Private equity unrealised assets – a secondary market solution?

December 2015 | SPECIAL REPORT: INVESTMENT FUNDS

Financier Worldwide Magazine

The issue of unrealised assets in mature private equity funds is one that transcends the secondaries market, and is of increasing concern for LPs and GPs alike as boom year vintages approach the end of their lifetime. This trend of ever maturing funds unable to fully realise their assets is occurring in tandem with a growing secondary market that has seen record fundraising and transaction levels in recent years. No longer a last resort for those investors seeking liquidity, the secondaries market now serves as a viable tool for the active management of alternative asset portfolios.

This article seeks to quantify the size of the task faced by GPs in coming years as they seek to disburse their assets and the opportunity this presents for secondary buyers. It also highlights the ways in which the secondary market is providing solutions to deal with remaining assets in maturing funds.

Unrealised value in tail-end funds

For funds raised in the boom years of 2005-2008, the issue of getting the maximum value from their remaining assets is pressing. Abundant capital and high prices in their investment years set the bar high to attain meaningful returns from assets acquired in that period. There remains around $115bn in buyout and growth capital funds with a 2005 vintage and older, while in venture capital funds that figure stands at $78bn.

The majority of these unrealised assets are in North America-focused funds; a combined $129bn, which accounts for 67 percent of the total. Another $44bn of unrealised assets are currently being held in Europe-focused tail-end funds. There are fewer unrealised assets remaining in older vintage Asia- and rest of world-focused funds, with an aggregate value of $13bn and $7bn respectively. These proportions are reflective of the pattern of historic fundraising, with North America-focused funds having garnered the most capital in the primary market, followed by Europe-focused funds.

The value of unrealised assets in funds with a 2006-2008 vintage is much higher, partly because these funds have yet to reach the end of their lifecycle, and will likely divest at least some of their assets before that point. In total, for buyout and growth funds of these vintages, there is $548bn in unrealised value, $196bn of which is in 2007 vintage funds. Venture capital funds of vintage 2006-2008, meanwhile, currently hold $133bn in unrealised assets. Even if distributions from these funds to their investors continue at current levels, it is likely that they will hold significant unrealised value at the end of their lifetime, which could lead to requests for fund extensions and LPs having to make a choice between holding on patiently for value to be realised, or seeking alternative options for immediate liquidity.

Secondary market solutions for tail-end funds

The secondary market can present many different opportunities for managers and investors looking to divest themselves of a fund or its assets. In some cases, the most appealing option can be a GP-led restructuring, wherein a secondary buyer takes on an entire fund. He can then offer LPs the opportunity to cash in their stake in the fund, or retain their investment. Typically, the buyer will make extra capital available for follow-on investments, so as to unlock the maximum potential for the unrealised assets.

These restructurings tend to be very much GP-led, with the manager engaging intermediaries to proactively find buyers for their fund interests. These processes tend to be pursued in tandem with the manager seeking to raise capital for a new vehicle, and so trying to find a solution for LPs in the older vintage fund. For the secondary buyer, assessment of the potential of underlying assets is a key part of its decision making, as is the ability to set new fund terms that re-incentivise the manager. With an increasing number of funds coming to the end of their lifetime with significant unrealised assets, this type of secondary transaction is on the rise, as managers look to launch new vehicles.

But restructurings are not the only means by which secondary buyers offer solutions to tail-end funds. Direct secondaries, where a buyer will purchase a portfolio of interests for companies in a tail-end fund, are also common. Some secondary investors are capable of such investments, but there are also an increasing number of private equity firms that pursue a direct secondaries strategy, utilising their experience in managing portfolio companies to pick out good opportunities, and maximise the value of assets.

The traditional ‘fund interest purchase’, where an individual LP sells its stake in a fund, also plays a part in providing liquidity for tail-end funds; the LP can cash in its interest before the fund is liquidated – albeit often at a discount to NAV. However, NAVs are high now, with strong stock market performance feeding through. Even with better performing managers (who are likely to command secondary prices close to NAV), an LP might decide to sell because it wants to reduce its administrative burden, or to alleviate the risk associated with the manager not realising investments soon. A healthy secondary market affords the LP with these options. For the secondary buyer, the price effect (purchasing at a discount to NAV) and distributions effect (with capital being returned quickly) make these investments particularly attractive. We profiled 85 investors that have stated an interest in purchasing tail-end funds, either through the traditional fund stake purchase route, or by participating in restructurings. Furthermore, there are 113 direct secondaries firms that seek opportunities to buy up portfolio companies in tail-end funds.

Secondary buyers remain very well capitalised given the fundraising success experienced in 2012-2014, which saw a total of $69bn raised by private equity secondaries funds. The largest 10 secondaries fund managers have $45bn available in dry powder, a significant amount of uncalled capital. This figure, though, is somewhat dwarfed by the total size of assets which could make secondaries opportunities. This illustrates the potential for further growth in the secondary market; especially as evidence shows that LPs and GPs alike have tapped into secondaries liquidity as an avenue to realising value in their more mature funds. Forty percent of funds involved in secondary transactions so far in 2015 were of a 2005 vintage or older, emphasising their importance to secondaries activity. The contribution of boom year funds to secondaries activity is also significant, as 43 percent of funds involved in transactions in 2015 were of a 2006-2008 vintage. Once regarded as a last-ditch attempt by investors to gain some value from a stake in a failed fund, the secondary market is swiftly becoming a permanent fixture of the private equity industry, allowing fund managers and investors more ways to manage their portfolios, and achieve easier liquidity in a notoriously illiquid asset class.

Patrick Adefuye is head of secondaries at Preqin. He can be contacted on +44 (0)20 3207 0327 or by email: padefuye@preqin.com.

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