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PE secondaries could reach USD100 billion, says Commonfund Capital’s Cari Lodge

Are LPs looking to move tactically out of certain PE investments to free up liquidity ahead of concerns over a market slowdown? And if so, is this creating a good opportunity for Secondary investors to pick up LP interests at a healthy discount?

Both General Partners and Limited Partners in private equity funds increasingly see the merits to using the secondaries market, which continues to deepen and provide various liquidity solutions. Last year, market volume grew to USD79.7 billion and is “on track to reach USD100 billion this year”, according to Cari Lodge (pictured), Head of Secondaries at Commonfund Capital. 

Commonfund Capital recently announced the closing of its second secondaries fund with USD450 million of capital commitments, more than doubling the USD170 million committed to the firm’s inaugural secondaries fund in 2016. 

“The first quarter this year was slower than Q1 2018 because there was a lot of volatility in the public markets and that delayed deal flow into the summer,” says Lodge. “But we are seeing consistent secondary deal flow since then and there’s really been no slowdown.” 

Indeed, a H1 2019 Volume Report published by Setter Capital shows that while total secondary market volume for the first half of the year was USD46.0 billion, private equity secondaries accounted for the majority of flow, accounting for USD42.10 billion (both funds and directs). 

Gerald Cooper is Global Co-Head of Secondary Advisory at Campbell Lutyens. He notes that most buyers they’ve spoken to “are ahead of their capital deployment pace for 2019”, therefore volatility earlier in the year doesn’t seem to have had an impact on the market. “However, given the buying activity was so robust in the first half of the year it’s unclear how robust demand will be in Q4,” says Cooper.

Ultimately, the secondary market is both a solutions provider and a liquidity provider for both LPs and GPs.

“The stigma that existed 20 years ago has largely gone away,” adds Lodge. “It’s not a reflection of the fund manager’s performance, but rather a reflection of an individual LP’s needs. GPs are seeing more ways to utilise the secondary market. For example, we are seeing more asset sales, where a manager might sell a group of five assets as part of a strip sale in the fund.”

As PE investors become more sophisticated, they are increasingly embracing portfolio management, shifting out of certain funds in their portfolios on a tactical basis, as they seek to optimise returns at a time when asset valuations remain robust. 

This is fuelling strong supply/demand and giving secondary fund investors a wider array of investments to consider. 

Portfolio management fuels supply

To some extent, rising global macro tensions and fears over economic burnout are influencing investors’ decision making, leading to continued selling activity, but this is not to suggest buying activity is drying up. Although buyers are getting a bit more defensive and increasing their return hurdles, and thinking more about which sectors to invest in.

“My view on how the macro environment has manifested itself in the secondaries market is two-fold,” says Cooper.

“From a buyer’s perspective, they continue to deploy capital, there’s been no pullback. In general, most buyers we’ve spoken to are ahead of their capital deployment pace for 2019. 

“From a seller’s perspective, the rationale continues to be largely related to portfolio management requirements. It’s really about selling non-core assets, perhaps taking some risk off the table and crystallising returns in case things do take a turn for the worse. Everyone acknowledges that valuations are quite high right now, so taking advantage of that and selling opportunistically is a strategy that many groups are seeking to execute on.” 

Private equity fund purchases totalCmed USD25.51 billion through June 2019. 

In Cooper’s view, higher quality funds are representing a greater portion of deal volume. He notes that GPs have been returning to the fundraising market more quickly than expected, forcing LPs to trim 2012-2014 vintage exposure in order to make room for new commitments. 

This active portfolio management has also resulted in more brand name GP fund interests being offered up for sale.

“We’ve done transactions that were GP-led as well as LP-led,” comments Lodge. “We are seeing more opportunities for different types of deal flow and the ability to put together a really unique portfolio of high quality secondaries, from younger through to older assets.” 

Lodge confirms that a lot of the deal flow is down to portfolio management considerations, but says more GPs are focused on gaining liquidity for their investors. The secondaries market is allowing LPs in older vintages, to reinvest their capital in new funds, either with the same manager or elsewhere. Forced selling is no longer the primary driver of supply.

“I don’t think of the secondaries market as much of a distressed market. One quarter of the market is secondary funds and FoFs winding down their portfolios; it’s a natural occurrence. Funds get too old and they need to be wound down,” states Lodge.

She states that Commonfund Capital buys secondaries across the board: small buyout funds through to mid-market and large buyout funds, VC funds, growth equity funds, emerging market funds, natural resources funds etc.  

Single asset GP-led transactions

One key trend that Cooper expects to develop over the coming years is single asset GP-led transactions in the secondaries market, which move one or several assets out of an older fund into a new or affiliated vehicle, offering an attractive opportunity for LPs who want to exit in the current macro environment.

“I think single asset sales are going to be a permanent feature in the secondary market,” suggests Cooper. “In an environment where it’s difficult to find good deals, GPs are going to want to hold on to good assets for longer. As long as you can demonstrate that there’s upside in the asset, and has the potential to generate a good return over the next three to five years, why sell it and give that upside to someone else?”

GP-led transactions account for around one third of deals and Lodge thinks this will continue to grow. As GPs look for liquidity solutions for their LPs, she says, LPs will become more familiar with the processes, and more brokers will enter the market and make it more efficient for GPs.

As the secondaries market evolves over the coming years, one additional feature could be that more LP-led transactions contain co-investments. 

This has been a huge focus for institutional investors as they look to partner up more closely with managers and in the primary market, the extent to which a GP can offer co-investment opportunities is playing a key part of their investment decision making. 

Any hint of recession, however, might impel investors to move out of certain co-investments if they feel valuations will be badly impacted.

“If we were to go into a downturn, or we have denominator effect where public to private market ratios are disrupted, it is logical to think that co-investment activity in the secondary market would likely rise. 

“I think any portfolio sales we see coming from LPs over the next four to five years are likely going to have meaningful exposure to co-investment interests, alongside the fund interests being sold,” concludes Cooper. 

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