Private Equity Secondaries: The Opportunity Set October 2013

Transcription

1 THE ART OF SERIOUS INVESTING LVW Advisors is an independent Registered Investment Advisor based in Rochester (Pittsford), New York. Our team of experienced financial advisors provides customized investment management solutions and comprehensive wealth management plans for institutional investors, individuals and family offices. For more information, call us at or visit Private Equity Secondaries: The Opportunity Set October 2013 The secondary market for private equity interests has become a hot topic in recent years. An increasingly tight regulatory environment has forced certain banks and financial institutions to reduce their stakes in private equity firms, boosting supply in the secondary market and creating investment opportunities for institutions and high net worth individuals. That environment has sparked greater interest in secondary market transactions. LVW Advisors conducted a careful examination of this market, focusing on the opportunities, the risks and the potential role secondary private equity holdings can play in a sophisticated investor s portfolio. We concluded that the potential benefits offered by this market make it well worth investors consideration. The Opportunity The secondary market provides direct private equity investors with a mechanism to sell their stakes. Buyers typically purchase both an existing investment in the fund as well as any unfunded commitments. Our research finds that buying on the secondary market is far more appealing than selling into it. Primary private equity investments typically lock up investor capital for up to 10 years. Primary investors in certain situations may need to liquidate the positions, and may accept steep discounts in exchange for liquidity. Lori Van Dusen, CIMA Principal lvandusen@lvwadvisors.com Richard H. Van Kuren, CFA Senior Partner rvankuren@lvwadvisors.com Jeffrey R. Wagner Partner jwagner@lvwadvisors.com Thomas H. Hawks III Relationship Manager thawks@lvwadvisors.com Patrick G. Knapp Research Associate pknapp@lvwadvisors.com LVW Advisors, LLC 67 Monroe Ave. Pittsford, NY This opportunity for investors in the secondary market is particularly noteworthy in the current climate. The regulatory environment in the U.S. and Europe may continue to spark a wave of forced selling in the private

2 equity market. As a result, the secondary market is likely to reward investors who can opportunistically provide liquidity. Inefficiencies in the secondary market also can create opportunities for alert buyers. There is no centralized exchange for these assets, and information about a fund s underlying assets tends to be limited. Funds generally disclose little detail about their underlying investments company level details such as profitability, growth and capital structure can be closely guarded by the fund s general partners (GPs) creating an information gap that sophisticated and well connected investors may be able to exploit. These inefficiencies, along with sellers need for liquidity, can cause transactions to be priced at a considerable discount to fair value. The chart below illustrates that bid spreads on secondary transactions can vary widely. The secondary market offers certain advantages over the primary market. Some of those advantages are specific to the current environment: Large volumes of capital have funneled into private equity, resulting in unattractive primary market valuations calling into question whether private equity funds can deliver the returns necessary to compensate investors for the investments illiquidity. Other advantages of the secondary market are more structural. Investors without the size, capacity or other resources to build a primary private equity program may be able to gain private equity exposure more easily with secondary market positions. The secondary market also provides investors with an opportunity to enter a private equity fund later in its lifespan, resulting in a shorter lock up period and therefore greater liquidity than is provided by primary investments. Entering a fund after its first few years may be attractive from a return perspective as well. The private equity asset class is subject to delayed return on invested capital, commonly

3 referred to as the J curve. Investing at a later stage of the private equity life cycle enables secondary interests to leapfrog the early growth stage and to realize return on their investments sooner. Investing later in a fund s lifespan also can provide greater visibility into the portfolio than is possible for a primary investor. A savvy secondary investor has the opportunity to gather more information about the fund s investments, reducing the blind pool risk associated with primary investing. During the secondary market s relatively short history these characteristics have helped secondary funds generate risk adjusted returns superior to other forms of private equity. Moreover, investments in the secondary market create an opportunity to increase and further diversify private equity exposure. We believe these characteristics are likely to continue, making this an attractive long term market for sophisticated investors.

4 These conditions have been present for a number of years, and have helped the market for secondary interests grow from around $500 million a year in 1994 to $25 billion in Recent regulatory reforms from the Volcker Rule to BASEL III have led many banks and insurance companies to discontinue private equity investing, resulting in more meaningful opportunities for buyers in the secondary market. Fund Selection When choosing investments in the secondary markets we consider several factors, including the following: Deal size. Larger investment interests in the secondary market those worth roughly $50 million or more typically become part of an organized auction process that can attract more investors, resulting in greater efficiency. We prefer to focus on the smaller end of the secondary market, which tends to be less efficient and therefore presents greater opportunity. Between 2004 and 2012 the size of the average secondary fund tripled from $391 million to nearly $1.4 billion. As of 2012, secondary funds with commitments of $1 billion or greater represented 90.2% of the secondary market, as measured by capital. But the volume figures tell a different story: Approximately half of all transactions completed in the secondary market are for less than $20 million. Larger funds generally ignore these small transactions, leaving nearly 10% of the investment in the secondary market chasing roughly 50% of deal flow. In short, focusing on the smaller end of the secondary market offers a much less crowded field where there is less competition and better pricing leverage. Investment focus. Secondary funds traditionally have focused on straightforward purchases of discounted assets. These days the deal flow in this market has become broad enough to allow for a more sophisticated approach to portfolio construction.

5 For example, a fund may try to diversify its risk/return profile by targeting an allocation to transactions that provide exposure to mature venture or emerging market funds, secondary direct transactions, spinouts of captive private equity programs, fund recapitalizations and other privately negotiated transactions with similar characteristics to secondary investments. Such transactions typically are complex; we believe that an experienced team with the right skill set can use this complexity to their advantage. Management. Management is another key factor in the selection process. Investment managers must have the experience and industry connections to be in a position to capitalize on the inefficiencies in the secondary market and to source attractively valued investments with strong growth characteristics. Managers also must be well equipped to underwrite the assets in the portfolio. They need access to key information about underlying holdings, and the expertise and analytical resources to evaluate that information. For these reasons, the firms we recommend must possess the following characteristics: 1. Long tenures and a deep networks to source attractive opportunities; 2. Relatively small portfolios (under $1 billion), which typically offer access to more attractively priced opportunities; 3. Global reach to source opportunities across geographies and asset types, and to create diversified portfolios with multiple drivers of return; 4. Primary businesses that can assist in the underwriting process; 5. Deep analyst teams that can effectively underwrite assets to gauge both the discount to purchase price and the potential for asset growth. Considerations The secondary private equity market offers attractive opportunities, but also carries considerable risks. The success or failure of a private equity investment depends on the performance of its underlying assets. As such, managers must provide thorough due diligence on the businesses underlying the position. Failure to perform sufficient underwriting of those assets can lead to weak returns. A deep management team with the resources to properly underwrite interests in the secondary market is critical to avoid this risk. Investors also must consider liquidity. The secondary private equity market is much less liquid than the public equity market, and as a result investors may not be able to sell their interests when they wish. This risk was especially prominent in 2008 and 2009, when the global financial crisis caused liquidity in the secondary market to dry up. Sector diversification can help to mitigate liquidity risk by reducing the likelihood that problems in a particular part of the economy could undermine liquidity in a portfolio. Investors also can manage the liquidity of their secondary market investments by diversifying by investment timeframe (vintage year). While these strategies can help manage liquidity risk, investors should enter secondary private equity positions with the expectation that they will not exit until realizations occur within the portfolio. Costs are another important consideration: Annual fees can range from 1% to 1.5% of assets, and often decrease over time as managers become less active in sourcing investments and committing capital.

6 Finally, investors must determine strategies for incorporating secondary market investments into their overall investment strategy. These investments typically fill a growth oriented role for investors, and should deliver returns in excess of publicly available equity options. Due to these investments exposure to illiquidity and other risks, we believe investors establishing positions in secondary private equity interests should maintain relatively modest allocations. Investors also should be prepared to re evaluate forward commitment levels on a regular basis, to account for the fact that secondaries exhibit less cyclicality and return capital sooner than most private investment opportunities. Careful consideration of the benefits and risks presented by the secondary private equity market leads us to conclude that institutional and high net worth investors should consider allocating a portion of their portfolios to this asset class. We believe that the secondary market presents opportunities for experienced management teams to capitalize on sellers need for liquidity and market inefficiencies, and for investors to diversify and otherwise enhance their private equity exposure. To learn how LVW Advisors can help you achieve your highest investment objectives, please call or Laurie Sheller at or lsheller@lvwadvisors.com to request a consultation with one of our advisors. Disclosure: Not FDIC insured No Bank Guarantee May Lose Value. For LVW Advisors Clients only. Past Performance Of These Funds Is No Guarantee Of Future Performance. The graphs and tables making up this report have been based on unaudited, third party data and performance information provided to us by one or more commercial databases and, in some cases, by the fund managers directly. Performance figures may be estimates. While we believe this information to be reliable, LVW Advisors bears no responsibility whatsoever for any errors or omissions. Additionally, please be aware that past performance is not a guide to the future performance of any manager or strategy, and that the performance results displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future. Therefore, caution must be used in inferring that these results are indicative of the future performance of any strategy, fund, manager, or group of managers. An investment involves risks, including the risks of losing some or all of the invested capital and liquidity restrictions as defined in the offering documents. All performance numbers shown herein are net of actual fees and expenses and include the reinvestment of dividends and other income, as reported by the manager and/or by the commercial databases involved. THIS IS NOT AN OFFER TO SELL OR THE SOLICITATION TO PURCHASE AN INTEREST IN THESE FUNDS. Any such offer can only be made by means of a confidential private offering memorandum which any investor should review thoroughly prior to investing. Index benchmarks contained in this report are provided so that performance can be compared with the performance of well known and widely recognized indices. The volatility of these indices may be materially different from that of the fund. You cannot invest directly in an index. Index results assume the re investment of all dividends and interest. In addition, the fund's holdings may differ significantly from the securities that comprise the index. Moreover, the information provided is not intended to be, and should not be construed as, investment, legal or tax advice. Nothing contained herein should be construed as a recommendation or advice to purchase or sell any security, investment, or portfolio allocation. Any investment advice provided by LVW Advisors is client specific based on each clients' risk tolerance and investment objectives. Please consult your Advisor directly for investment advice related to your specific investment portfolio.