Matthew Arkinstall, Investment Director, speaking at a conference in April 2009

As any investor knows, timing is everything. And over the course of the past 12-18 months, reading the market for signs to invest has become a full-time occupation. For secondaries investors, this is particularly true. In 2007, prior to the current economic downturn secondaries prices had reached historic highs, with premiums to NAV of 40-50% not uncommon. But during 2008 the balance of power shifted and over the course of 2009, as buyers and sellers have felt their way around in this unfamiliar territory, discounts to NAV of 40% to 60% have become commonplace.

Unsurprisingly against this background sellers have been reluctant to sell and, on the whole, many have managed to find ways of avoiding having to do so. Consequently the much anticipated secondaries boom of 2009 is edging towards 2010. But might it fail to materialise at all?

Clearly a lot hangs on the level of motivation of distressed sellers choosing to take the ‘elegant solution’ offered by secondaries. Focusing on LPs, their main reason for selling on unfavourable terms would be to free up capital, as a matter of urgency, to repair capital adequacy ratios or over-commitment strategies. Capital calls in the recent past have been kept as infrequent as possible and almost at a ‘keep the lights on’ level. Where deals have required a draw they have mostly been to support small add-ons to existing portfolio companies at low multiples.

If LPs can find alternative ways to raise capital their motivation as distressed sellers goes away. (They may, however, still wish to rebalance or finesse their portfolio by exiting a portion of their private equity interests to invest in other funds.) But with current forecasts for the UK economy remaining cautious to say the least, their options for increasing returns from other sources continue to be limited. Some relief on allocation indices has been achieved by improving public market performance and much has been made recently of the intentions of larger buyout firms to create liquidity through IPOs. We are even starting to see more volume on exits to trade buyers, albeit from a low base. However, even if all of these companies achieve whole or partial exits, it is unlikely that the capital flows will be sufficient to move the needle for LPs.

Despite compelling aggregated research data that suggests LPs will continue to maintain allocation to private equity over the long term, until equity indices and bond markets achieve a sustained and significant rally LPs will continue to struggle to fund their draw down commitments and will continue to need to address allocation issues and over commitment strategies. In the short term, therefore, it remains likely that a need to reduce their allocation to the asset class, combined with a need for cash will require them to exit fund commitments over the coming year – regardless of discounts to NAV.

So if LPs and GPs have reluctantly come to accept the new market paradigm – and this has taken far longer than many commentators anticipated – what is now holding back activity? No-one disputes that potential deal flow is higher than at any point previously; yet the volume of closable deals has fallen to its lowest level for many years.

The problem is the difficulty of assessing future returns. Investment committees take a long time to reach decisions in any market but, in the current market, it is extremely hard to assess performance while factoring in the lack of visibility and taking a view on GP quality and strategic viability.

In addition, many portfolio companies began missing their forecasts earlier in the year and are struggling with debt levels well in excess of the current norm. Until the economic outlook stabilises and the exit environment improves (particularly at the large end), calculating fair value is impossible. A ‘fear’ discount is being built into pricing, and that is the point on which sellers and buyers are struggling to agree. Consequently we expect the total value of deals completed this year to be less than $10 billion globally (compared with $20-30 billion last year), despite there being an estimated $70-$80 billion of interests for sale. For reference, the total volume of transactions in private equity interests, for the first five months of 2009 was $4 billion.

Once the issues of pricing and primary market activity can be resolved, the market is going to take off in earnest. The major factors influencing sellers’ current motivation such as economic uncertainty, draw down requests, unbalanced asset allocations and limited returns from their investment portfolios are unlikely to be resolved overnight. And GPs that have held off from making onerous draw down requests will not continue doing so forever.

We expect 2010 to be the best buyer’s market since secondaries began nearly three decades ago, both in terms of quality and quantity. Experienced secondaries investors such as Greenpark Capital, with detailed diligence models, proven expertise across multiple investment jurisdictions and firepower in reserve, will be well placed to identify and invest in the highest quality assets on offer.

The dynamics of the smaller and mid-markets are very different from the larger end of the market. There are investors who have always felt most comfortable in the large buyout space, with household name managers and portfolio companies to match. But now that we are experiencing highly testing economic conditions, investors who have chosen the small and mid-market route are seeing the benefits of their investment decision. It is not for nothing that some of the largest discounts to NAV currently seen in the secondaries space are for the larger end buyout funds with substantial unfunded capital commitments outstanding.

In essence, the advantage of small and mid-market funds for investors is that they generally avoid excessive amounts of debt, tend not to pay double-digit multiples for assets; and since their managers aren't in the habit of raising outsized funds that generate huge fees, their interests typically remain aligned with those of their investors.

Prior to the global economic downturn of 2008, the large-end investment model did yield attractive double-digit returns - but only on a temporary basis. Now that the private equity model has reverted to an emphasis on business growth and operational improvement, the benefits of the mid-market model are more apparent than ever before.

For mid-market specialists with established relationships and a proven track record, even a trading environment as difficult as the current one can still yield opportunities. In the mid market, where Greenpark has a particular focus, many late (70% plus funded) positions are now being priced at extremely attractive discounts.

When Greenpark Capital buys mid-market funds in the secondary market, portfolio investments are often leveraged at around three times or less, making them a very attractive proposition. For investors seeking high quality, mature assets with earnings visibility and a less competitive environment, the European mid-market continues to offer excellent investment potential.

The issues of liquidity and capital commitments will drive sales of attractive European fund positions, these drivers are as pertinent for Asian and MENA Limited Partners as they are for European and US investors. In terms of deal sourcing, secondary professionals with the right experience and a deep knowledge of local markets will be able to respond quickly to the growing market opportunities, invest across multiple territories and identify real value in a difficult environment. Avoiding the intermediated / auction route offers a wide range of benefits, most notably the ability to avoid buying at punchy valuations at the outset, which can impact exit returns. Detailed due diligence, from portfolio companies upwards, - the core risk mitigation for mid market secondaries investors - will continue to provide downside protection.

In the current market, where €500m+ primary deals are thin on the ground, larger funds are increasingly changing their focus to the mid-market. Greenpark, however, is an established mid-market specialist with a reputation for providing discreet, tailor-made solutions for its clients.

Interviewed by AltAssets, Greenpark's Daniel Green commented on the increased volume of deal flow in the secondaries market seen in H1 09 and the actual number of transactions completed, which was low. This was the result of low pricing levels by buyers, in the light of the perceived level of risk at that time. Only extremely liquidity-motivated sellers were able to accept this. Such sellers may not have received distributions, may be over-committed and in some cases highly leveraged. When the capital calls come in, they are faced with two choices: they can either default or sell. Greenpark is receiving calls from General Partners from across the industry who have Limited Partners interested in a secondaries sale and is expecting there to be an increased level of activity in the second half of the year.

A lot of the current deal flow includes commitments with a large proportion of unfunded - it may be deemed to be a secondary with as little as 20% funded. Most secondary firms, like Greenpark, would only be interested in funds that are 50, 60 or 70% drawn. However, it is expected that deal flow over the next 12 to 24 months should be extremely attractive. Dedicated secondaries teams have the expertise and rigour to transact effectively as opposed to firms approaching deals on an ad hoc basis, which has its risks. A lot of the market is relatively underserved and, with secondary transactions becoming an evermore accepted practice, there is still plenty of opportunity out there.

To read the full interview, please visit: http://altassets.com/private-equity-features/article/nz16196.html

Secondaries have come a long way from their humble beginnings in the 1980s, when they were largely perceived as a way of exiting illiquid positions in private equity funds. Two decades later, secondaries are a multibillion dollar market and an established portfolio management tool. Every type of private equity investor now uses them, and new products and investment strategies are evolving to meet the demands of a more sophisticated audience.

The market has been rising fast: the $10bn traded last year compares with a mere $6.7bn in 2005, and in 2007 it is expected to reach as much as $15bn. Of the wide range of factors fuelling this growth, the principal drivers are the growing range and type of deals traded and a significant increase in the seller base.

Though it’s hard to believe now, secondaries used to be perceived as somewhat exotic. But as sellers came to realise the benefits of secondaries as a portfolio management tool in the early 00s, the market began to really take off, leaping from $1.9bn in 2002 to $5bn in 2003. Using secondaries to re-up to existing funds or reallocate capital to other funds or asset classes is now the norm.

The dramatic increase in LP allocations to private equity as a whole testifies to the popularity of the asset class; and the liquidity offered by secondaries is helping to stimulate that appetite still further. As allocations have grown, some LPs have found themselves encumbered with portfolios that are too diverse or partly underperforming. Being able to select individual investments to sell to secondaries players has helped them rationalise their portfolios and make larger commitments to a smaller number of GPs; it has also added to secondaries deal volume.

In a survey by Almeida Capital in March 2007, 83% of LPs had bought, or intended to buy a secondary interest in a fund or portfolio of companies. Given that the vast majority of private equity investors are now also secondaries sellers, one might be forgiven for thinking the market is close to reaching saturation. But secondaries are increasingly attracting investment in their own right - as the amount of capital targeting secondary firms' funds in the last two years demonstrates.

Investors looking to commit larger sums to private equity are using secondary funds to supplement their primary fund commitments and augment their overall exposure. Strong investor demand enabled Greenpark Capital to close our third fund at €730m, well in excess of our €500m target, and secondaries operators have raised unprecedented sums in recent years. According to Private Equity Intelligence, $10bn was raised by 16 funds in 2006, with funds closing on average 28% over their original target. By mid-April 2007 six funds had already raised $10.5bn, and there were a further 10 funds seeking a total of $8bn. Commentators are predicting that $15-18bn will be raised this year.

As the market matures, the range of products being traded in the secondaries market is expanding. In addition to traditional secondaries transactions such as LP partnership interests in buyout and venture portfolios and auctioned assets, competition for assets and correspondingly punchy pricing is leading to more complex proprietary transactions and direct secondaries being done. We’re seeing newer products such as stapled primary-cum-secondary transactions, where a captive or semi-captive private equity investment team spins out of its parent company.

With increased liquidity, smaller deals are also now commonplace. Where previously sellers would look to exit whole portfolios, now they can exit individual investments with transaction values as low as $5m. Secondaries are no longer all-cash transactions, with structuring becoming a regular feature. With structuring, agreement is reached with the seller about the purchase price, with delayed payments, or with the seller retaining partial exposure to the portfolio. Structuring can also be buyer-driven, involving special purpose vehicles, leverage or vendor asset swaps. The use of leverage, in particular, is rising. The motto seems to be that whatever a seller’s liquidity requirements, there’s a secondaries solution that can meet them.

Over the last 18 months to two years competition for plain vanilla, larger and auctioned deals has been intense and as secondary prices have correspondingly risen significantly. Nearly all secondaries were sold at a discount two years ago, with venture deals at a high discount; today many bids are at par, with premiums paid for higher quality assets. Average premiums for larger auctioned assets were 9% in 2006, compared with discounts of 5-6% in 2005. In addition, leverage in some underlying assets is higher than a couple of years ago and therefore portfolio risk has risen.

Nevertheless in some areas there is far less competition, and these are likely to be the focus for specialist operators in the next couple of years. Smaller to mid-size, more complex deals, in Europe in particular (where auctions are less common) are still being sold at a discount, and that is Greenpark Capital’s specialist area.

The question on everyone’s lips is what impact the end of the cycle of cheap debt / record private equity transactions will have on secondaries. Naturally there are doom mongers predicting catastrophe on the grounds that people who are overpaying for assets now are likely to have to sell at a loss, as happened in the late 90s. With pricing, leverage and risk all rising, it does seem certain that, as in the primary market, average returns would be likely to fall.

But as in the primary market, top quartile funds may maintain more constant returns. Returns don’t automatically fall in line with downturns in economic cycles. They are expected to fall far less in the more customised part of the market, and average returns are still predicted to outperform other markets.

The extraordinary returns that secondaries have enjoyed in the last couple of years are unlikely to be sustained over the next few years – particularly for the larger, auctioned deals. But even these are still likely to be higher than public market or hedge fund returns, and that explains why LPs are still investing heavily in private equity. The outlook for the secondaries market is very positive, and Europe in particular should provide significant dealflow in the next few years.

Given the amount of primary private equity funds being raised, and strong demand from both GPs and LPs for liquidity, the secondaries market could well achieve predictions of $15bn this year. Of the pool of private equity capital raised in the last eight to ten years, with as little as 1-2% going to secondaries each year the market would reach $15bn – and that does not even include the portfolios of direct investments coming from corporate sellers.

In addition, as happened in 2001-2002 when large numbers of unfunded positions poured on to the market, any economic downturn is likely to simply increase the supply of assets coming on to the secondaries market and lower prices. Naturally there is a risk that a downturn could, after an initial uplift, lead to a contraction in the primary market that has a knock-on effect on secondaries, both in terms of the supply of assets and investor appetite for new funds. Secondaries might even struggle to invest the vast sums that have been raised in the last two to three years.

But this scenario is a long way off. With secondaries increasingly being viewed as interchangeable with primary investments, investors will continue to include secondaries among their private equity portfolio. The market has come of age.

The ‘credit crunch’ that many commentators are predicting is potentially one of the greatest threats to the private equity industry for many years. Private equity thrives on access to cheap debt, and so the assumption goes, if the supply of it contracts the industry will be left with a raft of highly geared and highly exposed investments, wondering how to make its model work. If the private equity market is put under pressure to achieve its double digit returns, will investors simply switch into better performing asset classes, and if so, will secondaries be the main beneficiaries?

The secondaries market is booming: from complex direct transactions to plain vanilla portfolio deals, every type of institution investor now trades in private equity secondaries. In addition, value-added strategies such as those with a structured element are providing specialist operators with an opportunity to make money. It is estimated that secondaries funds currently have around $20bn to invest, excluding capital available from private equity fund of funds and other pension fund allocations. If that is included, the total figure could be as much as $40bn.

Active portfolio management is driving volumes, allowing LPs to free up capital for redeployment elsewhere. But also, because competition for assets is so intense they can achieve strong premiums on non-core investments. Some quality LBO funds have been trading at a 30-40% premium, and double digit premiums are now commonplace for secondaries assets. As recently as two years ago, by comparison, discounting was standard.

Increasing demand for private equity means LPs that are new to the asset class and are looking to build portfolios and relationships with GPs relatively quickly are less reluctant to pay a significant premium for secondaries. Portfolios of partnership interests in buyout funds, pre-leverage, are currently being priced at IRRs in the low teens. At the same time, as sellers become less ‘distressed’ and more active, the solid but less exciting returns offered by mature secondaries are less appealing to buyers. Newer, less fully funded secondaries are commanding higher prices, partly due to sellers becoming more active earlier in the J-curve and looking to maximise returns.

The key factor driving the secondaries market, indeed with any market is a ready supply of buyers and sellers looking to do deals. After several years of economic growth across Europe and the US, there are signs that a slowdown, or even a full blown downturn are on their way. How will the secondaries market react, if and when that happens?

In the crisis of 2001, LPs under pressure began liquidating private equity positions at any price, discounting heavily in order to achieve a sale. But the market has changed dramatically since then, rising from $1.9bn in 2002 to an estimated $15bn in 2007. Private equity is now an established asset class for every type of institutional investor, and it is likely that LPs today would be much more reluctant to exit their investments. In addition, given that they have grown used to achieving strong premiums, selling at a discount might be a bitter pill to swallow. For sellers to start discounting heavily as happened in 2001, any economic downturn would need to be even more severe.

Already the difficulties being experienced in leveraged finance are making it prudent for secondaries to be even more cautious when pricing new investments. Investors need to incorporate views on the operational performance and exit scenarios for underlying companies, mindful of the volatility and uncertainty in the credit markets. The best way to do this is to have a clear view of the outlook for the capital markets, and apply it to each company individually.

If the credit crunch broadens to the wider economy, private equity firms could find themselves exposed to higher than expected risk and returns could start to fall. In addition, the reluctance of banks to lend at such heady multiples, coupled with the rising cost of borrowing could make it harder for GPs to do deals. That, in turn, could make the asset class less desirable. In that scenario we could see a number of LPs, not to mention GPs, wanting to sell their underperforming assets. But in a bear market, sellers might find it wiser to hold on to these investments rather than sell at a knock-down price. In addition, after the fundraising bonanza of recent years GPs are awash with cash – unlike in 2001.

Given the desirability of private equity and the wide range of investors it attracts, any fall in asset prices could potentially reignite the market. The use of secondaries as an active portfolio management tool might potentially take a back seat, causing volumes to dip, but as long as there are buyers and sellers in equal measure, prices will remain stable.