Breaking through the barrier

It’s hard to avoid weather-related cliches when discussing financial markets and economic cycles. Private equity is no different. Journey back in PEI’s archives to read secondaries-focused coverage in late 2008 and early 2009, and you’ll hear industry insiders discuss a looming avalanche of up to $30 billion in closeable dealflow. That glut of product expected to come to market was subsequently called a flood, a tsunami, and many other things – but, as with many meteorological predictions, it was wide of the mark. What was expected to be a torrential downpour turned out to be more of a light shower.

Though fundraising soared more than 200 percent in anticipation – the niche raised a record high of $22.3 billion in 2009, making it the only private equity sector globally that surpassed its 2008 totals, according to secondaries broker and advisory firm Probitas Partners – a gaping bid-ask gap kept secondary buyers and sellers from transacting in most cases.

“Last year, things didn’t happen as people had hoped because of the huge pricing gap between buyer and seller,” agrees Tim Jones, deputy chief investment officer for London-headquartered secondaries firm Coller Capital. “Everyone was really just trying to stay upright and solvent rather than sell assets.”

Stars are aligning for banks to start using the secondaries market Andrew Sealey

Most secondaries players estimate completed transactions for the year totalled around or just under $10 billion, with the disclaimer that the market remains opaque and there is no one, universal, official source for statistics. New York-headquartered secondaries manager Lexington Partners counted $9.2 billion in transactions last year – a 44 percent drop from its tally for 2008, though some insiders have argued that the volume of transactions may have been closer to 2008 levels given the large number of highly unfunded LP interests that changed hands last year.

But that’s all history now, market participants will tell you. Asked if the much predicted avalanche or tsunami was starting to materialise, Landmark Partners principal Ian Charles chuckles and says that “whatever it is, it’s already happening”.

CLOSING THE GAP

“You can draw a very stark contrast between this year and last year – about as stark as you could imagine,” says Andrew Kellett, partner with European placement and advisory firm Axon Partners. “Last year we were talking discounts at this time of 50 percent or north for brand-name funds. This year, we've actually seen one premium and more usually narrow discounts.”

Fellow Axon partner Dominik Meyer concurs, calling 2009 “the most unusual year in the secondary market”.  This year, he says, “we have a much more normalised market; prices have come back, trading patterns have normalised and there are some very interesting opportunitistic deals.”

Pricing began to rise dramatically in the second half of 2009, as risks to the financial system seemed to recede, a major economic downturn appeared less likely and better visibility on corporate earnings triggered some recovery in the M&A market. The average bid price for an LP fund interest was about 72 percent of net asset value (NAV) in the second part of 2009, up from 39.6 percent in the first half of the year, according to secondaries broker and advisory firm Cogent Partners.

Discounts continue to narrow, which has had a positive effect on transaction volumes, says Cogent partner Dominik Woessner. “Pricing increased further during the first half of this year, averaging at around 80 percent of NAV, which in turn led to a resurgence of deal flow. Transaction volume closed or announced during the first half of this year already surpassed the entire deal volume of 2009.”

Though pricing has improved dramatically, Kellett says there are differentiated views from a lot of players on the same assets. “We're seeing very wide ranges of pricing for the same assets – quite an astonishing spread – and usually the best pricing comes from the people already in the funds.”

As an example, Meyer points to a live deal. “For a good, small buyout fund we have a knowledgeable buyer who's already invested, who pitched a 6 percent premium, and we have another bidder who bid a 70 percent discount.”

BANKING ON IT

The secondary market’s momentum is being driven largely by bank-initiated transactions, whether that’s selling off certain portfolios of assets or fund interests – or spinning out in-house private equity units completely.

Already this year, Citigroup reportedly agreed to sell $900 million-worth of private equity fund and direct investment assets to Lexington as it slowly unwinds its private equity platforms. Bank of America Merrill Lynch sold a $1.9 billion portfolio of mature fund interests to AXA Private Equity, while two of BofA’s in-house private equity groups planned to spin-out. AXA also picked up some of French bank Natixis’ domestic private equity operations for €534 million. HSBC confirmed in early June that, because of a “changing regulatory environment”, it was in MBO discussions with its five remaining in-house units (its European buyout arm spun out as Montagu Private Equity in 2003). UK government-backed Lloyds Banking Group sold 70 percent of its Bank of Scotland Integrated Finance (BOSIF) portfolio, comprising 40 companies, to Coller Capital for £332 million (see p. 48). And the list goes on.

Everyone was really just trying to stay upright and solvent rather than sell assets Tim Jones

“Stars are aligning for banks to start using the secondaries market,” agrees Andrew Sealey, managing partner of advisory and placement firm Campbell Lutyens.

Though natural sellers given various looming regulatory issues (see p. 60), banks hadn’t transacted much on the secondary market last year. That was in part due to the distractions of dealing with other balance sheet issues such as repaying capital to governments. “And also the pricing was at such a level that it would have been destructive to Tier 1 capital to take those sorts of discounts,” Sealey says. “Pricing is now at a level where they can transact and [secondary sales are] getting senior management’s attention because they’ve dealt with the issues that were pressing on them last year.” And, he adds, “Regulatory pressure is increasing substantially as the regulators seek to interpret Basel II and also the expected pressure on Tier 1 capital as regards Basel III”.

Banks have now determined what’s core and what’s non-core, says Coller’s Jones. “The banks now are beginning to move and they’ve got a strategic objective to lighten their loads on private equity – they’re not distressed sellers,” Jones notes. “You’ve seen three or four large deals this year. I think you’ll see this continue over the next two to three years as banks slowly unwind their private equity portfolios.”

There will be far more $1 billion-plus portfolios put up for sale this year than one would normally see, adds Jones.

‘LOCALS’ TAKE CONTROL

Last year, non-traditional buyers – or “tourists” – permeated the marketplace. Traditional buyers like secondary fund managers were relatively quiet in part because many transactions in 2009 were single fund interest deals, many of which were highly unfunded “late primary” or “early secondary” positions.

“That allowed the primary players – who typically don’t have the resources or technical know-how to do big, complex, multi-asset transactions – to enter the market,” recalls Sealey. “Now there’s been a return to portfolio transactions and auction processes which favour more sophisticated players.”

Those sophisticated secondaries players, it must be noted, have a great deal of dry powder to invest. Paris-headquartered secondaries brokerage and advisory firm Triago estimates a capital overhang of roughly $40 billion for the sector – another reason why it is not surprising to see big-name secondary players successfully snap up much of what has hit the market this year.

Sealey adds, however, that some primary investors who “got a taste” for secondary investing will continue to be selective buyers going forward.

A good example might be a deal announced in April. The UK’s second-largest pension plan, the Universities Superannuation Scheme (USS), paid an undisclosed sum for a $135 million interest in Neuberger Berman Secondary Opportunities Fund II, a secondaries fund that was about 25 percent called as of April 2010. The acquisition of the interest, which was bought from the estate of failed bank Lehman Brothers, made USS the largest individual LP in the $1.8 billion fund. Mike Powell, head of alternative assets at USS, said in a statement at the time that the transaction was led by the pension’s in-house co-investment team and called co-investment “an area of increasing focus as we continue to expand our private equity investment programme”.

Bank of America: Secondaries deal source

Landmark’s Charles notes that non-traditional buyers will always be active to some degree in two instances: when a stake is being sold in a brand-name fund about which information is “sort of ubiquitous in the market”, and when highly unfunded positions are up for grabs. “But there aren’t a lot of those positions around today compared to two years ago,” he says of the early secondaries.

ON THE BLOCK

Early secondaries have receded in part because pricing for them has rebounded dramatically. “These days you see very narrow discounts – it is not so much the flavour of the day anymore,” says Axon’s Meyer.

It is for this same reason – narrowing of discount – that large buyout funds are particularly popular buys this year, says Cogent’s Woessner. “Buyout funds usually account for the largest share of the secondary market, due to the fact that the strategy accounts for the largest share of the primary market.” But the movement in pricing for that market segment – bids average 86 percent of NAV at present, up from 69 percent in the second half of 2009 – makes them more attractive. “This also includes mega-buyout funds, which for most of 2009 would not trade at all or only at very steep discounts. However, due to substantial write-downs of portfolio companies and the subsequent recovery of valuation multiples and operational performance, some of these funds have priced at the top end of the market during the course of this year.”

Fund books for sale make up about two-thirds of the potential secondary transactions in the market, estimates Coller’s Jones, with the balance made up of direct asset deals that may include spinning out a management team like the BOSIF deal.

For this latter opportunity, according to Sealey, there has been an “explosion” in for-hire managers of assets, which have traditionally included groups like W Capital, Vision Capital and Cipio Partners. Now some primary fund investors, such as European mid-market specialist Bridgepoint, have also added on divisions to evaluate such opportunities.

Just where opportunities are originating from, particularly as regards LP interest deals, has a lot to do with where there’s stress at the institutional investor level and a need for portfolio rebalancing and reconstruction, says Landmark’s Charles. “Institutional stress was very high in US, Europe and emerging markets/Asia 18 months ago,” he says. “It remains very high in the US, it’s pretty high in Europe and it’s nonexistent in Asia and the emerging markets.”

That’s in part because limited partners in places like Asia and Australia were comparatively underexposed to the private equity asset class. “If you’re a family office in Asia or an Australian superfund, you had that temporary shock like all the other LPs. [But] you were building your programme when your whole portfolio got shocked, and now that the assets have reinflated, you’re back to building your programme,” says Charles. Most European and US portfolios were fairly mature when they contracted, and though valuations have bounced back, their portfolios remain constrained to pre-2008 levels, and thus prime targets for secondary investors.

STRONG PREDICTIONS

Secondary market participants are cautiously optimistic about their deal pipelines for 2010. Based on the $10 billion figure that is generally agreed for last year in terms of transaction value, most practitioners expect between $20 billion and $30 billion in transactions to close this year.

Given that a “normal” year has a run-rate of around $18 billion, according to Jones, 2010 will not necessarily be a “mega-increase” over a normal year’s run rate.

“It feels like it’s going to be a very strong year,” agrees Charles, “but that’s all dependant on how pricing holds up.” Much of the secondary market’s activity tends to take place in the fourth quarter as LPs realise they need to rebalance portfolios ahead of the next calendar year, he says.

But secondary GPs shouldn’t stand by waiting for the phone to ring in the fourth quarter if macro events make markets falter, buyers become skittish and pricing seizes up. “Buyers and sellers have to price risk themselves and if buyers feel like they’re being compensated for the risks, deals get done,” Charles says. “There’s a whole host of things that could take pricing right back to where it was 18 months ago.”

The bright spot in that sobering reality? “Everybody survived 18 months ago.” 

TAKE TWO

One of the most anticipated and closely watched direct secondary deals this year was struck in July when Coller Capital acquired a 70 percent stake in a portfolio of 40 Bank of Scotland Integrated Finance (BOSIF) assets from owner Lloyds Banking Group. At one point in the bidding process – which formally began in January – 3i was expected to join forces with Coller, with Coller providing financial backing and 3i managing the assets. Bridgepoint, with potential backing from Lexington Partners, had also initially shown interest in the deal but later walked away.

Vue Cinemas: Coller wins front-row seat

Coller paid £332 million (€401 million; $502 million) for its stake in the joint venture, valuing the portfolio as a whole at approximately £480 million and representing a “small premium to current book value” according to a statement.

Tim Jones, Coller’s deputy CIO, said market chatter about the deal pricing too high was to be expected. “Whenever a transaction’s closed, there’s always some people saying the price was too high either because they weren’t invited [to bid on] the transaction, or they lost. It’s just natural,” he said, quipping, “I would perhaps imply that about transactions we weren’t in.” Both Lloyds, which is retaining a 30 percent stake, and Coller were happy with the price, he said. “Only time will tell whether we’ve made a smart investment; we believe we have, but time will tell.”

The assets in play were originally acquired by Halifax Bank of Scotland’s (HBoS) integrated finance division, a unit that invested both debt and equity in companies. Its investments were later inherited by Lloyds when it agreed to purchase HBoS in September 2008. The assets – reportedly including stakes in yacht maker Sunseeker, Vue cinemas and the Caffè Nero coffee chain – had originally been put up for sale in November 2008, with UBS hired to lead the process. At the time, the portfolio comprised stakes in roughly 70 companies and had been valued at about £1.4 billion, including debt.

The existing BOSIF team, now dubbed Cavendish Square Partners, was best placed to manage the assets and achieve maximum value as it knows the portfolio intimately, Jones told PEI previously. “If you seek third-party management for one or two investments that’s okay, but with 40 there’d be room for a lot of disruption.”

The partial disposal of the portfolio is part of Lloyds’ compliance with the European Commission’s request that it sell assets to avoid competition concerns. The bank, which received a government bailout during the financial crisis and is now 41 percent state-owned, as of July had sold six businesses in the preceding 12 months, realising more than £750 million.