A huge number of exits, and the record amount of dry powder
secondary investors hold, are driving up private equity secondary market
prices, raising concerns about what the future holds. Researchers at NYPPEX
LLC, a based private equity secondary market brokerage firm, expect a price
correction of 5% to 7% in the private equity secondary market sometime in the
second half of this year. The problem is that investors are failing to
appropriately price risk.
At least $37 billion of unspent capital commitments exist in
the private equity secondary market, NYPPEX officials estimate, with a crop of
new buyers — including sovereign wealth funds and new private equity managers
that specialize in the secondary market — driving prices ever skyward.
Meanwhile, many firms are piling debt onto their positions in private equity
fund limited partnership interests, adding more leverage to an already
leveraged investment.
At the same time, the spread between private equity funds on
the secondary market and U.S. government bonds is the tightest since 2007, said
Laurence G. Allen, managing member of NYPPEX. This tight spread between
high-risk and low-risk assets is one indication that there is bubble in the
private equity secondary market, leading to a market correction later this year.
In the first half of this year, for example, the secondary
high price of private equity fund-of-funds limited partnership interests was
104.15% of net asset values, up from 83.09% as recently as of Dec. 31.
"Leverage is
back'
Neil Campbell, global head of alternative investments of
Tullett Prebon Alternative Investments, said a correction won't happen until
the IPO market and capital markets cool down as prices have been driven up by a
huge number of exits and dry powder. But the markets are not without risk.
NYPPEX executives are not the only ones to notice the high
prices. Institutional investors are eager to sell on the secondary market, but
not so ready to buy. The State of Wisconsin Investment Board which
oversees $104.1 billion, is selling to take advantage of the high prices. SWIB
has been selling a portfolio of legacy private equity limited partnership
interests valued around $203 million, according to information released at a
June SWIB meeting. Mr. Drake declined to comment on the sale. Wisconsin had
$6.3 billion in private equity as of Dec. 31.
Indeed, volume on the private equity secondary market was up
33% in the first half of 2014 to $16 billion, according to a report from Setter
Capital Inc., a brokerage firm in Toronto.
In the first half of this year, pension plans were the most
active sellers on the secondary market, accounting for 25% of sales. Secondary
market funds were the most active buyers in 71% of transactions, according to
Setter Capital. The private equity secondary market is awash in capital that
has to be invested now.
Large funds
Managers of secondary market funds have been consistently
raising large funds. They closed on a combined $57 billion as of July 31, up
from $42 billion three years ago, according to data from London-based
alternative investment research firm Preqin. Private equity secondary funds
raised a combined $14.8 billion through July 31, compared to $20.8 billion
raised by 23 funds in all of 2013.
Preqin estimates that as of July 31, the 10 top secondary fund
managers had $40 billion of unspent capital to invest. And all this capital
that the secondary market managers have raised has to be invested in a certain
amount of time. Of the $11.3 billion in private equity purchases on the
secondary market in the first half of 2014, 73.1% were leveraged buyout funds,
according to Setter Capital's report.
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