Creative thinking in secondaries

David Atterbury, managing director at global private markets asset manager HarbourVest Partners, analyses the trends and developments in the private equity secondary market

Boston-based private equity firm HarbourVest Partners is one of the world's largest private equity asset managers. Here IFLR speaks with its London-based managing director David Atterbury. In 2016, the fund acquired the portfolio of SVG Capital after a fraught battle – the deal won the IFLR private equity deal of the year award at the IFLR Europe Awards 2017. It sparked a lot of media debate as it was launched as a hostile bid under the UK Takeover Code before switching to an asset deal: a secondary acquisition of SVG's investment portfolio. It also had a dramatic impact on the sleepy world of listed funds. Atterbury explains the way the secondary market is influencing private equity and the broader M&A market.

The private equity asset class as a whole is growing as investors globally look for ways to enhance returns in their broader portfolios in the current environment. Existing investors are increasing these allocations as they look at the returns that private equity has generated for them over past years (when you look at the long-term performance of the asset class there is a clear outperformance, certainly relative to the public markets). The asset class is also generating increased appetite from different types of investors.

One likely development going forward is greater penetration from retail-type investors, whether it be through the high net worth end of the marketplace via banks and intermediaries, who put their high net worth channels into private equity, or through defined contribution pension schemes, such as 401(k)s in the US, or other such plans in the UK.

The secondary market has played an increasing role in the growth of private equity. People have historically thought about private equity as an illiquid asset class, and certainly it is a long-term asset class given the nature of the underlying investments, but the illiquidity also comes from the fund structures that are typically used. The secondary market has gone some way to improving liquidity in this market, enhancing people's ability to move in and out of private equity holdings and realise their investment or their entire portfolio before the natural long-term realisation of their investment takes place. It has breathed some maturation into private equity in the form of increased liquidity.

There is also a whole spectrum of risk-return profiles within private equity, and secondary funds have a role there too. Secondaries have demonstrated the ability to provide very strong returns with good downside protection. If you look at the numbers, secondary funds have very low loss ratios and typically deliver strong IRRs (internal rate of return) for investors. Therefore they have a place within any broader private equity portfolio.

The secondary market has grown dramatically in recent years as investors have seen strong returns. The increase in allocations and thus capital available to invest has added to the level of competition for deals. We have seen smaller, more niche secondary groups spring up and at the same time, the more established players have increased in scale and raised larger funds. When it comes to larger deals, we have also seen some of the sovereign wealth funds or large pension funds becoming more active in pursuing deals directly. It is fair to say the market continues to be dominated by the same 5 or 10 large managers that existed 10 years ago, as we have not seen many new competitors of real scale. We have also seen increasing levels of specialisation.

One likely development going forward is greater penetration from retail-type investors

The secondary market has traditionally been dominated by fairly straightforward transactions with a secondary buyer acquiring an interest in a private equity fund from the original investor. That remains a big part of the market today, but it has become ever more competitive and with an associated upward move in pricing. What a limited number of secondary players have done is look for other ways to access private equity portfolios on the secondary market and find different ways of unlocking those assets. We consider ourselves at the forefront of that.

HarbourVest's secondary fund's acquisition of the investment portfolio of SVG Capital in 2016 is a prime example of moving outside the mainstream and looking for other ways of accessing portfolios of private equity assets. Those more complex opportunities have fewer competitors and therefore, we believe, present more fertile hunting ground.

What's more, it is not just about buying limited partnership interests in funds, the fundamental way in which we add value as a secondary buyer is by providing solutions that meet the seller's needs and allows us to create a compelling investment opportunity. For example, we have increasingly been working with funds and with general partners at the tail end of their fund's life to provide liquidity across an entire portfolio of investments as an alternative to a fund manager selling its companies one by one. That is providing more of an efficient and timely end to an older fund.

Over the years regulatory change has been an important driver of deal flow; whilst banks and financial institutions have always been a significant portion of the sellers into the secondary market, more recent regulatory change post financial crisis has placed even more pressure on them to sell. To a certain extent though, that pressure has softened in recent years. The banks slowed down their selling activities as some of the regulatory changes were pushed back, but as those deadlines come back into view, then the banks will likely come back to the market with a motive to sell, albeit having already sold a large part of their legacy assets.

I do not think there is much else in the form of specific regulatory change that has driven deal flow. Regulatory change always creates a level of uncertainty and that can catalyse opportunities for us. Aside that wave of bank sellers as mentioned before, our deal flow in recent years have not been based on regulatory changes. What we have seen over the last two or three years in terms of deal flow are many of the more complex deals I described before, working with fund managers to manage out their end-of-life funds. An example is HarbourVest's deal with Motion Equity Partners in Paris in 2013 – that was a fund nearing the end of its life.

This part of the market has gone from strength to strength and we have seen an increasing number of high quality fund managers look to provide solutions of this type to their investors. This is gratifying to see as some of the early deals completed in this space generated some negative attention and there was talk about potential regulation. The industry though has worked very hard in recent years with much greater transparency for all stakeholders involved and there is clearly a best practice as to how these deals are done.

There is a question in the US with the Volcker rule [which limits banks' total investments in private equity and hedge funds to 3% of their core tier 1 capital and individual investments in a fund to 3% of the fund's assets] and whether there will be a pull back in terms of implementation, which ties in with my comments above on deal flow. In terms of managing our own business, the Markets in Financial Instruments Directive II (Mifid II) and the Alternative Investment Fund Managers Directive (AIFMD) have had an impact on our day to day business – the structure of the funds we manage, the disclosures that our clients have to make, and the reporting we provide to them – rather than being a driver of our secondary investment activities.

Changes such as AIFMD and Mifid II create challenges for us in terms of managing our business, given the number of countries in which we operate and our local offices. This has a knock-on effect for our processes and systems as we strive to deliver best in class information to our clients. These types of change have led to growth and increased investment in that part of our business. .

The other obvious challenge being here in London is Brexit implementation and its impact on our business in the future. Clearly, this is something we are actively considering as we look at the next three years of business.

I think this was the first time a secondary transaction moved over from the private equity press into the broader financial news. Our funds previously closed transactions with two large publicly-listed fund-of-funds vehicles (Absolute Private Equity and Conversus Capital), but I think the SVG deal was propelled into the limelight as it took the market by surprise and as SVG was a high profile UK name in listed private equity. Then interestingly, SVG moved the focus from looking for a competing bid to our fund's share offer to trying to sell the underlying assets and the underlying portfolio – the other potential buyers that emerged were large quality institutions and this demonstrated there was some serious 'smart money' interested in this deal which kept it in the press. It was not just the fact that the SVG board went down that route, but also the fact that our deal team was able to change approach and move from a share offer to an asset deal in a very expeditious fashion that kept the media interested for quite a period of time.

The listed private equity space is not a big space. Several vehicles, post-financial crisis, have changed strategy and gone into liquidation mode, driving the absolute number of publicly-traded private equity vehicles down. The SVG deal certainly put the sector back on the map, especially with several blue-chip organisations chasing the assets. By virtue of what played out with SVG it illustrated that it is not an easy thing to do. I am not sure you are going to see a whole wave of deals that look like this.

The secondary market by definition is largely opportunistic. We have to look at where assets are available for sale. Part of the challenge has been that private equity has been very cash generative for investors for a number of years and there is not a great deal of pressure for long term holders of private equity to sell big portfolios. What we are seeing in the marketplace now is people using the secondary market to rationalise or restructure their portfolio, sell older managers and redeploy capital. We think the focus of the market will continue in the same vein.

This means that the average age of the assets sold in the secondary market has gone up. There are more tail-end portfolios and there are groups that are focused around tail-ends. The other big area of focus, and certainly for us, are those end-of-life transactions where we are working with fund managers on 'whole fund liquidity solutions', as we call them. This involves approaching a general partner or manager of a fund in year eight, nine or ten, and making a proposal to provide a liquidity solution. It is estimated that funds over 10 years old hold more than $100 billion of assets and there is an opportunity for the secondary market to come in and work with such funds and either acquire assets, or offer to buy out the underlying investors, or create a hybrid of that.

The obvious one as an investor is pricing. In the more mainstream traditional secondary market place it is clear that pricing is key. That part of the market is very competitive which has put pressure on the targeted returns for many secondary buyers. We are focused on the more complex end of where we the market can see more value.

About the author
		David Atterbury HarbourVest London, UK T: +44 (0)20 7399 9820 W: www.harbourvest.com David Atterbury focuses on European secondary investments. He joined HarbourVest in 2004 and has led a number of European secondary transactions, including Absolute Private Equity and SVG Capital. He currently serves on the advisory boards of funds managed by Abénex Capital, Bridgepoint Development Capital, Clyde Blowers Capital, Magnum Capital, Motion Equity Partners, and NewQuest Capital Partners. Atterbury joined HarbourVest after five years with Abbey National Treasury Services, where he was director of private equity. His previous experience also includes five years with PricewaterhouseCoopers. Atterbury received a BSc (with honours) in International Management and French from the University of Bath in 1994, and qualified as a Chartered Accountant in 1997.