LPs and secondaries: Subliminal stimulation

Visitors to the country town of Healesville, northeast of Melbourne, can enjoy the scenery and wines of the famous Yarra Valley vineyards, quaint antique shops, and glassblowing studios, and apparently, a sales pitch from Australia's largest sovereign wealth fund. Speaking at the Fiduciary Investors Symposium in the area last month, Future Fund CEO David Neal flagged ongoing efforts to divest a chunk of private equity assets with a world-of-mouth approach that seemed to fit the farmers' market atmosphere.

"If anyone wants a large slice of really high-quality private equity, let me know because we are looking. We have a process underway at the moment of doing a secondary sale of private equity, it is essentially a rebalancing trade," Neal said, according to event coordinator Investment Magazine. "We are not selling down to reduce risk. We are just selling down to increase liquidity in our portfolio. If you are not sure about what the future environment looks like you need to have the ability to change your portfolio."

The comments say much about LPs' thinking, and by extension, the outlook for the secondaries market. Future Fund is ripe for a recalibration, having run up its PE exposure from 10% in 2016 to an arguably overweight 16% today and overhauled its team for the asset class this year under Alicia Gregory, formerly of MLC. The most interesting bit, however, may be Neal's allusions to market uncertainty in a context where many buyers may well suspect a late-cycle rush to offload potential liabilities.     

To be sure, there are a number of things institutional investors with downturn jitters would logically get rid of before private equity, which has proven relatively robust across cycles. The strongest drivers of PE secondaries deal flow, therefore, continue to be the steady advance of the primary market and the percentage of that market that is considered re-tradable. Global assets under management are said to be increasing at 14% a year, while secondaries as a proportion of overall PE activity in that stock ticks up 0.5% every year.

By some estimates, that growth puts the global secondaries market on track to reach $100-120 billion this year versus $20-50 billion at the start of the decade. Layered on that are myriad situation-specific rationales for striking deals. Most of these involve portfolio restructuring or diversification, geographic reallocations, regulatory pressure to hit targets, plans to set new terms around co-investment, and reducing the j-curve effect by quickly accessing mature assets.

Late-stage uncertainty

In Asia Pacific, these pivots are often the result of a merger or internal reinvention at a relatively young institution. For Future fund, it also parallels a strategic thrust into late-stage technology. The group has made at least eight direct tech investments alongside portfolio GPs, according to AVCJ Research, including leading a $140 million Series E for US and New Zealand-based space player Rocket Lab.

All this is unfolding as headlines swirl around a perceived late-stage tech bubble now dubbed the "WeWork effect" after the US co-working start-up that saw its valuation tumble from $47 billion to $8 billion in recent months. Steve Byrom, co-founder of Potentum Partners, an advisory firm that serves LPs looking to build private equity exposure, and previously PE head at Future Fund, sees this sentiment as a potential sticking point for secondaries hopefuls.

"Investors are starting to become quite cautious about buying late-stage growth, which is a part of the investment universe that's harder to price today than it has been. That's certainly going to flow into the secondaries market because investors are pausing to see what happens," says Byrom. "I don't think pure-play tech will really be impacted. But when fundamentally non-tech companies are positioned as tech, questions are raised, it makes it harder to transact, and it's going to have some shorter-term impact."  

Perception issues outside of the investment industry may have even more nuanced effects. According to a recent study by placement agent Eaton Partners, 69% of LPs say they are concerned about anti-PE rhetoric from politicians and plan to take a more defensive approach to guard against a macro slowdown. This echoes the latest twice-yearly barometer survey by secondaries specialist Coller Capital, which found that 57% of Asia Pacific LPs were tracking greater public criticism of the asset class.

It is difficult to tie this feedback to predictions about specific actions in terms of secondaries, unless tighter scrutiny on corporate citizenship leads to sell-offs in portfolios targeting controversial industries. But the observations do fit a pattern of darkening moods around various economic, social, and geopolitical uncertainties. In a more direct connection to the secondaries outlook, Coller also found that 70% of Asia Pacific LPs believed their portfolios needed modification to weather the next macro slump.

"The sentiment in general is that an economic downturn is looming and although exposure to PE will persist, we expect LPs to use the secondary market more as a tool to readjust their portfolios, which is what we saw after the global financial crisis," says Kai Lin, a principal at Coller based in Hong Kong. "Asian sellers will look to adjust their portfolios – which could be global portfolios – and international LPs will also come to market with portfolios containing Asian positions."

Safety first?

One of the key caveats to this view notes that while macro factors could result in some growth in the volume of secondaries deal flow, the greater impact will be on the way LPs access the market. Specifically, they will be under increasing pressure to weigh varying risks around mark-to-market corrections across different alternative asset classes and within sub-classes of private equity.

At the large-cap end, brand-name PE funds offer perceived security but only single-digit discounts, while smaller ends of the market feature improved opportunity to benefit from information asymmetry but a riskier lack of general visibility. Secondary programs seeking to strike this balance will need to consider carefully integrated and diversified private markets portfolios incorporating a range of uncorrelated approaches.

Manulife Investment Management entered this maze in October with the launch of a new secondaries program and the hiring of two co-heads for the business to be based in the US. Myron Zhu, the firm's private markets head in Hong Kong, says the strategy will eventually make its way to Asia, but in the meantime, his plans to build out a regional presence will prioritize cash-yielding assets such as private credit, real estate, and infrastructure.

"If there's a major downturn, even PE might get hit because it's still benchmarked to the public markets and the valuations are at a record high at the larger end of the market, especially the buyout space," Zhu says. "The absolute money going into the mid and lower-mid market space has been steady, so the valuations haven't been as frothy, but if there is a major correction, those portfolios are going to feel the most pain. These concerns are on top of my list of what to watch out for, and it's not easy to see which path is right or wrong."

LPs in Asia will bring these worries to the regional secondaries market in step with its overall growth, which is progressing healthily in both buyers and sellers. The best illustrations of this traction are the milestones in the proliferation of specialist, regionally focused players, such as last month, when NewQuest Capital Partners closed its fourth Asia-only secondaries fund at an upsized hard cap of $1 billion, easily beating the previous vintage of $540 million.

In terms of assets purchased, Setter Capital estimates Asian secondaries transactions amounted to about $3 billion in the first half of 2019, up 40% year on year. During the same period, Asian sellers accounted for 20% of the global market versus 8% the year before, although that jump was largely due to Japan's Norinchukin Bank selling a $5 billion portfolio to Ardian in what has been called the largest secondary transaction globally by a factor of two.

Ardian, which is reportedly on track to raise the industry's largest-ever secondaries pool of capital, has reflected other aspects of the Asian market as well. For example, the region is seen as having a higher relative population of young institutions, often government or quasi-government outfits that could have less defined return profiles and therefore comparatively less impetus to buy. Ardian fueled this trend in April by acquiring infrastructure assets from China's Ping An Insurance to support the spinout of a new third-party investor.

"The sellers we've seen in Asia are always the top four or five institutions in their region, often sovereign wealth funds and insurance companies. There will be a second wave of sellers that are smaller institutions, but you need a certain maturity to be active sellers in the secondaries market," says Jan Philip Schmitz, Ardian's head of Asia. "That will come because it's arguably the fastest growing market in private equity, and it affects everyone in the industry, not just the niche secondary players."

Flight to quality

As smaller institutions join the chase for secondaries, it will exacerbate an already competitive environment caused by an ongoing flight to quality. Nerves about a major market dislocation have concentrated deal flow around GPs with track records successfully navigating previous crises – a trend that implies a deceleration in overall secondaries growth but which has had no such effect. This offers another example of how macro concerns are tilting secondaries activity without overtly impacting deal volumes. 

"When there's a downturn, there will be some distressed sellers and parties that need cash that want to exit. That will happen more than it did in the last crisis as the market has grown, but that's still not going to be the bulk of the secondaries market as most sellers don't want to take a big discount hit," Schmitz adds. "Buyers know there's going to be a downturn and they price that in, but you have to focus on quality. We have bought many large portfolios with mainly Western assets from Asian sellers. There are quite a few tail-end portfolios being sold by institutions in Asia where we just don't see much more upside."

This scenario offers a reminder that most of the tweaking in LP appetite for secondaries will be a result of filtering the relative inputs through the same themes that color the primary market, including the fact that the long cycles of private equity are only getting longer, which is making it harder to time anything. Patterns in strategic adjustments will be all the subtler in Asia due to the fledgling nature of the market; it still only represents 10-15% of the global secondaries space.

By the same token, macro tides will influence secondary processes by putting both sellers and buyers in the same apprehensive boat. This is already translating into more intense pricing negotiations forcing investors to ramp up efforts to source proprietary opportunities and look into the individual needs of counterparties to customize mutually beneficial transactions. It is no coincidence that these de-risking moves are fundamentally about improving liquidity – that's the secondaries market's key to survival.  

"The biggest check on secondaries will be the cycle itself, rather than expectations of or perceptions that we're late-cycle. The liquidity in funds would be used elsewhere and even if the spread widens, the ability to buy those deeper discounts will be more limited," says Potentum's Byrom. "But the interesting thing about the secondaries market is that it's giving institutional investors a more complete toolkit. So, I don't think it's going to go away, even in a downturn, because it's got enough depth and breadth that it's a feature of the private equity industry." 

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• Topics
• LPs
• Secondaries
• Asia
• Future Fund
• Coller Capital
• Manulife
• Ardian
• Economy