The typical transaction on the private equity secondary market is valued at 102.5 percent of net asset value in terms of mean, with the median at 101 percent, according to a Palico survey of limited partners who’ve successfully purchased stakes in closed funds over the last six months. This is the highest pricing Palico has recorded since we began tracking secondary transactions in March 2017. This latest survey covers 30 funds of all types from real assets to private debt, buyout and venture.
Most Funds Were Sold as the Stock Market Declined
Some 47 percent of the funds covered in Palico’s survey were sold prior to September 20, the S&P 500 stock index’s high before the recent correction. Remarkably, despite lower pricing for the publicly quoted comparables of underlying portfolio companies, Palico notes no discernible shift away from pricing at par or better for the funds sold after September 20 (secondary funds are priced off trailing quarterly net asset values). The disconnect between what remain analysts’ relatively lofty expectations for earnings growth for both publicly quoted and private companies and the recent stock market drop accounts for much of the stability seen in private equity secondary prices. Other apparent factors include the record amount of committed but unspent capital devoted to secondary funds – some $94.25 billion according to a recent report from Pitchbook – and the increasing use of leverage in secondary transactions. The same Pitchbook report notes that debt accounted for 23 percent of secondary market volume in 2017, compared to 19 percent in 2016 and only 4 percent in 2013. Leverage increases buyers’ potential return, allowing them to offer sellers more attractive pricing than would otherwise be the case.
Both Premiums and Discounts Reflect Attractive Pricing
Funds selling at par or better show an average premium to net asset value of 8 percent. The average discount to net asset value for funds selling below par is some 7 percent – a relatively narrow discount historically. Attractive pricing and the record sums of capital earmarked for secondary investment likely resulted in a record year for secondary volume in 2018. Final tallies are not in, but early estimates forecast total volume for 2018 to reach or exceed $75 billion which far exceeds the previous year’s high of $58 billion.
Gap Between Young and Old Portfolios Reflects Relative Potential
Of particular note, funds selling at a premium have an average age of 5.1 years versus 8.5 years for funds selling at discount. The significantly younger age of funds selling at par or better versus those sold at discount is logical. Older funds typically have more limited upside than younger portfolios. On balance, older funds also hold fewer companies, with so-called tail-end vehicles – funds that closed fundraisings ten or more years ago – frequently holding just one unrealized investment in their portfolio. Holding fewer investments increases relative risk compared to more diversified portfolios. So-called early secondaries, vehicles that closed fundraisings within the last three years, not unsurprisingly trade on average at a significant 14.8 percent premium to par, reflecting their appreciation potential. Tail-ends trade at an average discount to par of 6 percent.
Non-Traditional Buyers are Another Factor Behind High Prices
The rise of non-traditional buyers is another development that’s contributing to high prices. In August, Palico estimated that non-traditional buyers amounted to some 22 percent of secondary market transactions in 2018, up from just 4 percent a decade earlier. Such buyers encompass family offices, insurers, sovereign wealth funds, endowments, foundations and pension funds who historically focused on primary fundraising yet who are increasingly drawn to secondary transactions. The appeal of buying on the secondary market is a shorter time frame for receiving fund distributions from the sale of portfolio companies and less risk than in primary investing, where investors commit to a blind pool rather than to a portfolio of investments that can be analyzed (the case with secondaries). For non-traditional buyers another draw is exposure, or the ability to dial-up exposure, to fund managers they have found appealing as primary opportunities. In contrast to market specialists – secondary funds, funds-of-funds, and a range of in-house experts at what are usually very large institutional investors – non-traditional buyers take a more primary -minded approach to investment in secondaries. This means they put greater accent on potential appreciation, while specialists focus more on current net asset value, near-term liquidity and the ability to buy at discount.