By Bill Kelly
Private equity is quite simply capital not listed on a public exchange (props to Investopedia). This is certainly an apt description but as this asset class moves toward greater maturity, corresponding levels of responsibility and transparency must be ramped up too. Uninvested capital has reached dizzying heights which can only mean (on average) higher entry multiples, downward pressure on returns, less compensation for an illiquidity premium, and more sponsor-to-sponsor transactions as a form of exit.
A recent article in CAIA’s Alternative Investment Analyst Review takes a closer look at the secondary private equity market which has come a long way from its nascent roots dating to 1998. Back then, it was mostly a limited partner driven market consisting of one-off transactions where the LP was looking for liquidity in what was usually a distressed asset sale. These volumes, as measured in both numbers and dollar amounts, were tiny and the bid-ask spreads were quite wide. Twenty years later, a lot has changed.
Today’s secondary market is more and more dominated by the general partners, and transactions have become more strategic than tactical where volumes are up 20x and pricing is now pegged at 93% of NAV. Dedicated secondary funds are now open for business and the maturity of this part of the market has filled a void for LP’s as they look to rebalance their exposure to this asset class. The high levels of dry powder (measured in the $1.5T neighborhood), along with the potential of further sales due to the Dodd-Frank hangover, will continue to provide the necessary fuel for growth in this part of the PE market for years to come.
Membership in this PE club has its advantages but along with those, comes responsibility. Much has been written about the mostly maligned but allowable practice of GPs using subscription lines to fund limited partner commitments, which results in higher IRRs, with 20% going back into the coffers of that same GP. More recently, we’ve seen a new twist within the secondary market that has started to show some movement from the typical GP-to-GP transaction, to a fund-to-fund trade within the same GP shop. From a regulatory standpoint, this is perfectly acceptable and perhaps the same can be true from the economic vantage point of the underlying LP investors, but maybe we are starting to fly a bit too close to the sun? An allocator’s view of this practice was recently laid bare in an interesting article in Institutional Investor that is worth the short read.
We are at a stage in the capital markets where historical returns will become harder to replicate and asset class premiums will likely continue to shrink. As the challenge of producing basis points has gotten fiercer and more competitive; the LP’s awareness of market practices must evolve too and remain as sharp and as edgy as it is for the managers that they hire.
Seek diversification, education and know your risk tolerance. Investing is for the long term.