The Rise of Pre-Owned Private Equity

How interesting that the private equity fund secondaries market had a very big year and the private equity primary market, a very small one.

In 2010, institutions that back private equity funds remained subdued in their enthusiasm for, and ability to commit capital to, new private equity funds. But they went ga-ga for used ones.

According to new statistics from Cogent Partners, which advises on and tracks the sale of interests in private equity partnerships, deal volume globally in the secondaries market surpassed $20 billion for the first time. In fact, Todd Miller, a partner at Cogent, says his firm believes the real number is somewhere between $22 billion and $23 billion (it’s hard to get definitive data in this incredibly opaque market).

Whatever the figure, it is clear that last year was the biggest ever for the private equity secondaries market, and may have even marked its coming-of-age. Meanwhile, as anyone trying to raise a new private equity fund will tell you, 2010 remained a painful one for the primary market. According to Preqin, private equity funds globally raised $225 billion in 2010, which basically knocks the industry back to 2004 levels. Last year was even a step down from the tragic 2009 fundraising market.

There is an interesting statistic that comes from a comparison of the totals in these two markets. For the first time, private equity fund secondaries volume was roughly 10 percent of the primary volume. In other words, “traded” partnership interests were 10 percent of “newly issued” partnership interests. You only see that level of secondaries volume in a mature market for illiquid securities.

The milestones are further evidence that private equity has developed a widely accepted way to trade out of partnerships that are otherwise designed to bind all parties together for 10 years or more. Having gotten off to an obscure start in the 1990s, private equity secondary buyers and intermediaries never stopped evangelizing to investors about the gospel of active portfolio management. Whereas the standard tool for risk management in private equity may have once been limited to changing tactics with regard to new investments, now investors are more likely to consider strategic selling within their “pre-owned” portfolio in order to get closer to their preferred risk/return profile.

Secondaries in private equity have just about gone mainstream. Just as divorce became more acceptable throughout the 1970s, the stigma associated with secondaries deals fell away throughout the 2000s. Mommy and Daddy parting ways is not seen as a moral failure, necessarily. These deals still require the approval of the fund managers themselves, but today these general partners are much more willing to provide whatever information is necessary to facilitate a trade, including reams of sensitive information about the underlying portfolio companies. And in fact the smartest among the GPs use these transactions as exercises in high-touch investor relations. If there are hard feelings, they aren’t as openly expressed.

The development of the private equity secondaries market brings to mind the development of a secondaries market for another less-than-liquid asset: bank debt. These fixed-income securities are, like private equity funds, structured as long-term private agreements between parties, and yet things sometimes happen along the way that cause one of the parties to look for a way to get out of the agreement. The bank-debt secondaries market has a big head start on private equity, and so in it one can see a possible direction for private investment partnership secondaries. The broad market participation in bank debt trades is further facilitated by standardized forms and procedures from an industry body called the LSTA. No such body yet exists in private equity, but the procedure for completing private equity secondaries deals are becoming more routine and predictable, say market participants. That said, almost all sales of fund interests continue to require significant “hand-holding” because of the complex valuation issues that need to be negotiated on a deal-by-deal basis.

The latest Cogent report paints a picture of a private equity market in which investors expect further valuation recovery, and in which the “stigma of divorce” is further eroding. The average price at which a fund interest now changes hands is now nearly the value that the GPs themselves are reporting, at 90 percent of NAV. This is up from 86 percent of NAV seen in the first half of 2010, and way up from the nearly 40 percent of NAV pricing seen in the panic-stricken first half of 2009. Indeed, it could be said that the many of the mid-2000 vintage private equity funds will probably not perform very well except for the lucky few who bought into them in 2009.

The hopeful buzz surrounding the IPO market has boosted confidence even in the valuations surrounding venture funds, which tend to hold assets that are the most difficult to price, i.e. early stage companies. Investors have been fearful that selling an interest in a venture fund would only lead to their faces getting ripped off with regard to valuation, and therefore barely any venture fund interests have changed hands since the financial downturn. But in the second half of 2010 venture funds accounted for one-fourth of secondaries deals by number. When buyer and seller can agree on what a collection of venture-backed companies might be worth, it becomes a lot easier to sell a slice of said companies.

The secondary buying and selling opportunities continue to lure in new groups. Miller says that the seller composition of today’s market has expanded dramatically to include institutions that previously were only dipping their toes in the water. Public pensions and financial institutions, which in the past were only bit players as sellers, were in the second half of 2010 almost 40 percent of market volume by number and 75 percent by volume, he estimates.

Given the recent swoon in primary fundraising figures, and the lag effect in the secondaries market, it is likely that down the road primary fundraising will begin to pick up and secondary trades may fall. But the long-term trend is unmistakable – liquidity events within private partnerships are becoming more and more normal. This is good news for the development of this or any asset class, because transparency and standards gives confidence to new market participants, who want to know that there are fair and safe ways for them to rebalance their portfolios if they really need to.