The Pursuit of Liquidity Management on the Secondary Market
Neil Campbell, Head
World financial markets are back at or ahead of levels last seen in 2008 before the credit bubble burst. This surge has somewhat eased the liquidity woes of hedge funds and private equity managers, as well as their investors. The question now is how much more is there to go?
By industry estimates, we have only scratched the surface — over $100 billion worth of impaired assets remain, despite the market rise. Tens of billions of dollars, for instance, are still log jammed in side pockets — special liquidating vehicles and their ilk devised in late 2008 in response to spooked investors and parched financial markets. What lingers in these constructs is quixotically marked and arguably, didn’t really belong there in the first place. Chances for quick exits here remain elusive and could prove disappointing for general partners and investors alike.
From late 2010 however, mega buyout private equity funds and a handful of venture capital names appear to have turned a corner, at least for now. Thanks to the rebounding initial public offering market, prospects for asset-level exits look upbeat for the first time in over two years. Not surprisingly, GPs are upping their marks, some quite meaningfully, for the final three months of 2010. For limited partners seeking liquidity, there is good news as pricing has risen to par or premium. So it certainly makes a lot more sense to sell now than it did during the prevailing lows in 2009 and most of 2010.
But the same point cannot be made about the rest of the alternatives universe. Barring some outliers, most fund operators, particularly of the mid 2000’s vintage, continue to grapple with problematic, overleveraged legacy investments. Some GP’s are selling down assets at discounted prices in order to free up their capital even as many others are holding on to their inflated valuations. LP secondary interests continue to move in the 20 to 30% discount band, which while still deflated are way off their lows.
Thanks to all of this, the secondaries marketplace is well positioned to improve on transaction volume from last year – both for asset-sales and limited partnership interests. For hedge funds, panicked selling marked 2009 while measured exits for portfolio management drove traffic in 2010. We expect side pockets and liquidating funds to remain the active theme for buyers this year. For private equity and real estate investors, especially public pension funds, political and fiscal catalysts will drive the trend toward sales to meet funding shortfalls.
Certainly, sellers are coming to the table with realistic hopes of transacting certain positions at improved prices, and they aren’t altogether disappointed with what they are seeing. The market has shifted quite a bit from the dark days of 2009, when both investors and managers were in survival mode. Now, funds of funds appear more intent on cleaning up their rump positions, which post-harvests are even more illiquid than before, in order to get back to capital raising with a clean slate.
And as supply rises, so are ranks of buyers. Increasingly, private equity specialists have become buyers of hedge fund side pockets, which isn’t surprising given the exotic and long term nature of the investments they contain. Additionally, existing LPs, especially institutions, also have been keenly topping up their stakes, availing the discounts that are still to be had, albeit only on what’s truly illiquid. What’s more, certain multi-strategy managers have become selective buyers of secondaries too. Some have even carved out a sliver of their capital base for such investments. Yet with the period for low-hanging fruit clearly over, buyers’ Internal Rate of Return expectations could be in for a reality check.
For the first time post 2008, certain arcane strategies are showing signs of life. Specialists are slowly warming up to asset-based lending funds, insurance linked securities and trade finance. Yet the problem with most of these esoteric strategies, including too much leverage, is not over yet and this continues to depress prices. Another space seeing increasing buy/sell traffic is legal claims linked with litigated bankruptcies, including those associated with Bernard Madoff and Thomas Petters. So far, buyers had shunned these targets, even at fire sale offer levels.
Still, some are concerned about oversupply, which could result in falling prices. For certain niche hedge fund strategies such as Asset Based Lending, this could turn out to be the case. However, for both side pockets and ongoing funds of top-tier hedge fund GPs, demand has outstripped supply even as pricing is mostly still short of par.
In buyouts, could there be a supply glut in the short run? Not for the sought after names. This is pushing their prices higher. That said, it remains to be seen if this pricing trajectory is sustainable given the relatively wobbly global recovery. Indeed, a handful of private equity secondaries buyers are already reining in their demand, citing market froth.
With all eyes still on the economy, both GPs and LPs will continue to press on in their pursuit for liquidity via secondaries. This is creating healthy buy/sell opportunities in the marketplace. Interestingly, hedge fund secondaries have grown in acceptance and sophistication and in time, they look to gain as much legitimacy as private equity secondaries.
Neil Campbell is the head of alternative investments at Tullett Prebon. Campbell has over 20 years of experience in establishing institutional sales desks for OTC markets as well as allocating risk to alternative investment managers.