Martin said. "The rest of the LP world is catching up to us."

Since 2020, Oregon's liquidity and co-investment manager Pathway Capital Management managed two private equity limited partnership sales on the secondary markets and two GP-led secondary transactions that resulted in a combined $2 billion, according to the staff report. A portion of the proceeds from secondary market sales are reinvested in co-investments.

Pathway monitors a portfolio of 91 limited partnerships across vintage years 1999 to 2015, which could be sold on the secondary market. The program so far has helped smooth the private equity portfolio's vintage year exposure, decrease the number of GP relationships and generate accelerated liquidity, the staff report said.

However, the council needs to be "extremely careful" in making their next secondary market sale so it is not forced to sell LP interests in a buyer's market, Mr. Langdon said.

Transaction activity on the private equity secondary market was brisk in 2021, after a sluggish year in 2020. The overall alternative investment secondary market hit a record $143.4 billion in 2021, up from the $61.8 billion transacted in 2020, according to Toronto-based secondary market broker Setter Capital Inc.

Most of the secondary market transactions were private equity deals, which rose 137% year-over-year, to a total of $133.22 billion, Setter data shows.

"We are definitely seeing an increase in planned portfolio sales for pensions and endowments," said Conner Zell, Toronto-based member of Setter's fund advisory team at Setter Capital.

"Institutions are seeing the secondary market as a useful tool for portfolio rebalancing," he said.

Many institutional investors are continuing to trim the number of general partner relationships they have in their programs to make them more manageable and improve returns.

They are selling limited partnership interests in the funds of managers being cut from their private equity manager rolls and reinvesting the capital with core managers, Mr. Zell said.

An additional attraction for investors is that pricing was quite strong in 2021, with limited partnership interests selling at 85 cents on the dollar in the first half of the year and then dipping to 83 cents on the dollar in the second half, said Mike Bego, co-founder and managing partner, Kline Hill Partners.

On the buy side, alternative investment managers are aiming to capitalize on what they see as a fertile investment opportunity. Blackstone Inc. is in the market with a fund to invest in the private equity secondary markets, said Jonathan D. Gray, president and chief operating officer, during Blackstone's Jan. 27 earnings call. The fund raised $13 billion in the fourth quarter "and is on track to reach approximately $20 billion, which would be the largest secondaries vehicle ever raised," Mr. Gray said.

"Secondaries had a record deployment quarter," Mr. Gray said. "Many institutions have seen an extraordinary performance from their private equity pools, and some are looking to make new allocations, but they're selling older funds and that's led to huge deal volume there."

Blackstone's real estate and private equity secondaries business achieved a 50% internal rate of return in 2021, which was "the best annual return in over a decade in secondaries," he said.

The secondary deal flow last year made it a good year to be a buyer, said Cari B. Lodge, managing director and head of secondaries at Commonfund Asset Management.

But not all of the potential portfolios put up for sale in 2021 were sold because there were more LP interests for sale than capital to buy them, Ms. Lodge said.

"Only the highest quality assets sold because there was such a supply of deals," she said.

Pension funds and other institutional investors were not the only investors selling limited partnership private equity interests in 2021, Ms. Lodge said.

Family offices, insurance companies, secondary funds and fund-of-funds managers sold LP interests. Secondaries and fund-of-fund managers used the secondary market to help them wind down their funds, she said.

Ms. Lodge said she thinks limited partnership secondary market transactions will continue to grow in 2022. One reason is that the combined value of the transactions on the secondary market is still a fraction of the $5.33 trillion in private equity assets under management in 2021, Preqin data shows.

And Preqin predicts that the total worldwide private equity AUM will grow at a faster annual rate than in the past. Preqin estimates that private equity AUM will reach $11.12 trillion in 2026, reflecting a 15.9% compound annual growth rate — faster than the 10.2% compound annual growth rate between 2010 and 2020.

Also motivating private equity limited partnership sales is that funds are extending well beyond their expected lifespans, industry experts said.

"What's happened is the model for liquidity has changed," said Stephanie Pindyck Costantino, a Princeton, N.J.-based partner at law firm Troutman Pepper Hamilton Sanders LLP.

The time horizon for private equity funds has gotten longer and the COVID-19 pandemic impacted that, she said. Investors' models did not account for the extended length of time, Ms. Costantino said.

Some institutional investors are choosing to sell limited partnership interests on the secondary market themselves, rather than participate in one of their manager's GP-led processes in which assets from the existing funds are sold to a brand new fund called a continuation fund, she said.