By: Konstantin Danilov, AllAboutAlpha.com Editorial Board.
The secondary market for private equity interests has received lots of attention over the past year, but according to Michael Pugatch Vice President at HarbourVest Partners (writing in the Guest Column of the latest Debevoise & Plimpton Private Equity Report), the long-awaited “golden age” for secondaries did not transpire in 2009. However, the market has evolved and signs are pointing to an increase in transactions in 2010.
Historically, only large financial institutions and corporations have participated in the secondary market. Pugatch states that as a direct result of the financial crisis, several endowments and publicly traded private equity funds also entered the market in early 2009 (mostly as sellers).
For endowments, the need for current or future liquidity and the desire to reduce private equity allocations are the top reasons for wanting to sell. The latter is due to both the decrease in the valuation of public assets in 2008 and Q1 09, and the increase in risk aversion following the crisis. Last week’s post provides an overview of the Coller Capital private equity investor survey, which reaches a similar conclusion. For publicly traded funds, leveraged over-investment in private partnerships – a winning strategy during the 07-08 heyday – backfired when distributions ceased and liquidity became nonexistent.
Buyers of secondary interests have traditionally been specialized firms that actively acquire private equity stakes, such as secondary private equity funds. Most recently, non-traditional buyers like insurance companies, pension funds and some endowments have entered the market as buyers to opportunistically increase their stakes in certain partnerships at an attractive price.
Active buyers of secondary interests dramatically scaled back their purchases in the second half of 2008 and the first half of 2009. Market uncertainty was obviously a factor, and a general lack of confidence in the valuation of private equity portfolio assets compounded the problem. Secondary bids dropped dramatically, falling as low as 30% of NAV for some partnerships, which in turn further decreased the number of secondary deals . Even the most cash-strapped investors were understandably reluctant to part with their private equity stakes for pennies on the dollar.
The Great Flood
HarbourVest expects that and increase in deal activity and the resulting increase in capital calls should spark the long awaited secondary market flood. Since capital calls have been minimal in the first half of 2009 (see chart below), and have picked up as the recovery has gained momentum, he speculates that some investors will face immediate liquidity concerns and will be forced to sell on the secondary market.
Will 2010 be the year that the private equity secondary market finally becomes a viable portfolio management tool? It will likely take longer than most had hoped. The reason is the level of complexity involved when valuing a private equity portfolio.
To keep things relatively simple, assume that the fund is fully invested. The first step is to value each individual company in the portfolio. Since the financials are not publicly available, the only option is to try to guess or take the FAS157 valuation as a fact. Unless of course, you either already own a stake in this particular fund or have a great relationship with the GP, in which case you can probably get a pretty good sense of how things are going.
Even if you were able to get a relatively accurate valuation of the portfolio assets, you are not done. Unlike a mutual fund manager, the GP has an active role in each portfolio company, which needs to be factored into the calculation (perhaps you already factored it into the discount rate for each company, but that is a longer discussion). Next, adjust for the vintage year (a proxy for purchase price for each company), already paid-out distributions, the fee structure, and any other factors that could affect the future distributions from the fund.
The level of complexity that is involved in valuing a secondary market portfolio favors buyers with lots of money already invested in private equity partnerships, lots of experience and many good relationships with GPs. Average sized pension funds, endowments, MFOs and individual investors are clearly at an informational disadvantage relative to secondary funds and large private equity investors. Until the information gap is narrowed, the private equity secondary market will continue to be viewed as a last resort for most investors.