With valuations proving a point of contention between would-be vendors and acquirers, sales of private equity portfolios to secondary buyers have been relatively subdued in recent months. But the need to free up capital means action will have to be taken sooner rather than later - and that's why secondaries specialists believe a highly productive period lies ahead. Andy Thomson reports.

“Anything is being prepared for sale that's not nailed to the floor” is the dramatic version of events offered by one seasoned observer of the private equity secondaries market. But he's talking about one specific category of sellers: financial institutions. Once again – and secondaries specialists are quick to point out that it's not for the first time – some banks have waded into private equity's waters only to scrabble frantically for the shore when a big wave crashes around them.

“Banks have tended to increase their activity in private equity during market peaks and then need to unwind those positions during troughs. It's a regular cycle,” says Jason Gull, global head of secondary investments in the Chicago office of Adams Street Partners. “It was great for them from 2004 to 2007 and, now, given the impact of the credit crunch, they're in need of liquidity.”

Asked about sources of deal flow, Nigel Dawn, managing director and head of the secondary market advisory team at UBS in New York, agrees that the pressure on financial institutions to sell in order to ease the pressure on their balance sheets is the market's most interesting dynamic. “Financial institutions will this year most likely account for over 60 percent of deal flow in the secondaries market, whereas last year it was below 40 percent,” he says.

And flowing from this dynamic, he says, is the appearance on the market of some high quality assets. “Financial institutions need to rebuild their capital positions and will look to sell their private equity portfolios to facilitate this. The quality of these portfolios will generally be high – core portfolios rather than non-core – assets that they would rather hold if they could.”

While pressure on financial institutions to sell is arguably the big story in today's secondaries market, it's not the only story. Portfolio management – particularly among the larger pensions – has been a well established trend for a while now and is ongoing. Evidence of the seriousness with which large LP groups now view the secondaries market came last year when it emerged that the California Public Employees Retirement System (CalPERS) was planning to sell a legacy portfolio reportedly worth around $2 billion. In February this year, it emerged that a number of investors including fund of funds Conversus Capital and asset manager Oak Hill Investment Management had acquired interests in special situations funds from CalPERS for around $200 million.

No mega-disposals have come onto the market since news of CalPERS' apparent intentions broke, but few observers hold the opinion that the rationale for such deals today is any less compelling. “There are so many pension funds with a large number of different private equity investment lines – significant housekeeping is badly needed,” says Marleen Groen, chief executive of London-based secondaries specialist Greenpark Capital.

Adds Mathieu Dréan, managing partner and head of Paris-based secondaries adviser Triago-X: “Many LPs have diversified to 70 or 80 managers, and concluded that's too many and that it's better to have 30 to 40 core relationships.” Aside from the requirement to make the number of GP relationships more manageable, there is another dynamic behind the offloading of non-core positions: i.e., the need to free up capital to meet capital calls at a time when the rate of distributions from funds has slowed dramatically.


Specialized Secondary Private Equity Funds
Amberbrook V 250 137 1995 New York
Auda Secondary Fund I 500 410 1989 New York
AXA Secondary Fund V 4,000 2,900 1996 Paris; New York
Coller International Partners VI 6,000 4,800 1990 London
CS Strategic Partners IV 2,500 1,900 2000 New York
CS Strategic Partners IV VC 325 210 2000 New York
Dover Street VII 2,000 600 1997 Boston; London; Hong Kong
European Secondary Development Fund I V €350 €175 1993 Paris; London
Fondinvest 8 €400 €292 1994 Paris
GS Vintage Fund V 3,000 3,000 1869
Hamilton Lane Secondary Fund I 400 325 1991 Bala Cynwyd,
PA Hybrid Secondary Fund 400 N/A 1989 Simbury, CT
Landmark Equity Partners XIV 2,000 1,200 1989 Simbury, CT
Lehman Brothers Secondary Fund II 1,500 800 N/A New York
Lexington Middle Market Investors II 1,000 555 1994 New York; London; Boston
Lexington Partners VII 5,000 3,800 1994 New York; Menlo Park; London
Pantheon Global Secondaries Fund IV 4,000 2,000 1982 London; Brussels; Hong Kong;
San Francisco; New York
Partners Group Secondary 2008 €2,000 €1,000 2002 Zug; London; New York
Pomona Capital VII 1,000 821 1994 New York; London
Private Equity Investment Fund V 250 171 1993 New York
Symmetry Secondary Fund 2007 100 45 2003 Edgewater, CO
Thomas Weisel Secondary Fund 125 N/A 1999 San Francisco; New York
Wilshire Private Market Opportunities Fund II 200 N/A 1984 Pittsburgh; New York;
Santa Monica; Amsterdam;
Direct Private Equity Secondary Funds
Acretive Exit Capital Partners II 300 125 2002 Boston
Cipio Partners Fund IV 400 N/A 2003 Munich; London; San Jose
Endeavor Opportunity Partners II 150 17 1988 Westport, CT
Industry Ventures V 200 105 2002 San Francisco
Nova Capital I €300 N/A 2002 London
Vision Capital Partners VII €1,000 €350 2000 London
Real Estate Focused Secondary Funds
Belveron Real Estate Partners Fund 200 N/A 2006 San Francisco
CS Strategic Partners IV RE 420 300 2001 New York
Landmark Real Estate Fund VI 750 368 1989 Simbury, CT; Boston
Madison Harbor Secondary 150 N/A 2006 New York
Real Estate Fund of Funds

Opinions about pricing in the current environment vary greatly. It's easy to be cynical and see vested interests at work: at a time of such uncertainty some may see an opportunity to talk the market up, others to talk it down. To be less cynical, to refer to secondaries pricing as if it were some sort of generic concept would be unrealistic: there has perhaps never been a time when pricing is more variable from one transaction to another. Dréan says: “It's an ever-more inefficient market. Two to three years ago, spreads were around 30 to 40 percent; now it's more like 40 to 50 percent.” It's difficult to even say whether this is a period characterised by premium, par or discounted valuations: all three are being seen regularly.

The more secondary market professionals you talk to, the clearer it becomes that nothing can be taken for granted. It would be easy to assume, for example, that the pressure on financial institutions would equate to steep discounts on their disposals. However, as mentioned earlier, these portfolios often include some high quality assets and, however pressurised, banks are not about to be embarrassed.

Elaine Small, a secondaries partner in the London office of global investor Paul Capital, says: “Pricing has not come off as much as you might think. Large financial institutions have been reallocating their assets to improve liquidity, to satisfy regulators and shareholders, and generally to improve capital ratios. But, even here, they have objectives beyond divesting of assets at any price. And, if they are selling private equity funds, they want to be careful to maintain good relationships with the GPs with whom they often have other business such as leveraged lending and M&A.”

All of which said, Jason Gull maintains that, in the first quarter of this year, a number of sellers were “fishing for par”. This phenomenon disappeared, he says, when they had to accept they were being unrealistic. He reflects: “There were people saying 'before things get any worse, let's see if I can get my cost back. Give me par and I'm good – I can just step back and re-orientate my portfolio'. But people remember 98/99, the last time you had a bad buyout vintage, when top quartile returns ended up around 8-10 percent. That's not very attractive.” Unable to secure par and unwilling to sell at a discount, many sellers have placed potential deals in limbo.

Tim Jones, a partner at London-based secondaries giant Coller Capital, says that “while buyers are looking forward in terms of valuation, sellers are looking backwards” . He adds: “Buyers have got used to buying at the last quarter's NAV and, as these kept going up, there was always a premium. Now people are saying we'll buy at next December's NAV,” [on the assumption that the number will be lower].

Given what some describe as the “dance around pricing” that is currently taking place, it is understandable that some organisations are presently hesitant about putting money to work in the secondaries space. Sam Robinson, a director at SVG Advisers which invests in secondaries through its SVG Diamond CFO programme, says he would approach any assets with which he was not familiar with caution. He says: “I've no idea what will happen with regard to the performance of assets over the next six months, so what discount is appropriate? There are a lot of imponderables in relation to the economic climate, such as employment levels, consumer appetite and the level of interest rates. If you don't have to do secondaries, you have to ask yourself whether it's the right time to be active.”

One thing's for sure, though: given the deal flow that can be seen looming on the horizon, secondaries funds stand to vacuum up a lot of limited partner capital. The closing of Paul Capital's latest secondaries fund on $1.65 billion in May, beating a $1.25 billion target, was a promising sign of investor appetite – and there are plenty of funds with multi-billion dollar targets in the market at the moment (see p. 66).

Indeed, there is even speculation that the turmoil in the larger buyout market could mean that, within the not-too-distant future, the world's largest private equity fund is a secondaries fund. “Obviously it depends on whether we see a recovery in the LBO market, but in the short term it's difficult for funds in that space to increase their size, and the trend may be towards a decrease. In two to three years' time, I think we could see the largest secondary funds rivalling the largest buyout funds,” says Stephan Schäli, partner and head of private alternative investment strategies at Swiss alternative assets firm Partners Group.

One thing that market participants concur about is that the new money being raised will, in the immediate future at least, be put to work in some rather less complex scenarios than has been the case in recent years. In a highly competitive market, “a lot of people have been using leverage to justify high prices. Today that's too scary and it will disappear like the dinosaurs,” says Coller's Jones.

Jones adds that committing primary capital as a way of helping to secure secondaries deals (the socalled “stapled transaction”, see also page 76) may, allowing for the occasional exception, be a thing of the past. “Staples are a bull market phenomenon where people are desperate to do the secondary and swallow the primary. There is now more caution. The GPs that do this are not normally the likes of KKR or Blackstone. It's often where there's a change of ownership or they're having trouble fundraising and, in a market like this, you have to be cautious about that kind of thing.”

Jones' conclusion is that, with multiple potential sources of deal flow mitigating the need for innovative financing and structuring, “life will get simpler and deal flow even stronger” for secondaries players going forward. The credit crunch and economic downturn may have sown widespread gloom, but secondaries players have rarely been more upbeat.