Secondaries: Waiting for the shoe to drop

When direct secondaries specialist NewQuest Capital Partners closed its third fund at $540 million, it underlined both the steadily snowballing demand for secondary assets in Asia and the increasing role of creative deal structures in capturing the sector's inherent value. The new fund confirms many concerns about the reliability of traditional exit options, and at the same reveals a growing imperative to tackle the shortcomings of Asia's young secondaries market through more inclusive deal-making strategies.

Like its two predecessors, NewQuest Asia Fund III will focus largely on acquisitions of single assets and portfolios of assets in the region on a direct basis. However, the vehicle will also target a wider array of deal opportunities by expanding the firm's approach to include schemes closer to the traditional LP interest end of the secondaries spectrum. This means a greater focus on fund restructuring or spin-out opportunities whereby a significant LP stake in a fund facilitates go-forward collaborations with incumbent GPs.

"There really hasn't been enough buyers out there," says Darren Massara, managing partner at NewQuest, which was itself created through a secondary spin-out from Bank of America Merrill Lynch in 2011. "There are enough investors who want liquidity for their positions, but historically there just hasn't been as many players willing to do a 100% secondary transaction - but that's changing."

I’m certainly expecting more Asian LPs to be sellers in Asia for the coming year or so. It won’t take five years – it will be quicker than we might have anticipated – Dan Kim

While raising of the fund only two years after final close of the prior NewQuest vehicle - which had a corpus of $316 million - hints at accelerating near-term potential in the Asian secondaries market, the firm's efforts to adapt its GP-for-hire formula suggest perhaps a more significant emergence. Demand for secondary liquidity solutions is outpacing supply, but investors seeking to take advantage of this imbalance in a still-maturing investment environment are going to have to be flexible.

Deal drivers

The most critical driver for direct secondaries investment in Asia remains a familiar yet doggedly convincing refrain about the maturing of 10-year funds spurred in the beginning of the region's robust years from 2006-08. Close to $175 billion was raised for pan-Asian and single country funds during this three-year period, according to AVCJ Research, and around $230 billion was invested, including capital from GPs outside the region.

Considering the broader pool of unrealized investments, an industry consensus has emerged that about $100-200 billion worth of fund commitments made in Asia from 2005-2010 are now looking to be sold in a precarious near-term macro context.

This pending eruption of secondary deal opportunities has tested the patience of eager firms for a number of years, but has recently gathered new credibility as funds near the very brink of their investment horizons amid a hardening macroeconomic malaise. Many GPs, having sought fund life extensions, are beginning to face pressures related to weakness in regional equity markets and a related lack of reliability in planned IPO exits. Meanwhile, trade sales have hovered erratically around 250-300 per annum during the past five years.

"Fundamentally, with so much capital having been raised and invested in Asia from the primary side, perhaps $200 billion worth of funds are coming to the end of their lives," says Lucian Wu, a managing director at HQ Capital. "Without sufficient DPIs [distributed to paid-in] that GPs can show to LPs, it's only natural that a lot of these inventory will need to seek solutions through the secondary market. This is happening at the fund level as well as at the asset level."

Although the difficulty of getting large groups of LPs to agree on asset valuation has historically stymied secondary deals, concerns that valuations are generally eroding has also represented a considerable secondary market driver, particularly in the VC sector. Regulation is another factor, particularly among financial institutions. A spate of secondary sales in the immediate aftermath of the global financial crisis was followed by a period of reduced activity as groups waited for clarity on the Volcker Rule, which limits financial institutions' exposure to alternative assets. With the compliance deadline now set for 2017, investors are hoping to see another upturn in transaction volume.

This combination of opportunities in skewed valuations and pressure to sell among asset holders has created a prospective environment for firms that are able to leverage the Asian market's unique inconsistencies. "If you look at everything raised in 2005-2007, there is a lot of asset value still on the ground and LPs are looking for liquidity," says Andre Aubert, partner and head of secondairies at LGT Capital Partners, an LP in all three NewQuest funds. "The mismatch between what liquidity you can get in the market and what LPs are looking for is increasing, which means a bigger opportunity for us."

Both direct and traditional secondary investors in Asia are also benefiting from global-scale economic machinations such as the correction in China during the past 12 months and to some extent even the UK's recent vote to exit the European Union. While this event is unlikely to result in a flood of Asian assets coming to market from troubled UK and European sellers, it does help illustrate the hedging effect of secondary strategies amid macro uncertainty.

"We believe [Brexit] will create opportunities because some European investors will have more pressure to sell direct stakes in companies or LP positions," says Paul Robine, co-founder of TR Capital, which targets middle-market LP and direct secondary transactions in Asia. "We are also seeing an increasing number of fund restructuring situations. It's still nascent, but you're going to see more situations like this in the coming year. We're actually working on two of them at the moment."

Embracing these trends through thematic deal types that are new to Asian secondaries players such as GP restructuring may be the way forward for regional market. As this environment matures, more spin-outs, stapled secondary transactions, GP-led whole fund liquidity solutions and direct-LP interest combinations are tipped to increasingly characterize the secondary landscape, giving managers more scope to seize the opportunities that exist.

Diversified strategies

This diversification of approach - already a facet of some managers' programs - will underpin stronger platforms that allow direct secondary investors to investigate a broader range of deals while helping traditional secondary firms improve deal origination and due diligence processes by deepening relations with GPs. The arrival of this more colorful secondary market is set to be further supported by a gradually increasing openness among Asian sellers to explore alternative exit solutions.

"I'm getting a lot of questions from Asian LPs asking us to walk them through the process or how they should value their current portfolio, so there are signs that they're trying to get comfortable with secondary transactions," says Dan Kim, head of the Asian division at Pomona Capital. "I'm certainly expecting more Asian LPs to be sellers in Asia for the coming year or so. It won't take five years - it will be quicker than we might have anticipated."

Additional diversification will emerge geographically as China and India - the natural centers of gravity in Asia - begin to redraw a regional secondary map currently dominated by the more mature markets of Australia and Japan. TR Capital has placed a strong emphases on a China-India strategy, citing lower competition for deals and opportunities in addressing local inefficiencies. NewQuest, likewise, has recently set up offices in Beijing and Mumbai, and has projected that more than half of its upcoming deal flow would come from China.

The establishment of China and India as the drivers of Asian secondary activity, however, will not be sudden and immediate. Tim Flower, a managing director for HarbourVest Partners, says his firm has seen a significant amount of deal-related activity involving India-based operations in both traditional secondary opportunities and portfolios of direct investments. But a pricing gap caused by varying risk-reward perceptions has prevented this interest from translating into a significant number of deal closures.

"The big question is whether we will start to see an increase in China-based portfolios for sale, either via a traditional or complex secondary opportunity such as the sale of a tail-end portfolio of direct investments," Flower adds. "We have started to see an increase of Chinese assets for sale, but again there is a pricing issue partly due to the high unrealized valuations as well as challenges in forecasting the path to liquidity, since the market is still so reliant on the public markets for exits."

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• Topics
• Secondaries
• Secondaries
• Fundraising
• NewQuest Capital Partners
• LGT Capital Partners
• HarbourVest Partners
• Pomona
• TR Capital
• HQ Capital