Q1 2019 - Secondary Private Equity Market: Offering Flexibility amid Brexit

Published: Feb 19, 2019
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Amid the uncertainty over Brexit’s outcomes and challenges in the British economy, the U.K. private equity (PE) market remains strong. PE returns have been steadily increasing and have demonstrated “significant levels of stability,” the last data from the British Private Equity and Venture Capital Association (BVCA) show.

But for investors wary of Brexit’s looming uncertainties, a more adaptable alternative exists: the secondary PE market.

PE investors have been careening toward the secondary market, where they can buy and sell assets before the end of a PE fund’s traditional ten-year term. Investors traded $36.7 billion in the more liquid secondary PE transactions in the first half of 2018, up by 26.2% from the same time last year, according to secondary market brokerage firm Setter Capital.

As investments in secondary markets tend to be more liquid, the market for secondary PE investment in the U.K. is set to expand, especially for investors who have been timid in allocating more investment in U.K. funds over fears around Brexit.

The secondary PE market provides a quick escape during ominous foreign exchange swings, which have been a staple for the sterling since the Brexit referendum in June 2016. The pound plunged to $1.2659 — the weakest it’s been since June 2017 — on December 4 as the House of Commons debated on Brexit. But on December 5, it rebounded to $1.2777 as Parliament signaled the impossibility of a no-deal Brexit.

Whichever direction the pound ticks, investors in the sterling-denominated secondary private equity have the leverage to deploy — or relinquish — their shares at the right moment. A weaker sterling, for instance, would attract overseas investments in U.K. funds.

There are two ways investors can engage in the secondary PE market. First, one can invest directly in an operating company or portfolio of companies from another investor who seeks liquidity — also known as a direct interest purchase. Second, a pre-existing investor in a limited partnership can sell their shares to another investor — also known as fund interest purchase.

Secondaries, traditionally the preferred investment among limited partners who seek liquidity, have also gained traction among general partners, according to a Blackstone Group report. The secondary market not only allows general partners to scout for buyers’ interest in primary investment, but also serves an opportunity to enhance their limited partner base, the report said.

More Flexibility, Risk-Weighted Returns

Two decades ago, secondary PE’s reputation was marred by sellers on the rush to dispose of their assets and significant discounts. Today, secondary PE investments are well-received among asset managers, as they provide more fluid cash flows, a more diverse portfolio and easier portfolio monitoring.

Secondary PE investments also tend to have lower risk — with potentially more attractive returns, according to a report by PE firm Coller Capital. By tapping into more mature funds, investors have the ability to mitigate the likely period of negative returns during the investment’s early stages, the report said.

With PE firms establishing new offices and relocating people as Brexit looms, investing in U.K. secondary PE investments would help mitigate foreseeable negative exposures. Among the industries entangled in the quagmire are highly regulated sectors such as pharmaceuticals, aerospace and industries reliant on shipping. But a secondary investment into those industries’ funds, having matured past their early stages, could potentially still bring risk-adjusted returns.

In the U.K., medium-term PE investments have performed better than their long-term counterparts, BVCA said in a report. Five-year investments in the 310 firms surveyed by BVCA resulted in a 327.8% per annum internal rate of return (IRR), which is an annualized rate of earnings in an investment. Meanwhile, the traditional ten-year investments in those same firms yielded a 290.8% IRR.

U.K. private-equity investors also seemed to have shrugged off their concerns surrounding Brexit. Foreign investors have been keener to strike deals as the pound dips, the Financial News reported October 12. From July 1 through September 30, buyout and growth firms invested in 65 U.K. companies, the report said, citing analytics company Dealogic. The number rose by about 14% from the same time last year.

In contrast, other parts of Europe saw a decline in the number and total value of deals. Investors struck 176 deals worth $37.57 billion across Europe from July to September—down from 189 deals worth $44.17 billion the same time last year, Dealogic data show. With U.K. investments over-performing those of the continent, the U.K. secondary PE market is set to grow — and be more competitive.

Regulatory Reforms

But even without Brexit, secondary investments in PE are robust thanks to post-crisis banking regulations.

During the global financial crisis of 2008, investors treated private equity secondaries with caution, as their bid-offer spread widened. But as the spread narrowed afterwards, the secondaries’ transaction volume surged. Financial institutions partly drove the rally in investment as post-crisis regulations limit banks’ ability to invest in funds.

Under the Bank of International Settlements’ Basel III, for instance, banks must meet minimum capital requirements and proper leverage ratios. And under the United States’ Dodd-Frank Wall Street Reform and Consumer Protection Act’s Volcker Rule, banks are prohibited from investing in private-equity funds in most circumstances.

Thus, secondary private-equity investment will still warrant its own robust market, especially in the U.K. — even through the tides of Brexit.

Asset Management Intelligence – Q1 2019