Private Equity Secondaries
December 18, 2017 12:50pm
By Stuart Pallister
Private equity (PE) transactions hit their highest levels since 2007 in the US and Europe in the first nine months of the year, according to the Financial Times citing data from Thomson Reuters, with the value of deals amounting to some 212 billion dollars, partly on cheap debt.
At a conference on private markets, held recently at Ecole hôteliere de Lausanne, senior PE executives and academics discussed buyouts and the ‘booming’ secondary market for PE fund stakes.
Professor Ludovic Phalippou of Saïd Business School at Oxford University, named in 2016 by RealDeals magazine as one of the 20 most influential individuals in PE in Europe – the only academic listed – warns however that “not everyone should show up as a buyer on the secondary market because it’s not that simple. You don’t earn anything through providing liquidity, we don’t care about that,” he told EHL Hospitality Insights on the sidelines of the one-day conference. “You earn something if you’ve outsmarted the other guy.”
Earlier he had outlined his research into whether liquidity is the main factor for making good returns in this market or if it’s down to the skill of the buyer to earn a premium. “What we found is that it doesn’t look like it’s liquidity because we see that in times when liquidity is very expensive overall in the bond and stock markets, we don’t see better deals, better returns, lower prices on that secondary market … We see them getting similar returns when liquidity is high or low.”
Professor Phalippou said that, based on his research, buyers of secondaries may on average be making “a bit more” but due to a lack of benchmarking, “it’s not easy for people to really appreciate how much they’re making on the market. But it’s an exciting market.”
Some firms may be selling a “nice story” to create a new product or raise money, he said, but “it’s more complex than that to understand why people are very excited about it and want to continue doing it.”
In a roundtable session at the end of the conference, experts coming from a range of firms and institutions discussed trends and developments in PE, from governance and fees to blind pool investments.
Describing the secondary market as ‘frothy’, Bernhard Engelien, Managing Director of Greenhill, urged caution when investors “buy into a fund at a deep discount. That may not be a good deal.” For fund managers, he said, it may be better to pay the full price for high-quality assets, rather than buy average assets at a discount. “You can buy into a fund at a premium and that may be a much better deal.”
Christophe de Dardel, Head of Private Equity at Unigestion, provided concrete examples. Bought at a premium of nine percent to net asset value, a stake in a Northern European buyout fund still turned out to be an “excellent deal.” On the other hand, a stake in a portfolio of venture capital funds, bought at a discount of 40 percent to NAV, proved problematic. “We thought we couldn’t lose money but we hardly recovered our costs. It shows that discounts don’t tell much about the final outcome of secondary deals.”
“You can trade anything at the moment,” Engelien responded, “even assets of average quality are priced at very high prices. I shouldn’t say that, but that’s the case.”
He continued: “I would say, as a buyer, I would be very cautious about what I buy at the moment.” With an estimated pool of ‘dry powder’ in the secondary market standing at more than 110 billion dollars currently, not including non-traditional buyers and sovereign wealth funds, Engelien said, “there’s a lot of money chasing essentially a deal flow which has remained more or less stable (at around 35-40 billion dollars a year). So ultimately that means prices are going up.”
Liquidity certainly isn’t a problem. If anything, “there’s too much of it,” said de Dardel. With the cost of borrowing very low, he added, the market “is a bit distorted and we have to be careful.”
Olivier Dauman, Head of Private Equity at CFM Indosuez Wealth, took a contrarian view. He believed it still made sense. “There’s still room for growth … It’s quite a new strategy in private equity but I do believe it all comes down to what type of returns you want to make.”
“If you look at the returns, secondaries have outperformed primary investments,” Engelien replied. “That doesn’t make sense from a finance theory point of view, because you should actually get a higher return for taking more blind pool risk.”
For Engelien, rising stock markets have been a major factor in the surge in the secondary market, along with access to debt. “If there’s a market correction and it’s material – let’s say 25 percent or so – then you know the returns will not look so nice.”
Whereas institutional investors had previously taken a buy and hold approach to secondaries, he said, they are now actively managing their portfolios to review their holdings regularly and make adjustments every few years.
Co-investments also came in for scrutiny during the roundtable session. But with a general partner or GP – the main investor who holds liability for the partnership – in the driver seat, the limited partners (LPs) who are co-investing are effectively “in the side car,” said Cyril Demaria, Head of Private Markets at Wellershoff & Partners. “I think it’s very risky.” He cited the example of institutional investors who had put money into gun manufacturers and then had to backtrack. So they may have saved on fees but then faced other costs. “Save a penny but lose a dollar,” he said.
To be a buyout investor, Demaria said, you need to create value. “Assuming that anyone can generate the expected level of performance in private equity only through the leverage effects does not make sense. This would basically assume that the others, especially future buyers of the assets, are the stupid ones.”
For Fulvio Maccarone, head of private assets with a family office, it’s important to take a close look at a potential investment before taking a decision, “or you’re not in the driving seat.” This, he added, helps to “prevent accidents because, in the end, they’re equity investments.”
On the topic of fees, he said some portfolio managers had become “a little bit arrogant, even if they are excellent funds. They really asked for too much. Over the past 12 months, it’s been very aggressive.”
While the secondary market has been booming, thanks largely to the ability to borrow money, dark clouds may be gathering. According to Engelien, there has been a “huge explosion of private debt over the last four or five years as the banks have also retreated from the market.”
Emmanuel Jurczenko, the EHL finance professor who co-organized the 1st private markets research conference, writes:
While investing in private markets – private equity, private debt and private real estate assets – is becoming increasingly popular among institutional investors, the lack of any reliable public source of data on private markets poses serious challenges both to academics and practitioners. We hope this event will provide valuable insights into the ‘art and science’ of investing in private markets and will become an important reference event in the field of less liquid alternative investments research, attracting leading academics and industry experts.
Professor Jurczenko is a member of the organizing committee of the 1st Private Markets Research Conference, along with Cyril Demaria of Wellershof & Partners, and Serge Darolles of Université Paris-Dauphine.
The conference, which aims to be an important academic event for researchers in the field of private equity and real estate investment, was staged at Ecole hôteliere de Lausanne on June 30, 2017, and benefited from the financial support of the Research Initiative ARDIAN/ Private Equity and Venture Capital, HES-SO University of Applied Sciences & Arts Western Switzerland and Unigestion.
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