Secondaries: Bifurcation point

The rupee is currently trading at around INR65 to the dollar. It has slumped more than 20% since May, driven by international investors pulling their money out of India.

For an LP in an India-focused private equity fund, that committed capital in US dollars, it makes for grim reading. Those that went in when the market was at its peak in 2006-2008 were getting INR40 on the dollar. Even if the fund portfolio has doubled in local currency terms, with talk of the rupee entering INR70 territory and beyond, the LP could still be looking at a US dollar return closer to 1x.

Are these investors looking to cut their losses and trade out their positions at a discount on the secondary market, or is there a sense that the situation can't get any worse?

"Net asset value (NAV) is down by 50% in US dollar terms so performance is much worse and distributions are paling in comparison to what many people expected - but at the same time capital calls are cheaper if you are investing," says Juan Delgado-Moreira, managing director at Hamilton Lane. "In the first half of the game you don't worry too much; that comes in the second half. Most secondary deals normally happen in years 4-7. There will be more rebalancing but it hasn't happened yet."

Other market participants say the wheel is already turning, and not just on India.

Although economists have revised their China growth projections upwards on the back of recent encouraging indicators, GDP expansion has slowed in nine of the last 10 quarters. Indonesia, meanwhile, saw growth slip below 6% last quarter for the first time since 2010, adding to concerns about slowing investment, accelerating inflation and a weakening currency.

There may be optimism regarding these countries' long-term prospects, but investors are calculating the opportunity cost of their exposure.

"We are seeing more Asian funds in global portfolio sales," says Hiro Mizuno, a partner at Coller Capital. "Right after Lehman there were so many secondary transactions but quite a few sellers opted to hold on to their Asian assets because they expected more outperformance. Now sentiment has changed. There is no justification for holding on to Asian funds."

Still small fry

Another explanation is simply that the market is maturing. Asia saw a huge amount of fundraising during the vintage preceding the global financial crisis; many of these vehicles are now fully invested and LPs are considering their options. In addition to the pan-regional funds, there are now more country-specific vehicles, with China, India and a touch of Southeast Asia joining Japan and Australia on the block.

Even so, the region still makes barely a ripple in the secondaries market globally. Alex Lee, a partner at Axiom Asia, estimates it is no more than 5-10% of worldwide deal flow.

According to Cogent Partners, global secondaries volume dropped off in the first half of 2013, with approximately $7 billion transacted - the lowest level in four years. In both 2011 and 2012, the full-year total came to $25 billion. Meanwhile, prices were rising. The average first round high bid for all funds was 84% of NAV, an increase of four percentage points on the second half of 2012.

"With NAVs rising and secondary buyers actively seeking to deploy more than $35 billion of dry powder, current market conditions have been nearly ideal for potential sellers," the Cogent report concluded. "The question therefore remains how long will this seller-favorable window remain open?"

The answer rests on two factors: public markets and secondary fund dry powder.

First, the upswing in public markets - after treading water for much of 2012, the Dow Jones Industrial Average Index is up more than 16% year-to-date - was a disincentive for many prospective sellers. Having seen better distributions from portfolio GPs in the last 6-12 months and hopeful that NAVs would improve still further, they decided to bide their time.

"It created a situation where people felt far less pressure to do something," says Philip Tsai, a managing director at UBS. "With the lag in reporting as well, people decided to wait one more quarter and see if GPs write up their portfolios even further."

Cogent found that the drop in deal volume is due to reduced activity on the part of public pension funds and financial institutions specifically, groups that can typically be relied upon to execute a few transactions of $1 billion or more. These two categories of investor accounted for approximately 25% of sellers in the first half of 2013, down from nearly 50% in the previous six-month period.

According to Coller's Mizuno, financial institutions have lost their urge to sell because most have now been through a couple of secondary transactions. While still carrying significant PE positions, they now know how quickly they can offload them when required.

Adam Howarth, a managing director with Partners Group, adds that financial institutions are delaying on sales because the regulations requiring them to divest - Basel III and the Volcker Rule, which impose stricter capitalization levels and limit balance sheet exposure to alternative assets, respectively - have yet to be put into a final timeline.

However, the general consensus is that activity has picked up in the last 2-3 months. Tsai of UBS is predicting full-year secondary deal volume to reach $16-18 billion, while Cogent thinks $20 billion is within reach.

"Investors don't necessarily want to push their luck - they've had a good run and may want to take chips off the table for interests they deem non-core, taking advantage of relatively strong pricing," says Tsai.

Dry powder debate

The second factor, dry powder held by secondary investors, is more complicated and asks questions of managers' differing approaches to the market.

Since the beginning of 2013, HarbourVest Partners, Adams Street Partners, StepStone, LGT Capital Partners and Deutsche Bank have all closed secondary vehicles on or above target. Last week Hamilton Lane joined the club. Of the big beasts, Coller and Axa Private Equity raised funds of $5.5 billion and $8 billion, respectively, last year, while Lexington Partners will reportedly return to market this year, seeking $8 billion.

UBS put the amount of dry powder in the secondaries market at nearly $42 billion at the start of 2013; Cogent's projection is $35 billion. These estimates only include dedicated secondary buyers, so there could be more capital earmarked for the space from opportunistic investors with generalist funds.

Dominik Woessner, a director with Cogent, notes that secondary demand exceeded supply during the first half of the year, which contributed to the increase in transaction pricing.

However, he claims not to be unduly worried by the current capital overhang. Even if dry powder levels reach $40 billion this year, a transaction volume of $20 billion would be sufficient to maintain a capital overhang of 2x, which has been fairly common over the past few years.

Coller's Mizuno is even more effusive, declaring that 2012-2013 will be a golden vintage for secondaries because the funds raised ahead of the global financial crisis - when more than one third of the PE funds ever raised globally drew capital - are coming to market.

"This is my third fund with Coller," he says. "After we raised the first two funds, I asked who we should be approaching. Now it's obvious; all the banks have a lot of private equity on their balance sheets."

Fortune has not favored all industry participants, though. According to market sources, a deal is already in place that will see StepStone acquire Greenpark Capital in some way, shape or form, after the latter struggled to meet its fundraising target. The future of Paul Capital is also said to be uncertain.

This may be evidence of an industry becoming increasingly bifurcated, with large players at one end of the spectrum who feature in all the auctions and smaller, more specialized practitioners at the other. It is also increasingly competitive. The likes of HarbourVest, Adams Street, Hamilton Lane, Partners Group and LGT offer combinations of primary fund-of-funds, co-investment and secondaries as they seek to meet the needs of a more sophisticated LP base.

In a number of cases, LPs have the option of cutting out the third-party manager entirely as intermediaries approach them with secondary opportunities - although their ability to respond is a function of internal resources.

"The portion of managers in the secondary market by dollars who are also primary managers is increasing," says Hamilton Lane's Delgado-Moreira. "If you go back to the 2008-2009 vintage, that is when a lot of the fund-of-funds starting raising secondary vehicles of $1 billion or more."

A primary business represents a competitive advantage: a manager has access to more data, enabling him to respond quicker to opportunities; and GPs may prefer to deal with an investor that could come in on their next fundraise.

Partners Group claims that its existing GP knowledge and relationships in Asia are already delivering secondary positions at attractive prices. The firm monitors 30 funds in Asia every quarter and, based on its analysis of the underlying assets, bought an LP interest in one of these vehicles.

"Subsequently we saw the same fund in a portfolio come to market through an advisor and we were told it cleared at a premium to where we purchased it," says Howarth.

The impact of this information advantage is contested by secondary specialists that have built their businesses without a primaries arm, but it potentially offers an edge in a market some say is badly in need of differentiation. As one industry source puts it, secondaries have become so well established and funds so large that it is difficult to replicate the returns seen 10 years ago.

In this context, a smaller practitioner with access to proprietary deal flow might be able to generate the returns investors are looking for. But how far is a firm willing to go in order to get it?

The theory posited by several market watchers is that Greenpark and Paul are victims of a general perception that, for all the benefits secondaries bring in terms of eliminating blind pool risk and ameliorating the J-curve effect, it is difficult to outperform the median and mean. And in trying to bridge this expectations gap, they shifted strategy.

"People have tried to stretch themselves to create an edge, and then got caught a little bit," says UBS' Tsai.

For Greenpark, this edge included an emerging markets angle. The firm teamed up with International Finance Corporation (IFC) to create a $500 million fund that would give it access to IFC's 180 portfolio GPs, positioning it to get the first call whenever an LP was looking to exit.

Greenpark said it expected to see in excess of $3 billion in emerging markets secondaries in 2012; and because the fund sizes tend to be smaller there would be less intermediation and less competition for deals.

AVCJ understands that the agreement between IFC and Greenpark has lapsed.

Niche opportunities

The secondaries market is large enough to support different fund sizes and strategies. As Axiom's Lee notes, it comes down to the individual manager's discipline and returns. "Even for pure secondary players, you don't have to be a $5 billion fund to be competitive," he adds.

But it is difficult to find space beyond the reach of intermediaries and in the current fundraising environment LPs are unforgiving.

Furthermore, the industry appears to be in the midst of a broader consolidation. The Blackstone Group's recent acquisition of Credit Suisse Strategic Partners suggests there are willing buyers among PE firms with aspirations to become multi-strategy asset managers.

As for Asia's prospects, it may be case of soon, but not quite yet. Although assets are coming to market, and there is evidence to suggest more will follow, it is a trickle not a torrent.

"We are working on a handful of emerging markets deals right now," says Jason Sambanju, managing director at Paul Capital. "It's not just banks that have private equity side pockets; plenty of hedge funds and corporations have them too. If you look at the behavior of Asian corporates in recent years, a lot of them are starting PE-like businesses."

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