Topics of Interest

TOPICS OF INTEREST The Private Equity Secondary Market: Its Characteristics and Role in a Private Equity Portfolio By Peter Wilamoski, Ph.D. Director of Capital Markets Research JANUARY 2013 Introduction At a time when private equity general partners struggle to raise new funds, and buyout and venture capital deals have failed to recover from their 2009 peaks, the secondary market for private equity continues to grow as investors have been drawn to a range of claims about the merits of investing in portfolios purchased on the secondary market.i With less than $5 billion in completed transactions in 2002, it is expected that 2012 will close with nearly $30 billion of secondary transactions. As described by proponents, it appears investing in private equity via the secondary market is a “sure‐ thing”, offering something for everyone. General partners raising funds point to the discounts to NAV (net asset value) that secondary portfolios have sold for recently as well as suggesting that they (1) return capital more quickly; (2) can avoid the J‐curve effect faced by traditional private equity investments; and (3) avoid the “blind pool” risk associated with primary funds by evaluating assets further along into their investment periods. Proponents suggest these characteristics can help secondary funds produce superior IRRs compared to direct and primary funds, and under some circumstances, superior return multiples. Before uncritically accepting the case for, and investing in secondary private equity portfolios, investors should recall earlier “investments of the day” such as portable alpha and 130/30 strategies. On paper they could no wrong, but in practice failed to fully deliver on their rosy promises. This review examines why investing in secondary funds might be attractive to limited partners and ask under what circumstances the strategy is likely to live up to its promises.ii We are left to conclude that secondary portfolios can reduce the risk of investing in private equity, but that superior returns most likely require a market imbalance that favors buyers, a condition that is likely to exist for some time, but is not assured. Evolution of a Market The secondary market for private equity positions has grown more than ten‐fold in the last ten years, with much of that growth occurring after 2009 as “distressed” private equity investors found themselves Page 1 over allocated and in need of liquidity. General partners responded by raising tens of billions of dollars over the last few years to meet the increased supply (Figure 1). As of 2012, the volume of completed transactions continues to exceed new fund raising, but estimates put capital available to purchase secondary positions (dry powder) at $35 billion with secondary funds on the market attempting to raise approximately $20 billion over the next year.iii Prospective investors should question whether the increase in private equity portfolios being offered for sale on the secondary market is permanent or temporary. If temporary, it is possible that new fund raising could exceed supply, pushing secondary prices up and hurting returns. So is the increase in supply temporary or permanent? Historically about 3% of private equity investments are offered for sale in the secondary market each year. With primary capital committed to private equity growing from less than $100 billion a year in 2002 to over $400 billion by 2007‐08, an increase in secondary offerings was to be expected (private equity portfolios tend to be offered for sale in the secondary market 3‐to‐5 years after commitments are made). But after 2008, private equity commitments dropped off sharply and have yet to recover (Figure 2), suggesting the future supply of offerings in the secondary market could do the same. The increase in the supply of offerings in the secondary market could also reflect an increased willingness by investors to sell their holdings. There are many reasons as to why investors may choose to offer positions in the secondary market including a desire to (1) actively manage their portfolio; (2) reduce unfunded commitments; (3) lock‐in accrued gains; (4) maintain a portfolio’s diversification by various exposures, including manager and vintage year; and (5) to divest from non‐core assets and managers in order to refocus on core manager relationships. One reason to believe that the turn‐over rate of private equity commitments could be permanently higher is the recent dynamics of private equity. The slower return of capital, poor manager performance and impending capital calls have forced investors to make greater use of the secondary market as a tool for actively managing their private equity portfolio. As an example, in 2008, when public equity markets lost significant value, many investors found their portfolios over allocated to private equity; with liquidity highly valued, many investors chose to rebalance their portfolio by selling off some of the private equity commitments. And once investors learn how to use the secondary market to manage their overall private equity portfolio, the evidence suggests they will become repeat sellers.iv Figure 1 Figure 2 Secondary Capital Raised versus Primary Capital Committed to Private Equity Secondary Transaction Volume (billions of dollars) 40 500 30 400 20 300 10 200 0 100 0 Capital Raised Secondary Transaction Volume Committed Capital Source: Cogent Partners Source: Cogent Partners Page 2 Others believe that the increased rate at which investors are selling their private equity portfolio in the secondary market is only a temporary phenomenon ‐ the result of new regulatory pressures forcing many private equity investors to reduce their overall commitment to the asset class as a means to meet higher capital requirements. Most notable among these regulatory pressures are the Volcker Rule, Basel III and Solvency IIv which will force banks and insurance companies to reduce their balance sheet exposure to illiquid assets such as private equity. Once financial institutions have reduced their private equity portfolios to meet new regulations, the rate at which they turnover their private equity holdings in the secondary market should return to normal levels, signaling a decrease in supply. Who is selling in the secondary market, and why? It appears that the market continues to be driven by sales from public pensions (primarily North American) and by financial institutions (primarily European); they made up 64% of the $13 billion in transaction volume in the first half of in 2012 (Figure 3). Sales by pension funds appear to reflect a desire to reduce private equity exposure and to invest with a smaller group of managers, while sales by financial institutions reflect a response to regulatory requirements. So what does the evidence tell us about the changing supply and demand dynamics of the secondary market and what it means for pricing and prospective returns to investors in secondary portfolios? Demand for secondary portfolios, as measured by the amount of capital being raised by new funds is clearly rising, but the direction of new supply, however, is unclear. First, the original source of secondary supply, commitments to private equity funds have failed to recover to pre‐2008 levels. And second, increased turnover of portfolios is likely to decrease once portfolios are rebalanced and meet new regulatory requirements. As demonstrated in Figure 1, the supply‐demand dynamic has favored buyers of secondary portfolios the last several years. While this trend should continue for another several years, it is not clear what the supply demand dynamic will look like five or more years from now. Figure 3A Figure 3B Secondary Seller Universe 2012 Reasons for Selling 2% 1% 2% 5% Financial 5% Portfolio 8% Institutions Rebalancing Public Pension Regulatory 33% 11% 18% Other Admin. Clean‐up Corporate Pension Existing Asset 12% Class Asset Manager Loan Repayment 72% Other Family Office 31% Source: Cogent Partners The Appeal of Secondary Portfolios to Investors The recent appeal of private equity secondary markets can be largely attributed to the 2008 financial crisis where many owners of private equity portfolios were forced to sell off their investments at Page 3 distressed prices. Investors with dry powder happily stepped in to buy these assets at sizable discounts to NAV. But as the history of private equity secondary pricing reveals (Figure 4), transactions are not Figure 4 Secondary Pricing ( Percent Discount to NAV) 20% 8% 10% 4% 0% ‐10% ‐6% ‐20% ‐14% ‐15% ‐16% ‐15% ‐30% ‐20% ‐19% ‐28% ‐40% ‐50% ‐39% ‐60% ‐70% ‐60% Source: Cogent Partners always completed at sharp discounts to NAV. If prices are not cheap, why might investors seek to own private equity acquired on the secondary market? Managers seeking to raise funds have laid out a number of reasons for owning a secondary portfolio rather than a direct or primary portfolio including (1) the faster return of capital; (2) mitigation of the J‐curve effect faced by traditional private equity investments; and (3) avoidance of “blind pool” risk. Managers suggest that these characteristics of lower the risk/return profile of owning private equity and can help secondary funds produce superior IRRs compared to direct and primary funds. Figure 5 compares the characteristics of private equity secondary portfolios to primary funds. Figure 5 Private Equity Characteristics: Primary Funds versus Secondary Funds Factors Primary Funds Secondary Investments Strategy Exposure to fund manager(s) that have Portfolio of mature fund

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