Secondaries: Deal flow spike

After well over a year in the making, last month J.P. Morgan Chase finally entered a definitive agreement to sell about half its stake in the portfolio of its private equity arm, One Equity Partners (OEP), to secondary buyers Lexington Partners and AlpInvest Partners. The deal - involving the sale of around $2 billion out of OEP's roughly $4.5 billion in investments - is one the largest secondary transactions of 2014, a year which so far has seen around $16 billion worth of assets change hands, according to Cogent Partners.

Under the terms the transaction, J.P. Morgan is to retain ownership of about half of One Equity's nearly 30 portfolio companies, of which two are based in Asia. The rest will be spun out a new private equity firm, OEP Capital Advisors, led by existing OEP managers but independent from J.P. Morgan. The new firm will manage the portfolio being sold by the bank as well as those investments being retained.

The sale comes at a time when many banks are under regulatory pressure in Europe and the US to de-risk their portfolios by shedding private equity assets. While J.P. Morgan says the planned spin-out is not the result of these regulatory changes - it or any other bank would be unlikely to say so if it was - they are undoubtedly a contributing factor to deal flow.

"Many banks have already done some disposals and there are still quite a lot of institutions looking to shed private equity assets on their balance sheets," says Tim Flower, managing director with HarbourVest Partners in Hong Kong. "It is a very strong year in terms of deals and the level of activity is potentially going to be similar, or higher, to that of 2013, which was a record year in terms of deals done globally."

However, headline-grabbing spin-outs like OEP are just part of the picture. According to Cogent, deal volume is expected to exceed $30 billion for the first time this year after more than $16 billion was transacted in the first six months of 2014. While these record-breaking figures can partly be put down to more cyclical drivers, the data also suggest that the global secondaries market is being powered by longer-term trends resulting from a maturing market.

Big beasts

To understand what has been happening this year in terms of secondary deal flow, it is useful to look back to 2013 when the industry began to see an uptick up in activity. Secondary market volume reached an equally record-breaking level of $27.5 billion, compared to $25 million for both 2011 and 2012.

What was notable about 2013 was that in the six months there were less of the mega fund portfolio sales of previous years, but rather deal flow was bolstered by increased participation from investors involved in smaller transactions, including single interest sales. According to Preqin, the largest groups selling fund interests were private equity funds-of-funds, representing 21%, while public and private sector pension funds accounted for 18% and 11%, respectively. Insurance companies, banks and investment firms made up most of the rest.

However, towards the end of the year the secondary market looked as though it might be given additional momentum with the finalization of implementation guidelines for the Volcker Rule, the regulation introduced in 2012 to put a cap on banks' private equity exposure. It was decreed that by July 2015 banks could not own more than 3% of a captive private equity program or have more than 3% of their total tier-one capital in any form of alternative asset pool.

As a result, by the start of 2014 some of the banks that had been holding off selling through most of the previous year started to come to market in anticipation of the compliance requirement. This put some of the large portfolio deals back on the table. Lexington has made a string of investments taking advantage of the banks' renewed desire to sell. In addition to the OEP deal, it has also recently bought from Citigroup the lion's share of a $1.5 billion commitment to a fund managed by mid-market buyout firm Metalmark Capital.

"With the regulatory pressure on the banks the opportunities to do large deals are there if you can provide a compelling solution," says Wilson Warren, a partner with Lexington in New York. "Our hit rate has been much higher on complicated bank transactions because they are large and they involve complex legal issues. Having a reliable, well-known counterparty is more important to those institutions than price."

Other recent examples of institutions bringing - or preparing to bring - large fund portfolios to market include Australian asset manager QIC, which was reported to have hired Cogent Partners to offload a portfolio of fund stakes valued at $1 billion. Meanwhile, Ardian is said to be planning to acquire $1 billion of fund positions owned by Singapore's state-owned investment company Temasek Holdings. One of the main motivators for these deals coming to market has been valuations.

"Pricing has been pretty frothy, and clearly you want to buy assets that allow you to underwrite at a better return, so it can be a struggle," says HarbourVest's Flower. "The silver lining is that strong pricing has meant more people are exploring the market and selling. This is one of the reasons 2014 has been such a good year so far for deal flow."

Cogent's most recent study shows that the average high bid across all strategies increased to 93% of net asset value (NAV) during the first half of the year. Buyout fund pricing, meanwhile has been particularly strong, with the average high bid increasing to 100% of NAV, the first time that any strategy has priced at or above NAV since 2007. Other fund strategies also saw an uptick in pricing, with real estate and venture funds posting average high bids of 92% and 82% of NAV, respectively.

Dominik Woessner, a director with Cogent in Singapore, notes the impact this global trend has also coincided with a pick-up in activity in Asia. "In the first half of the year the secondary market in Asia was very busy, and it is shaping up to be busy is second half, and the biggest driver has been attractive pricing levels," he says. "In Asia people have come to the conclusion that these are very attractive pricing levels and have started acting on that."

Woessner adds that while in previous years Asian assets accounted for less than 5% of global transaction volume, this year he expects the figure to be in the region of 5-10%. Attractive pricing is not the only factor behind increased seller activity. Others include tougher liquidity requirements, portfolio rebalancing and the need to exit from poor- performing funds.

Liquidity opportunities

An investor survey conducted by Preqin this year offers additional insight into seller trends. According to the report, this year 39% of LPs said they used secondaries to meet liquidity requirements, an increase of 23% on the previous year. Selling fund interests as a means of rebalancing portfolios was the second most common response, though the score was down on the 42% posted in 2013. Meanwhile, the third reason - exiting poor performing funds - dropped to 21% from 29%.

This seems to support the view that aside from being motivated by temporary drivers such as the Volcker Rule and high valuations, more sellers are turning to secondaries as means of managing their private equity investments.

"Everyone has something for sale and the secondary market has become an accepted solution and a necessary part of the market - one where institutions and investors alike are focused on trying to manage their portfolios more actively than ever before," says Tom Kerr, managing director and head of the secondary team at Hamilton Lane.

Another factor likely to drive increased deal activity not described above is the increased levels of secondary buyer participation in GP-led restructurings.

There are still a number of GPs managing vehicles that are close to, or past, their pre-agreed life-span with significant unrealized value remaining. LPs are unwilling to back follow-up vehicles, which means existing portfolio companies are starved of the capital needed for value generation. Caught in this capital bind, more GPs have turned to the secondary market in search of investors that can take out existing LPs that want to exit and then inject fresh capital into the fund, usually after spinning out the assets into a new vehicle.

Preqin data show that the investment potential is considerable, with these so-called "zombie funds" - defined as funds with a vintages between 2002-2007 and managed by firms that have not successfully raised capital since 2007 - number 1,049 globally with around 10% in Asia.

However, it is worth noting that such deals are notoriously difficult to transact, not least because the secondary buyer must agree a valuation with each exiting LP. Perceptions of value, often driven by the amount of pressure an LP is under to exit, can vary hugely. The new investors must also decide whether they want to retain some or all of the existing GP management team, and if not, identify a new one.

Who's buying?

While the market may have plenty of willing sellers, what is driving the buy side? Again, Preqin's recent LP survey data sheds some light on this issue. Currently, secondary buyers are predominantly made up of public pension funds, which represent 18% of the market, followed by private sector pension funds and insurance companies, on 13% and 11%, respectively.

Currently over a third of these buyers cite mitigation of the j-curve effect on their portfolios as motivation - an increase from 2013, when only 17% of investors cited the same reason. There has also been an increase in the number seeking secondary investments as a means of accessing top performing managers - 31%, compared to 17% last year. As expected, there has been a substantial reduction in interest in the market due to appealing valuations (down to 33% from 67%).

Interestingly, the data reveals that an increasing number of buyers - like sellers - recognize the benefit of utilizing the secondary market to diversify and manage their private equity portfolios by vintage year, reflecting a more active and increasingly sophisticated investor universe. Lexington's Warren also makes this observation.

"If you look at the turnover rate - percentage of primary market being sold into the Secondaries market - it has increased from something like 1% 20 years ago, to somewhere around 5-6% today," he says. "So there increasing adoption of liquidity in the market."

Asia, meanwhile, will still account for a small fraction of this activity, but this too will likely change as the market matures. In the short to medium term, the overall sentiment is that the combination of attractive deal opportunities, increasing need for liquidity and the fact that investors can actively managed their portfolios at attractive prices, the deal pipeline will continue to be robust.

"Over the next five-year period the market is likely to run at $30-35 billion a year. Could we have a year that reached $45 billion? Yes. Could you have a year that is $20 billion? Absolutely. It will depend on the cycle," says Warren.

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• Topics
• Secondaries
• LPs
• Secondaries
• Secondaries
• Lexington Partners
• AlpInvest Partners N.V.
• HarbourVest Partners
• Hamilton Lane
• LPs
• Asia