By James Williams – Private equity has never been synonymous with the word liquidity when it comes to investing in alternative assets, but a new report by SEI’s Investment Manager Services division suggests that this may be changing.
The report, entitled “Private Equity Liquidity – A Work in Progress”, finds that nearly half of general partners (47 per cent) and a third of limited partners (36 per cent) and consultants (33 per cent) agreed that the private equity market was “more liquid than it used to be”. For reference, SEI surveyed 212 private equity professionals during November 2014 to canvass their opinion on the evolution of private equity liquidity. Half of the responses came from GPs and fund managers, whilst a third came from LPs or investors.
This trend of institutional investors seeking greater liquidity provisions is symptomatic of the wider alternatives industry where, in recent years, there has been a concerted drive towards negotiating improved liquidity provisions and more transparent reporting; particularly in respect to hedge funds as institutions build bespoke mandates. Moreover, the desire for liquidity has led to the growth of the liquid alternatives marketplace.
The figures above are an early indication that those same needs are starting to filter in to private equity. According to the SEI report, this liquidity injection is occurring in three ways: the growth of the secondary market, the listed private equity market, and retail funds. Combined, they are helping to ease the liquidity constraints that have long been the preserve of public equity.
Of particular import seems to be a burgeoning secondary market, which is providing investors with the opportunity to sell assets without fear of taboo given that this activity was, historically speaking, often associated with the forced selling of toxic assets at heavy discounts.
That perception is now changing as the secondary market shifts from a niche to a mainstream activity. According to SEI, 58 per cent of investors either bought or sold assets on the secondary market. In addition, 38 per cent said they planned to buy secondary assets in 2015.
As Giles Travers (pictured), Director, Alternative Investment Funds at SEI Investment Manager Services in London comments, the secondary market has been the most mature vehicle for PE liquidity. Total global transactions in 2014 reached record levels of USD42 billion and according to Preqin, 2015 could see another all-time high being achieved.
“Private equity has traditionally required ‘patient’ capital from investors; LPs willing to commit long-term funding due to the time required by GPs to find, manage and realise superior returns in illiquid assets. However, as the industry has evolved, so has liquidity in the form of a growing secondary market and a variety of investment options in private equity whether it be listed private equity or private equity’s experiments in the retail market,” says Travers.
From an LP buyer’s perspective, the secondary market provides another avenue to access private equity returns with the potential to avoid the fees and costs associated of being a day one LP. From a seller’s perspective, many investors are rebalancing their private equity portfolios from a risk and regulatory requirement and the taboo of leaving early is no longer viewed as major breakdown in the relationship between investor and manager according to Travers, who adds: “On the GP side, private equity managers are becoming increasingly diversified asset managers, encompassing strategies such as credit, distressed, and infrastructure and even other asset classes including hedge. Developing a wider array of investment structures and liquidity options for their investors enables GPs to provide a more flexible investment platform for their LPs. As the duration of private equity funds has also increased post-crisis, the secondary market has enabled GPs to hold portfolio companies longer and find further funding with the aim of securing more fortuitous exits.”
Whilst the rising levels of dry powder – capital committed to PE funds but yet to be invested – are expected to keep demand for secondaries strong, Christopher Elvin, Head of Private Equity Products at Preqin told Hedgeweek recently that the ability to find attractive investment opportunities is set to be challenging, which managers fear could negatively impact on performance. Fifty-four percent of those surveyed by Preqin felt that the level of competition for PE transactions had increased year-on-year.
In SEI’s report, they write that the supply side of the secondary market is healthy “in part because regulatory changes are compelling banks and other financial institutions to divest some holdings”.
Higher valuations are driving demand
Fund-of-funds are particularly attracted to the PE secondary market with 80 per cent surveyed by SEI confirming that they use it to find assets.
The recent growth, says Travers, has been helped by self-confirming success – as deal flow has increased, prices have risen, “encouraging buyers and sellers alike to consider the secondary market as an attractive market”. The recent surge is also underpinned by the eagerness of LPs to invest in private equity in the search for yield.
Whilst the hunt for returns is not surprising, Travers says that it is interesting to note that many LPs still decide to do this directly rather than through investing in a secondary fund.
“In our SEI survey, as well as other market research, direct and intermediary advised purchases are the preferred route to market. The opportunity for secondary managers is attracting LPs to their funds on the basis that enhanced returns are more likely with a specialised manager with the requisite analytical talent and resource,” confirms Travers.
Indeed, 89 per cent of investors said they planned to invest in secondaries by purchasing assets directly from brokers or sellers. This figure drops to 73 per cent when it comes to selling assets to brokers or buyers.
Without doubt, the secondary market is far less taboo than it once was. Some 52 per cent of GPs and 49 per cent of LPs surveyed said that they felt there was no longer a taboo selling assets on the secondary market, whilst 41 per cent and 48 per cent respectively felt there was “a little”.
This is now a viable market for alternative asset portfolios. Industry veterans such as Coller Capital, HarbourVest Partners and Pantheon have long extolled the virtues of the asset class.
“One of the key indicators of the maturity of the secondary market has been the diversification in transaction types: whether they be traditional fund transactions (portfolio and single interests), direct secondaries, GP restructurings, tail-end fund purchases or spin-outs. Emerging secondary managers such as 17 Capital have also developed financing models for LPs to unlock liquidity whilst still returning future upside,” explains Travers.
In fact, London-based 17 Capital successfully closed its third fund at the start of 2015 with commitments of EUR500 million. This exceeded the target fund size of EUR450 million and to underscore the level of investor demand, the fund closed just months after launching last summer.
One of the key considerations for anyone looking to acquire assets on the secondary market is determining how accurate the valuations are. The overwhelming majority (> 80 per cent) of GPs and LPs surveyed by SEI said that they considered the valuation process to be “mixed”, with one in 10 LPs responding that they were “frustratingly opaque”. So whilst valuations appear to be rising, investors have to be careful that the assets they are acquiring reflect fair value; i.e. that they aren’t undervalued or overvalued at the time of purchase, which will obviously have an impact on future returns.
For secondary managers, generating good returns is more than just identifying attractively priced assets that have the potential for upside. As Partners Group wrote in a paper entitled “Private equity secondaries: Key components of value creation”, an effective secondary investment strategy relies upon the following skills:
• A targeted, global sourcing effort;
• Persistence in investment development and flexibility in structuring;
• Enhanced due diligence capabilities;
• Deep knowledge of underlying investments and investment partners and:
• Strong closing and execution capabilities
Travers notes that secondary managers face pressure to validate and aggregate reporting data on underlying fund positions and repackage this into customised reporting for their investors. When asked how SEI’s technology capabilities help position the firm to support these managers in light of the growth expansion taking place, Travers responds:
“Our experience with both direct and fund-of-funds private equity helped the development of the SEI Manager and Investor Dashboards – secure, web based reporting portals for LPs and GPs underpinned by data warehousing and automated workflow. We’ve seen this technology leveraged by secondary managers to provide a more efficient operating model to support their investment decisions.”
When asked what the key takeaway of the report is, Travers says: “As the private equity industry matures, the liquidity needs and demands of LPs will continue to drive the profound transformation that is already underway. As new fund structures emerge, GPs need to equip themselves with the expertise and operational competitiveness to offer investors something they might not have dreamed possible just a short time ago: meaningful private equity exposure with a high degree of liquidity.””
To read SEI’s report in full, please click here
