Liquidity may have been hard to come by for PE investors in the 90s, but almost thirty years down the road it has become a demand. Regardless of the numerous reasons LPs have cited for selling their stakes, one thing is clear, they are less eager to wait for returns. So one can ask: are LPs going schizo? They’ve been investing in the PE market for years knowing of its illiquid state and 10-year plus lifecycles, so is waiting a lost art? And especially, what is fueling their growing desire to cash out?
Market Evolution: the everlasting role of Cash
One thing is clear, the secondary market is by no means the complex niche it used to be. The once nascent pawn shop around the corner, mostly driven by distress, is rapidly becoming a $100bn a year auction house, making it easier to navigate, allowing investors to differentiate investment strategies and manage portfolios. The main reason for entering the market remains the need for liquidity. With the average fund being dragged out between 11 to 15 years, the assumed exit and pay out 7-10 years down the line seems like a distant reality. As an example, a key insight from Pitchbook highlights that nearly 53 percent of funds from 2004 are still active.
Volume seems to be partly driven by investors looking to cash out before the economy potentially weakens. In the event of a downturn one thing is certain, cash is king, and LPs holding onto stakes with little to no value may look to get out. On top of the multitude of single stakes being sold to cash out, the recent uptick in sales of billion-dollar portfolios may be another indication of larger LPs looking to rebalance their positions. Divesting from one asset class to re-invest in another is a significant part of these massive overhauls, but one doesn’t barter VC fund stakes with LBO fund stakes, as PE swaps have not been invented yet. As shells or beads have been replaced 4000 years ago by shekels, it has to go through cash, the one currency that controls them all – economy 101.
Market Dynamics: the impact of Supply and Demand
Pricing has been high recently, the reason behind is that the secondary market has attracted a wealth of buyers, creating the conditions necessary for a sellers’ market and giving LPs the ideal medium to find liquidity and mitigate risk. Is this a sign of LPs looking to reduce exposure to the asset class before the longest running bull market hits a wall? No, as PE fundraising will also hit a record this year, especially for Secondary Funds, now sitting on around $90bn of dry powder, and for whom raising capital is currently easier than getting candy on Halloween night.
Although competition is up, and sellers are coming in droves, what may be the biggest take away from a highly active secondary market is its ability to give a true value to PE funds. With top funds being bought and sold on the market, sellers can actually see what buyers are willing to pay. Jim Strang of Hamilton Lane recently noted when speaking at a seminar in London that with “the top 20 funds in Europe you can almost look at [them] like a stockbroker. There’s a bid and ask spread for these things, which there never used to be in the past.” Where this new-found transparency in pricing may be giving GPs a bit of a headache as they try to finesse fund performance with IRRs, it is opening the eyes of owners. Players in the market may be buying and selling more freely and opportunistically given the real market value placed on funds.
Changing the Paradigm: a new Dawn
Large restructurings have flocked to the market. Since August there have been at least seven transactions of portfolios worth more than a billion dollars and as sellers look to finalize deals by the end of the year, 2018 is guaranteed to be yet another record-breaking year according to PE Hub Wire. With GPs now helping their LPs restructure their portfolios, in the first half of 2018 alone, such transactions already accounted for 26 percent of all secondaries and are expected to hit 40 percent by end of year, ie 10 percent more than in 2017. Considering the lengthy lifespan of funds which continue to age and with long-term funds becoming more popular, liquidity will only grow in importance. This may mark the beginning of so called “liquidity windows” being added to LPAs in order to give investors a clear path to exit multiple times throughout the duration of a fund. Helping LPs get out, and in the meantime finding staple investments from new ones is in the end a massive win-win, illustrated by the equally growing number of single stakes sold by GPs. Considering new market conditions and the ever increasing need to differentiate oneself from the crowd, providing sales and restructurings could even become part of new fundraising strategies. A duty for their LPs? Maybe. A “Liqui-Duty”, certainly.
Private equity is far from providing the liquidity public markets do. However, with the secondary market having reached record levels, and given the newfound flexibility of GPs and rising demands of LPs, private equity is starting to make liquidity commonplace for a historically lock-in asset class. LPs today aren’t schizo, they are just enjoying the benefits of favorable market conditions which have given them easier access, in and out, increasing their options to arbitrage and reducing their underlying risk.