There are some confusing messages out there about private markets’ secondary prices that are worth distilling to identify latent signals of opportunity and risk.
It is recent news that a family office and private equity investment platform has pulled back on a large secondary sale[1] reportedly due to unsatisfactory bids.
Overall though, the secondary market is described as being a very seller-favorable environment:
“showing record-high pricing and transaction volume” “with public equity gains, buy-side demand, and readily-available financing options pushing secondary prices up across the board”[2].
The same report describes sellers as opportunistically divesting non-core assets and buyers as highly selective about where “they are choosing to bid most aggressively”.
Prices are kept up by leverage (now cheaply available from banks) making it possible for secondary buyers to put the increasing amount of capital available at work and seek a return boost[3]:
- “by delaying the request for cash from backers, secondary investors can improve their internal rate of return, a performance gauge that factors into account how long a firm takes to return money”.
Leveraging up to 40% of the purchase price is considered “perfectly reasonable”, when applied to holdings that are diversified, generating cash and include companies that have themselves reduced their borrowing:
- “if an investor buys a portfolio of leveraged-buyout funds at face value, using debt to fund about 40 percent of the purchase price, the return could be more than 1.6 times the original investment, compared with 1.3 without”.
All this holds true if the loans’ interest rates do not go up to strain the financial structure and if business and market conditions do not deteriorate and impact negatively the performance of portfolio companies.
As acquisition and leveraging of secondary stakes are medium (to long) term decisions, market consensus seems to be anticipating that:
- current high valuations at portfolio level will stay high, and
- debt service and valuation will not be an issue.
Investors are expected to keep on investing (also reinvesting the huge distributions received in 2014) in the secondary market based on the assumption that “buying in the secondary market can turn a risk factor – today’s exceptionally high purchase prices – into a return enhancer. Those prices, and investor eagerness to pay them, mean an exit market where assets already held for several years by private equity funds are sold quickly and at levels that are frequently above carrying values”.[4]
- The thinking implicitly relies on the logic that the faster turnover of capital of secondary transactions smooths J-Curve effects and increases IRR;
- It also assumes NAV valuations to be conservative and M&A conditions to continue to be favorable.
The M&A valuations are reported to be steady with larger deals becoming more expensive in EBITDA terms. Median debt level for PE transactions hovers around 60%[5].
Interestingly, a prominent secondary investor is said “warning” his backers that the secondary market is becoming increasingly competitive[6], signaling that high prices of second-hand private equity interests (so sellers-favorable conditions) may reduce returns for secondary investors.
What these messages boil down to is that there is a disconnect in the definition of high prices between sellers (not seeking liquidity at all costs but trading based on opportunity), buyers and intermediaries:
- It’s a sellers’ market at buyers’ prices, which implies that there is plenty of liquidity for liquidity seekers willing to accept the bids made by the buyers.
- The highest of the bids received by the sellers may not be the highest of the bids possibly made by the buyers also because of the way auction processes usually work in the secondary market – allowing competitive bidding only during the non-binding offers phase.
- The risk-adjusted attractiveness of investing in secondary funds is challenged by their success. Increasing amounts are being raised and need to be deployed in a more competitive context and with a riskier financial structure.
If pricing is driven by these pro-cyclical, rear-mirror views, both buyers and sellers risk allocating resources inefficiently, in particular in the current period characterized by high equity valuation, low interest rates but significant uncertainty.
Without more transparent relative valuation pricing mechanisms, sellers could end up sticking to assets they wanted to dispose of; secondary asset buyers could aggressively factor in adverse selection biases to drive down prices at the risk of not closing deals and leaving funds undrawn or could be outbidding competition and have to leverage up not to dilute returns.
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[1] http://www.pehub.com/2014/09/bregal-pulls-back-on-400-mln-secondary-sale/.
[2] Cogent Partners’ semi-annual secondary market pricing study – first half 2014.
[3] http://www.bloomberg.com/news/2014-09-09/top-lbo-fund-investors-pile-on-leverage-to-boost-returns.html.
[4] http://www.forbes.com/sites/antoinedrean/2014/06/20/as-investors-grapple-with-growing-cash-piles-private-equitys-secondary-market-booms/
[5] http://pitchbook.com/3Q_2014.html
[6] http://www.efinancialnews.com/story/2014-08-18/jeremy-coller-warns-of-increasing-private-equity-secondaries-competition?mod=rss-home
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