The secondaries price is right

The search for the right price is one of the defining characteristics of the free-market system, but it is causing a sidelining of the secondary market even as the number of interested buyers increases.

As part of PEI Media’s Active Portfolio Management Forum in May, representatives of secondaries firms and advisers such as Landmark Partners and Cogent confirmed that secondary deal activity will be way down this year, with only $2.5 billion in transactions closing so far in 2009 as opposed to $20 billion last year.

In short, don’t completely trust the media reports that have talked up a major rush into the secondaries market since the fall of Lehman Brothers last year. That’s not to say that there is no interest, with Greenpark Capital recently adding to its secondaries buyout team, Coller Capital preparing to raise its sixth secondaries fund and Houlihan Lokey recently starting a secondaries advisory practice. A recent Preqin survey found that 11 percent of 568 institutional investors want to sell their fund interests in the next one to two years.

But while firms are looking forward to an increase in volumes as cash-strapped LPs look to unload fund interests to gain liquidity, the divide between bid-ask prices and discounts is proving difficult to bridge. Potential sellers of fund interests are especially reluctant to go to the market with discounts to net asset value (NAV) as deep as 60 percent, while buyers are prepared to wait for better quality assets.

According to participants at the forum, among the biggest trends that have affected the secondaries market are:

1. Pricing measured as a percentage of NAV declined throughout 2008, from moderate discounts in the first half to substantial discounts in the second half.
2. Optical secondary pricing in the second half of 2008 dropped meaningfully as company carrying values were not fully adjusted to reflect the market downturn. This has made secondary pricing relative to mark-to-market carrying values appear more attractive.
3. On a relative basis, the spread between high and low bids in the secondary market have reached an all-time high from their lowest point in 2007.

Buyers and sellers must rely on fundamental analysis when evaluating pricing for secondary transactions, with key inputs including underwriting rates, timing and value of portfolio exits, capital call timing, return on future investments, public market performance and general economic and industry trends. But because of the widely varying valuation assumptions, it has become difficult for buyers and sellers to come to an agreement on the “right” price.

While the picture remains murky, Duff & Phelps managing director David Larsen and Cogent partner Brian Mooney sought to provide some clarity during a panel on arriving at a value for a secondaries transaction. The two experts came up with a fictitious buyout and venture fund that are representative of the types of high-quality, well-regarded funds that are seeing the most interest in the market.
To represent the buyout side, Mooney came up with the hypothetical Buyout Fund V, a 2004 vintage fund with $5 billion in committed capital and an established track record and excellent reputation.
 
Among its most significant characteristics are that it is almost fully invested, with the majority of its current investments made in 2004-2006, and that its interests periodically transact on the secondary market, although there is not an oversupply of this fund.

By contrast the hypothetical Venture Fund IV is a 2007 vintage fund that is broadly recognized as a top-tier venture capital GP based in Silicon Valley. It has $396 million in committed capital and is only 35 percent paid in, with $257.4 million in uncalled capital. It specialices in investments in early-stage and start-up ventures, including mobile wireless and consumer internet services, and its two most recent fund were oversubscribed.

Poll positions: Attendees at the 2009 PEI Active Portfolio Management Forum were given valuation data for the hypothetical Buyout Fund V and Venture Fund IV, including the NAV estimated by Cogent. The nearly 140 mainly limited partners and secondaries buyers/advisers/brokers in the room were then polled on what NAV they would want to buy and sell these funds; results are described below:

Buyout Fund V Valuation: The results for the buyout fund showed that, compared to the venture, buyers and sellers were more on the same page in seeking the appropriate NAV. A full 52 percent of sellers and 44 percent of buyers were in range of the estimated 44.1 percent NAV, while a third of the sellers polled would want a higher price than valued. Meanwhile a large majority of the buyers wanted a bigger discount. Three percent of sellers and no buyers were in the 0-20 percent range, while three percent of sellers and 6 percent of buyers were in the 81-100 percent range.

“It is easy to see why there is a deviation in bid-ask spreads” in the market, Larsen said, as 85 percent were willing to sell at least above 60 percent of the estimated NAV, but nearly that same number needed to be below 60 percent to buy.

Venture Fund IV Valuation: For the venture fund that had a given NAV of 49 percent, there was a much larger dispersion between the expectations of buyers and sellers. Thirty-seven percent of sellers and 21 percent of buyers were in the given estimated range. Nearly 50 percent of buyers wanted an NAV between 61 percent and 80 percent, while only 16 percent of sellers would agree. Nearly half of the sellers would accept an NAV below the 41 percent range.

One reason why there was a closer concentration in value expectations for the buyout fund may be due to the extra data and lack of unfunded commitment, as opposed to the venture which had significant uninvested capital. The head of private equity at Switzerland’s Unigestion recently supported this notion by saying that pricing was poor for stakes with heavy undrawn capital obligations.

Conclusion: “Sellers are still thinking that prices should be relatively high, buyers are thinking that prices should be relatively low, which means that transactions that are getting done are arguably doing so because there is some duress for the seller to sell,” Larsen said. While most in the industry see the secondaries market as somewhat attractive, but with a cloudy future, deals in the next year or two will be driven on a case-by-case basis based on factors including the need for liquidity, the rebalancing of a portfolio and distressed situations.