Accessing alternatives through the secondary market

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Financial graphs analysis © awrangler /123RF Stock PhotosCurrent economic factors like low bond yields, which make it quite difficult for pension plans to meet their long-term return requirements, are driving institutional investors to allocate more to alternatives, according to Jason Campbell, a principal at Eckler Ltd.

“Growth in alternatives has been steady and quite significant,” he said during a Canadian Investment Review webinar on May 2.

Other factors include the worries about taking on too much equity risk, especially after the shock of the financial crisis, as well as the potential to take advantage of the illiquidity premium, added Campbell. Apart from economic factors, the number of tools available to help pension plans implement alternative investments is also on the rise, he said.

In terms of how plans are currently implementing those allocations, larger plans are able to use direct investments more often, said Campbell. Smaller plans, meanwhile, don’t usually have the scale to allocate enough capital to these deals, so they go through open- or closed-end funds to get similar exposure, he said.

“An open-end fund is where an investor can buy into an existing pool of assets . . . and when you buy in you get a pro rata slice of all the existing holdings. That portfolio will provide instant diversification and instant yield. And we tend to think of those as ideal for more core, core-plus strategies.

“Moving out the risk spectrum a little bit, we tend to see closed-end funds more likely used for value-add or opportunistic strategies, which would include private equity. In this case, investors make a commitment to a new fund. The initial investments will be either zero or maybe a few initial investments made. But investors are generally committing to a blind pool and looking for the manager to build a portfolio.”

Notably, closed-end funds have very limited liquidity, added Campbell, which is a significant factor in why there’s rising interest in the secondaries market. He noted it’s best to look at secondaries as an addition to the portfolio rather than a replacement for alternative asset funds.

Campbell also highlighted the four main elements of secondaries’ appeal to investors:

  • Investors can diversify the vintages of their investments, meaning they’re able to buy existing stakes in funds they’d previously invested in.
  • Secondaries produce an attractive internal rate of return, often trading at a discount to their net asset value which boosts the return of the asset at the outset. However, this advantage is tempered by the fact that secondaries have lower multiples of capital since they’re bought later in the cycle of the investment, he added.
  • Secondaries have a reduced, or sometimes no, J-curve, which is the phenomenon where an investment can have negative returns early on, before gains begin to build. This is especially attractive to smaller, less experienced institutional investors, since they can enter a position after the negative returns have already elapsed. Further, investors jumping in later in the cycle will have fewer remaining fund commitments.
  • By buying a secondary, the investor reduces much of the blind pool risk, since often the better part of the fund’s underlying assets is known in a secondary transaction.

Another major factor is when investors look at an alternative asset class like private equity, liquidity or the lack thereof, said Paul Lanna, partner at Coller Capital, also speaking during the webinar.

With private equity, investors often have to commit to a fund for 10 years or more, he said. “The secondary market is the only way for individual [limited partners] to exit early from these commitments. It was created to satisfy demand for early liquidity so that investors can proactively manage their portfolios.”

While the volume of assets trading in the secondary market is steadily increasing, having reached more than US$70 billion in 2018, it remains vastly outstripped by the activity in the primary fund market. Still in its early stages, the secondary market should increase significantly down the line, said Lanna.

Among secondary market transactions, LP secondaries are the simplest, he noted. “This is where an investor looks to sell their limited partner interest in an existing private equity fund. . . . This could be a position in a single fund or it could be a portfolio of hundreds of funds.”

It’s not unusual, he added. to see transactions that exceed a $1 billion of value in one single trade.

“It’s a simple transaction. The buyer pays the seller a price to acquire their position in the fund and the buyer simply steps in the shoes of the seller and becomes a limited partner of the fund. The general partner is generally not involved in the transaction until the point at which they need to agree to allow the transfer to occur.”

Direct secondary transactions are a little different, said Lanna, noting they involve directly selling assets — usually a portfolio of assets — from one investor to another. “An example would be a bank selling a portfolio of a dozen companies. Typically both sellers in these transactions are financial institutions or corporations, potentially a family office. These are more akin to [merger and acquisition] transactions — they’re larger, they’re more complicated. And most of the time the secondary fund that is acquiring the assets will ultimately wrap the assets in a fund-like structure and hire a manager to look after them.”

General partner-led secondaries are also on the rise, said Lanna. “[They] can take the form of LP transfers or asset transfers, but the key differentiator here is that it’s the general partner of the fund that’s initiating the transaction.”

Moving from $13 billion to $24 billion between 2017 and 2018, general partner-led secondaries now make up about a third of the overall secondaries market, he added.

Overall, secondary transactions increase the liquidity potential of the private market, which is appealing to institutional investors as they continue to gravitate towards alternatives, said Lanna, noting the financial crisis highlighted the need for liquidity in a major way. “What you saw there was a need for liquidity from lots of institutions and also you saw new regulations coming to market, which necessitated the selling of certain assets.”

Most recently, the Asian and Latin American secondary markets have been maturing, which is spiking interest in those regions. “As you would expect, the more developed market for [private equity], North America and Europe are where we see most of the volume, but we are seeing volume increase from other geographies.”

Currently, both public and private pension funds are the largest segment of sellers in the secondaries market, while financial institutions, endowments and family offices are all major players as well, said Lanna, noting more than half of transactions are still simple limited partnership deals.

As far as pricing is concerned, buyout deals trade closest to the net asset value of the underlying assets, at an average of 97 per cent in 2018, followed by real estate at 89 per cent and venture capital at 83 per cent, he said. “This really reflects investors’ views on the underlying companies, the stage of those companies, the risk and where the market is going.”

In addition to the natural correlation with the overall growth in the alternatives market, there are several other market drivers relating to asset owners’ need to sell.

“First and foremost, we’re simply seeing more LPs actively managing their portfolios, so trading in and out of certain [funds] in order to improve the return profile of their portfolio,” said Lanna. “We’re also seeing LPs actively reshape their portfolios, so focusing more capital on their core managers, selling their non-core managers, typically managers they’re not re-upping in.”

As well, some investors have held certain assets for many years, having invested pre-crisis, and want to extract their capital because they feel it could be of better use elsewhere, he added.

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