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Secondary Prices Take a Tumble

Emerging Private Equity

July 2008
 

With a 78% leap in emerging market PE fundraising last year (up to US$59 billion), secondary investors and intermediaries are preparing for an increase in deal flow in this space.

Emerging markets exposure is already becoming an accepted part of the secondary landscape, as Thomas Liaudet, principal at Campbell Lutyens, which acts as an intermediary on secondary sales, explains: “More and more frequently we see an emerging markets component to portfolio sales. And we see a bigger component of emerging markets funds in the portfolios. We feel this is because we have seen more and more funds raised for emerging markets and the secondary market is a derivative of the primary.”

The increase in private equity fundraising has been across the board but has arguably been dramatic in the emerging markets space because of the absolute and percentage increases over the past three years. And for the fact that these have been felt across all emerging markets.

Indeed, despite the short history of the bulk of private equity funds in India and China, some analysts already question whether these two countries – that have to date, received the bulk of emerging market attention – can any longer be classified as emerging markets. This is because of the volume of funds now operational, which means there is, in theory at least, real choice for institutional investors wishing to access these markets. Although this crude assessment ignores the development of the legal and regulatory framework in these countries and indeed whether or not a significant enough number of funds will be able to progress to second and third generation funds.

Deals to Date

“Historically we saw emerging market interests being sold by institutions as part of larger portfolios, and these larger portfolios often included fund assets from more mature markets. We started seeing emerging markets portfolios in the 1990s, and these grew in significance from 2003 onwards,” says Elly Livingstone, partner and head of global secondary investors Pantheon Ventures.

Peter Wilson at HarbourVest says: “Our overall take on emerging markets is two-fold. In the period 2000-2006, sellers in the emerging markets, by which I mean primarily Asian investors, were typically selling developed market ‘product’, ie LP interests in funds based in the US or Europe. Now what’s happening is those very same investors are building out emerging market GP groups in Asia and Australia, so that when the next wave of selling occurs, it will include emerging market funds themselves.”

The inference being that in time those Asia-based investors will dip into the secondary market for the same reasons as others; portfolio rebalancing, housekeeping and possibly in time for over-exposure reasons.

Wilson is excited by the prospect of what emerging markets might yield in the mid-term. He says: “In the next three to five years, lots of interesting product will come out of the market from Asia, Central Europe, Russia and Latin America. I believe there will be a lot of money to be made in emerging market secondaries in the years ahead, and it will be a very interesting place to be. But it’s not for the faint of heart. We will be out there, but with our crash helmets on!”

Like others, he notes that the potential of emerging markets is enhanced by the lack of intermediation in this market, meaning transparency is an issue that investors experienced in these jurisdictions are perhaps best placed to tackle.

Important to note, however, is the increase in emerging market private equity fundraising over the past three years. In 2005 the figure was US$25.7 billion (up from US$6.4 billion the year before), in 2006 it was US$33.2 billion and in 2007 US$59 billion. This helps to explain Wilson’s three to five year timeline as this puts the secondaries as fully invested portfolios at 5+ years of age where proper analysis of the underlying investments can be undertaken.

Although deals will doubtless crop up in the nearer term, there are likely to be fewer sellers from the pre-2005 fundraising period as a good proportion of this money will have come from government agencies and FDIs that are unlikely to sell. These FDIs have continued to place vast sums in emerging private equity markets like Africa and that too may lead to a slight distortion in the expected secondary deal flow.

Pricing

Since the credit crunch, pricing in the secondaries market for private equity funds has become subject to the same pressures on pricing elsewhere. Kelly De Ponte at Probitas Partners says: “For most of 2006/2007, well established buyout funds were trading at NAV or a premium to NAV. The uncertainty in the market has bought pressure on those transactions and they are now selling at a discount.”

As pricing has come under pressure and started to dip, instead of sellers falling away, there has been something of rush to exit. Given the acceptance that the US is in recession; (as 1Q2008 drew to a close, the question being asked in the US moved from; ‘are we in recession?’ to ‘how long will this recession last?’) sellers, aware that the term recession is not applied to a few bad months and that the market is likely to experience sustained price drops over a year or more, are piling in now to maximise their chance of optimising their exit price.

Wilson at HarbourVest says: “We are seeing an increased level of deal flow; 1Q2008 was almost twice what it was in 1Q2007. That is, however, deal flow, not closed deals! The first quarter is typically the slowest quarter of the year as buyers and sellers wait for the 31 December valuations to come out in the second half of February and then in April/May time in their final form. We think it will continue to be a busy year.”

Wilson’s point that deal flow, not closed deals, has risen is causing most of those active in the secondary space to predict that there may be few deals closed before the tail end of this year. This is simply a function of the mismatch between sellers’ and buyers’ expectations. Secondary buyers have already priced in market uncertainty while sellers have yet to see several consecutive quarters of falling NAVs in their portfolios and so tend to stick with the view of their historic rather than future worth.

Future worth may be bought into sharp relief sooner rather than later for some. “High yield bond defaults are forecast to rise steeply in 2008. Of the weakest credits in the high yield bond market; 50% of those are portfolio companies of buyout funds,” says De Ponte.

Emerging market private equity funds for the most part will be unaffected by such woes given that there is little debt (outside some of the larger pan-Asian buyout funds) in these deals and what is there tends to be sourced outside the international credit markets. The as yet unanswered question vis-à-vis emerging markets, however, is how insulated emerging markets will be from a full scale US recession, especially one that tips into Europe too.

“My guess is that we will see more secondary transactions (with an emerging market component) take place over coming months. We are seeing some such transactions coming through but depending on where the markets end up going it seems probable that more sellers may emerge; there will be a little bit of hesitation while people try and work out what’s happening,” says Simon Goodworth, partner at Covington & Burling, which has been an active legal advisor in the secondary space for more than a decade.

Liaudet at Campbell Lutyens says: “People do have appetite for emerging markets exposure. The main issue is that the buyers have very little knowledge of some of those managers and it will be hard for buyers to assess the underlying companies because, although there is more appetite, some buyers still lack the ability and knowledge to value the assets properly.” This has been the curse of some portfolio sales with an emerging market component to date, where buyers’ uncertainty and unfamiliarity leads to a ‘no hope’ bid being applied to that component. Intermediaries have been creative in their attempts to eradicate this problem; primarily by joint bidding with developed and emerging market LPs, the latter being interested in bidding for the emerging markets component.

The good news on pricing though is that all practitioners agree top tier GPs will continue to see their secondary positions trade at NAV or higher. This is just as true for the emerging market private equity funds as it is for ones in developed markets. “Today a lot of LPs want to increase their allocation to emerging markets; it’s difficult because you have to create relationships but you can gain access to managers through a secondary sale. We have seen secondary players that have told us, ‘we like that fund and if you come across (a secondary sale in their fund) tell us!’” says Liaudet at Campbell Lutyens.

The traffic flows both ways, with GPs also seeking to have any secondary positions in their funds sold to LPs that have a genuine interest in committing to follow on funds that the firm plans to raise in the future.

Goodworth at Covington Burling says: “I have noticed slightly more ‘stapled’ transactions over the last couple of years. Some GPs are looking for opportunities to secure investors or money for the next fund that they will be raising. One way of doing that in the context of secondaries is by trying to get purchasers also to commit, in principle, to investing in their next fund.”

Down the Road

“For the secondary market in emerging markets, there are two different ways in which things could happen. If you have a major upset in emerging markets, like the Asian Crisis in 1997, we could have increased in activity in secondaries, which would be bad thing. A spate of secondary activity in way that would be good is that secondary activity grows slowly and naturally through things like rebalancing of portfolios,” says De Ponte at Probitas Partners.




This article first appeared in emerging Private Equity’s May/June 2008 issue. For more information, please visit http://www.emergingpe.com.



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