Published: October 25, 2010

Investors wary of buyout secondaries market overheating

By Nathan Williams

The secondaries market is the last great private equity frontier. As the sale of a $1.2bn portfolio of Warburg Pincus fund stakes by Bank of America last month illustrated, deals are invariably struck below the radar and access to information is key to determining winners and losers. One adviser said: “The closing of a deal of this size in the primary market would never have gone unreported.”

Because of the opaque nature of the secondaries market, there are limited statistics on the number or value of secondaries deals, although secondaries market adviser Triago estimates that $12bn worth of stakes have been traded this year, with the number likely to hit $20bn by the end of the year.

This opacity means that a rise in activity can quickly turn into an unsustainable boom as investors without reliable information rush to invest, fearful of others sealing good deals. Patrick Knechtli, investment director at fund of funds SL Capital Partners, said: “There is certainly an element of not wanting to miss out on the recovery in portfolio valuations and this is driving pricing [and therefore increased deal activity].”

Lack of visibility on assets can also mean the difference between paying a discount or a premium, depending on the seller’s valuation. Mathieu Drean, managing partner at advisory firm Triago, said: “There can be price variances of 30%, 40% or even 50% for the same portfolio and sometimes the same fund.”

Rushing in for fear of missing out and failing to conduct robust analysis is a classic recipe for boom conditions, and increased competition has quickly pushed prices up.

Vincent Gombault, managing director at Axa Private Equity, said: “Big funds have done good deals and the smaller players have followed. Some of these smaller funds have not always done a thorough job in respect of due diligence. On some transactions we are seeing premiums being bid. That is totally crazy.” In April, Axa paid $1.9bn for a portfolio of fund stakes from Bank of America.
According to research by Cogent Partners, a secondaries market adviser, the price of buyout funds in the secondaries market rose to 86.4% of net asset value in the first half of this year, up from 42.7% in the same period of 2009.
Knechtli said: “Some secondaries players have recently raised big funds and are therefore keen to deploy capital into large, well-diversified fund portfolios. Pricing on these larger deals has come back fast, to the extent that there is a concern about over-correction.”

Some believe that an overly cautious approach by secondaries investors a year ago is translating into higher prices now. Drean said: “Deals which are transacting today at par, if these buyers had proposed a 10% or even 20% discount last year they might have got the deal. It’s easy to say today, but in retrospect it’s clear that funds missed lots of good deals in 2009.”
Knechtli agreed: “There don’t seem to be too many bargains around now. A year ago, if you were brave enough, you could pick up fantastic bargains, albeit mostly for relatively unfunded positions.”

Unlike when a private equity fund invests directly in a company, or an investor commits capital to a fund, the process by which an investor in a private equity fund sells its stake is often unstructured. Rainer Ender, managing director at Swiss fund of funds Adveq, said: “We prefer over-the-counter arrangements, bilateral agreements after discussions and phone calls with the seller. There is no structured process by a sellside adviser.”
Auction processes, accepted and integral to investing directly in companies, are shunned by many secondary investors. Gombault said: “We would never enter an auction process. It is bad for the buyer and bad for the seller.”

From one angle, this approach is understandable. Lack of competition will ensure a less than full price and thus enhance the reward for one or two lucky buyers. Conversely, the lack of intermediation and limited information can result in a premium price for a less than premium asset.
This dynamic held back the market last year. Buyers were nervous about the quality of private equity portfolios and priced in this uncertainty when valuing fund positions. This led to a demand for large discounts to net asset value and sellers were not prepared to offload assets, as they saw it, on the cheap. Gombault said: “We saw discounts of as much as 80% because no one could understand the value of an asset.”

Philippe Munch, investment director at UK-based secondaries firm Greenpark Capital, said: “Last year we couldn’t close deals because of the bid/ask spread. We couldn’t get visibility from GPs [private equity firms] on the true value of the portfolio. They often didn’t know themselves.”
Not only has that risk premium been eliminated, but pricing has rapidly swung in the opposite direction, with fund positions now commanding prices above their net asset value. Munch said: “I do not understand why someone would want to start paying premiums unless there is some real hidden value somewhere in the fund. [But] there can only be a minority of funds which command a premium.”

Ender said: We have seen premiums [being bid] for assets so we are being very cautious.”

Prices in the secondaries market may be booming, but not all believe this signals danger. Investment calculations are not as straightforward as par or premium equals a bad deal, a discount a good deal. Par today can turn into a healthy profit tomorrow and a discounted deal can continue to slide. As Gombault said: “A huge discount on a bad asset will never be a big enough discount.”