According to Preqin, in 2000, there were just eight private equity secondary players in the market globally, but even then they had managed to raise aggregate capital of approximately $8bn. At the peak of the market, in 2009, there were 20 funds, with a combined size of more than $22bn. In 2011, in line with the correction seen by other segments of the market, there are fewer funds (14) although their total fund size of $9.5bn still shows that they have a role to play in the global private equity cycle.
Secondary funds have a unique status in the industry. They can be seen as sitting in between a limited partner (LP) and a general partner (GP) in the investment model. A secondary fund’s business model is to purchase LP investor commitments in GP funds, thus providing institutions with the freedom to adjust their allocations to different asset classes. The principal by-product of this is that liquidity is created in what is traditionally a very illiquid industry. Having bought the underlying investment, usually at a discounted price, the secondary player will hope to make a return on its investment by taking advantage of any potential upside in the value of the portfolio.
There are a number of reasons why institutions may wish to divest themselves of their fund investments. These reasons differ depending on the type of institution.
The secondaries business is all about liquidity, and that is largely driven by the need to comply with the constant stream of legislation. In the US one of the effects of the Volcker Rule is to place restrictions on banks in relation to their private equity and hedge fund investments. Consequently, US banks are looking for ways of disposing of their private equity portfolios, and secondaries provide a convenient solution.
On the other side of the pond, Basel III imposes capital adequacy rules on European banking institutions, imposing a cap on their capital to-total assets ratio. According to data supplied by the European Venture Capital Association, banks, which accounted for 19 percent of total funds raised by European private equity houses in 2009, significantly reduced their commitments in 2010, accounting for nine percent of the total.
The consequences of these regulations are evident in the market today. For example, in 2011, AXA Private Equity purchased $1.7bn in private equity fund assets from Citigroup, and in mid-December Credit Agricole announced that it was selling its entire private equity portfolio to Coller Capital. This deal is rumoured to be worth approximately €300m and would help the bank reduce its risk-weighted assets by a sizeable €900m.
Insurance companies are also feeling the regulatory pinch. Solvency II, which will come into effect in 2013, imposes new, risk-based, solvency requirements on insurance and re-insurance firms. Industry practitioners are predicting that one result of this directive could be that insurance companies will be forced to decrease their prospective allocations to private equity. This is because the capital that an insurer would need to hold against its private equity risk may be materially increased from the current requirements for that insurer.
Finally, pension funds are also reducing their exposure to alternative assets, with some of the larger groups, such as the New York State Pension Fund and CalPERS having become more heavily regulated in the wake of well-documented financial impropriety, and others including GEC and the Harvard University Pension Plan, reducing their allocations to private equity and in some cases severing GP relationships altogether. According to Preqin, the $93.2bn of new commitments made to the asset class from pension funds in 2010 represented less than half the $204.4bn that pension funds invested at the peak of the fundraising market in 2007. And if they need to reduce their allocations, secondary funds are in an ideal position to offer them the quick fix they need.
And in Europe, the most significant factor to shape the institutional, private equity, and secondaries industries, will be the outcome of the eurozone crisis. Institutions that hold sovereign debt are now holding on to assets that have been downgraded by ratings agencies, and as a consequence are looking for ways to reduce their potential liabilities. In the good times private has the potential to bears extraordinary returns for the savvy investor, however, it is still one of the more riskier asset classes around.
In the first half of 2011 the secondary environment was buoyant, although prices were fairly high. However, with the onset of the sovereign debt crisis, activity in the second half of the year slowed significantly, as institutions adopted a wait and see approach, choosing to hold on to their assets until the new year. In 2012-13, however, there could be lots of dealflow, especially from pension funds, banks and secondary sellers.
Outside Europe, there could be a different story. The Asian institutional market – much like that of the Nordic region – is showing relatively little secondary activity. In these regions, the predominant sentiment is to buy and hold rather than sell. LPs don’t want to appear untrustworthy by breaking a relationship, in spite of the fact that they have relatively mature portfolios and would benefit from increased liquidity.
However, taking a global outlook, it looks as though there is a strong outlook for the secondary market. You have only to look at what’s been happening over the last 18 months to see the upward trend for secondary transactions. Also, if you take the view that today’s primary is tomorrow’s secondary, we should expect to see somewhere in the region of $1.8trn of potential secondary assets waiting to come to the market in the next couple of years.